RATIONAL CHOICE

THEORY
- Dr. Aashita Dawer
Preferences

 Economics portrays agents as choosing rationally

 Derived from ‘Folk Psychology’ - from beliefs and from a wide array of
motivational factors such as urges, emotions, habits, and commitments.
 particular set of cognitive capacities which include—but are not exhausted by
the capacities to predict and explain behavior - behavior represented in the
brain
 Desire vs. Preference
 choices not as mental determinations but rather as actions that arise from
constraints, preferences, and expectations(or beliefs)
 Economists typically take preferences to be predetermined or
 “given” facts about individuals and not themselves in need of explanation
 or subject to rational appraisal
Consumer Behavior

 Theory of consumer behavior gives an explanation of how consumers

allocate income to the purchase of different goods and services.
 Basic Assumptions

1. Preferences are complete

 Consumers can rank market baskets

2. Preferences are transitive

 If they prefer A to B, and B to C, they must prefer A to C

3. Consumers always prefer more of any good to less

 More is better
Consumer Preferences

 The theory of consumer behavior does not require assigning a numerical

value to the level of satisfaction.

 Although ranking of market baskets is good, sometimes numerical value is

useful.
 Utility: A detour

 A numerical score representing the satisfaction that a consumer

gets from a given market basket.
 If buying 3 copies of Microeconomics makes you happier than
buying one shirt, then we say that the books give you more utility
than the shirt.

Utility function is a formula that assigns a level of utility

to individual market baskets.
 Let the utility function, U(F,C) = F + 2C

Then a market basket with 8 units of food and 3

units of clothing gives a utility of 14 = 8 + 2(3)
 Utility : A detour

Market Food Clothing Utility • Consumer is indifferent between

Basket A & B and prefers both to C.
• Baskets for each level of utility
can be plotted to get an
indifference curve
A 8 3 8 + 2(3) = 14
• To find the indifference curve for
a utility of 14, we can change the
B 6 4 6 + 2(4) = 14 combinations of food and
clothing that give us a utility of 14
C 4 4 4 + 2(4) = 12 • We will return to indifference
curves…
WHAT THE CONSUMER WANTS

 A consumer’s preference among consumption bundles may be illustrated

with indifference curves (ICs).

 An indifference curve is a curve that shows consumption bundles that give

the consumer the same level of satisfaction.

 Let’s see how an indifference curve looks for two goods – Pizza and Pepsi –
graphically.
 Figure 2 The Consumer’s Preferences
Quantity of
Pepsi

B D
I2
Indifference
A
curve, I1
0 Quantity of
Pizza

Representing Preferences: Indifference Curves

 Representing Preferences: Indifference
Curves

 The Consumer’s Preferences

 The consumer is indifferent, or equally happy, with the combinations shown at
points A, B, and C because they are all on the same curve.
 The Marginal Rate of Substitution
 The slope at any point on an indifference curve is the marginal rate of
substitution (MRS).
 It is the rate at which a consumer is willing to trade (substitute) one good for
another.
 It is the amount of one good that a consumer requires as compensation to
give up one unit of the other good.
Marginal Rate of Substitution (MRS)

Marginal rate of substitution (MRS) is the

maximum amount of one good a
consumer will sacrifice to obtain one more
unit of another good.

It is change in Y/ change in X which is the slope

of the indifference curve between two points.
 Indifference Curve Convex to the Origin
 The MRS from bundle a to
Pepsi bundle b is -3.
From bundle a to bundle b,
Lisa is willing to give up 3
 This is the same as the
slope of the indifference
units of Pepsi in exchange curve between those
a for 1 more Pizza… two points.
8
From bundle b to bundle c,  From b to c,
–3 Lisa is willing to give up 2
units of Pepsi in exchange  MRS = -2.
b for 1 more Pizza…  This is the same as the
5 slope of the indifference
1 curve between those
-2 From bundle c to bundle two points.
c d, Lisa is willing to give
3 up 1 Pepsi in exchange
1  From c to d,
-1 d for 1 more Pizza…
2  MRS = -1.
1
I  This is the same as the
slope of the indifference
0 3 4 5 6 Pizzas curve between those
two points.

MRS along an Indifference curve

Quantity
of Pepsi
C

B D
MRS I2
1
Indifference
A
curve, I1

0 Quantity
of Pizza
The Consumer’s Preferences: MRS
Five Properties of Indifference Curves

1. Higher indifference curves are preferred to lower ones.

2. Indifference curves are downward sloping.

3. Indifference curves do not cross.

4. Indifference curves are bowed inward.

5. Ics are not necessarily parallel.

Properties of Indifference Curves

 Property 1: Higher indifference curves are preferred to lower ones.

 Consumers usually prefer more of something to less of it.

 Higher ICs represent larger quantities of goods than do lower indifference curves
for economic goods.
Quantity
of Pepsi
C

B D
I2
Indifference
A
curve, I1

0 Quantity
The Consumer’s Preferences of Pizza
Properties of Indifference Curves

 Property 2: Indifference curves are downward sloping.

 A consumer is willing to give up one economic good only if he or she gets more
of the other economic good in order to remain equally happy.
 If the quantity of one good is reduced, the quantity of the other good must
increase if ICs are downward sloping.
 For this reason, most indifference curves slope downward.
Quantity
of Pepsi

Indifference
curve, I1

0 Quantity
The Consumer’s Preferences of Pizza
Properties of Indifference Curves

 Property 3: Indifference curves do not cross.

 Points A and B should make the consumer equally happy.

 Points B and C should make the consumer equally happy.
 This implies that A and C would make the consumer equally happy.
 But C has more of both goods compared to A.
Quantity
of Pepsi

0 Quantity
of Pizza
The Consumer’s Preferences
Properties of Indifference Curves

 Property 4: Indifference curves are bowed inward.

 People are usually more willing to trade away goods that they have in
abundance and less willing to trade away goods of which they have little.
 These differences in a consumer’s marginal substitution rates cause his or her
indifference curve for economic goods to bow inward.
Quantity
of Pepsi

14

MRS = 6

A
8
1

4 B
MRS = 1
3
1
Indifference
curve

0 2 3 6 7 Quantity

The Consumer’s Preferences of Pizza

Pepsi 50 B

40 • The consumer prefers A to all

H E combinations in the yellow box, while all
those in the pink box are preferred to A.
30 A

• Any market basket lying northeast of an

20 D indifference curve is preferred to any
G market basket that lies on the indifference
curve
10

Pizza • Points on the curve are preferred to

10 20 30 40 points southwest of the curve
Clothing

• To describe
preferences for all
D combinations of goods,
B A we have a set of
U3 indifference curves –
an indifference map.

U2 • Each IC in the map

shows the market
U1 baskets among which
the person is
indifferent.
Food

Indifference Map
THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD

 The budget constraint depicts the limit on the consumption “bundles” that
a consumer can afford.
 People consume less than they desire because their spending is constrained, or
limited, by their income.

 The budget constraint shows the various combinations of goods the

consumer can afford given his or her income and the prices of the two
goods.
Budget Constraints

The Budget Line

 Indicates all combinations of two commodities for which total money spent
equals total income.
 We assume only 2 goods are consumed, so we do not consider savings.
The Consumer’s Budget
Constraint
THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD
 Let’s draw a consumer’s budget constraint on a graph.

 Any point on the budget constraint line indicates the consumer’s combination or
trade-off between two goods.
 For example, if the consumer buys no pizzas, he can afford 500 pints of Pepsi
(point B). If he buys no Pepsi, he can afford 100 pizzas (point A).
Figure 1 The Consumer’s Budget Constraint
Quantity of Pepsi

B
500

Consumer’s
budget constraint

A
0 Quantity of Pizza

The Consumer’s Budget

100

Constraint
Quantity of Pepsi

B
500

Alternately, the
consumer can buy
50 pizzas and 250
pints of Pepsi in the
same budget.
C (point C)
250

Consumer’s
budget constraint

A
0 Quantity of Pizza
50 100
The Consumer’s Budget
Constraint
THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD
 The slope of the budget constraint line equals the relative price of the two
goods, that is, the price of one good compared to the price of the other.

 Therefore, it measures the rate at which the consumer can trade one good
for the other.

 Let’s take another example. Let this consumer use her income on two
goods - food and clothing.
The Budget Line

 Let F equal the amount of food purchased, and C is the amount of

clothing.
 Income I is allocated to F and/or C.
 Let price of food = PF and price of clothing = PC
 Then PFF is the amount of money spent on food, and PCC is the amount of
money spent on clothing.
 The budget line in this case is (algebraically) written as:

PF F  PC C  I
 Different choices of food and clothing can be calculated that
use all income.
 These choices when graphed give us the budget line.
 Example: Assume income of $80/week, PF = $1; PC = $2

Market Basket, Food (F) Clothing (C) Income (I)

(F,C) PF = $1 PC = $2 I = PFF + PCC
A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80

The Budget Line: Choices

Clothing
A
(I/PC) = 40 C 1 PF
Slope   -  -
B F 2 PC
30
10
D
20
20
E
10
G
Food
0 20 40 60 80 = (I/PF)

The Budget Line: Graphical

The Budget Line: Interpretation
 As consumption moves along a budget line from the intercept,
the consumer spends less on one item and more on the other.
 The slope of the line measures the relative cost of food and
clothing.
 The slope is the negative of the ratio of the prices of the two
goods.
 The slope indicates the rate at which the two goods can be
substituted without changing the amount of money spent.
The Budget Line: Constraints

 The vertical intercept, I/PC, illustrates the maximum

amount of C that can be purchased with income I.
 The horizontal intercept, I/PF, illustrates the maximum
amount of F that can be purchased with income I.

 What happens when income and/or prices change?

 As incomes and prices change, there are changes in
budget lines.
The Budget Line : Income

 The Effects of Changes in Income

 An increase in income causes the budget line to shift outward,

parallel to the original line (holding prices constant).
 Consumer can buy more of both goods with more income.

 A decrease in income causes the budget line to shift inward,

parallel to the original line (holding prices constant).
 Consumer can buy less of both goods with less income.
 Clothing
(units
per week)
80
An increase in
income shifts
60 the budget line
outward

40
A decrease in
income shifts
20 L3
the budget line L1 L2
inward Food
(I = $40) (I = $80) (I = $160)
(units per week)
0 40 80 120 160

The Budget Line: Shifts

The Budget Line - Changes

 The Effects of Changes in Prices

 If the two goods increase in price, but the ratio of the two prices is
unchanged, the slope will not change.
 However, the budget line will shift inward parallel to the original
budget line.
 If the two goods decrease in price, but the ratio of the two prices is
unchanged, the slope will not change.
 However, the budget line will shift outward parallel to the original
budget line.
 Clothing
(units
per week)

A decrease in the
price of food to
$.50 changes
the slope of the
40 budget line and
An increase in the L2 rotates it outward.
price of food to
$2.00 changes L1
the slope of the L3
budget line and
rotates it inward.
(PF = 1) (PF = 1/2)
(PF = 2) Food
40 80 120 160 (units per week)

The Budget Line - Shifts

 The Effects of Changes in Prices

 If the price of one good increases, the budget line shifts inward,
pivoting from the other good’s intercept.
 If the price of food increases and you buy only food (x-intercept),
then you can’t buy as much food. The x-intercept shifts in.
 If you buy only clothing (y-intercept), you can buy the same
amount. No change in y-intercept.
 If the price of one good decreases, the budget line shifts outward,
pivoting from the other good’s intercept.
 If the price of food decreases and you buy only food (x-intercept),
then you can buy more food. The x-intercept shifts out.
 If you buy only clothing (y-intercept), you can buy the same
amount. No change in y-intercept.

The Budget Line – Prices

Consumer Choice

 Given budget constraints, how do consumers choose what to buy i.e. what
do they do about their preferences?

 Consumers choose a combination of goods that will maximize their

satisfaction, given the limited budget available to them.
Consumer Choice

The maximizing market basket must satisfy two conditions:

1. It must be located on the budget line

 They spend all their income – more is better
2. It must give the consumer the most preferred combination of goods and
services
The Consumer’s Optimal Choices

 Combining the indifference curve and the budget constraint determines

the consumer’s optimal choice.
 Consumer optimum occurs at the point where the highest indifference
curve and the budget constraint are tangent.
Consumer Choice

 Graphically, we can see different indifference curves of a consumer

choosing between clothing and food.
 Remember that U3 > U2 > U1 for our indifference curves.
 Consumer wants to choose highest utility within their budget.
Clothing
•A, B, C on budget line
40 •D highest utility but not
affordable
A •C highest affordable utility
•Consumer chooses C
30 D

20 C

U3

U1
B
0 20 40 80 Food (units per week)

Consumer Choice
Consumer Choice

 Consumer will choose highest IC on budget line.

 In previous graph, point C is where the indifference curve is just tangent to
the budget line.
 Slope of the budget line equals the slope of the indifference curve at this
point.
 The consumer chooses consumption of the two goods so that the marginal
rate of substitution equals the relative price. Why?
 Because at the consumer’s optimum, the consumer’s valuation of the two
goods equals the market’s valuation.
 Consumer Choice
C
MRS  
F
 Recall, the slope of an indifference curve is:

PF
 Further, the slope of the budget line is: Slope  
PC

 Therefore, it can be said at consumer’s

PF
optimal consumption point: MRS 
PC
 Clothing
Point B does not
maximize satisfaction
40 because the
MRS = -10/10 = 1
is greater than the
B
30 price ratio = 1/2

-10C
20

+10F U1
0 20 40 80 Food

Consumer Choice
 Consumer Choice

 It can be said that satisfaction is maximized when

marginal rate of substitution (of F and C) is equal to the
ratio of the prices (of F and C).
 Note this is ONLY true at the optimal consumption point.
 If MRS ≠ PF/PC then individuals can reallocate basket to
increase utility
 If MRS > PF/PC
 Will increase food and decrease clothing until MRS = PF/PC

 If MRS < PF/PC

 Will increase clothing and decrease food until MRS = PF/PC
Consumer Choice:
An Application
 Consider two groups of consumers, each wishing to spend $10,000 on the
styling and performance of a car.
 Each group has different preferences.
 By finding the point of tangency between a group’s indifference curve and
the budget constraint, auto companies can see how much consumers
value each attribute
 Styling

$10,000
These consumers
want performance
worth $7000 and styling
worth $3000

$3,000

$7,000 $10,000 Performance

Consumer Choice
 Styling
Consumer Choice
$10,000

$7,000
These consumers
want styling worth
$7000 and
performance worth
$3000

$3,000 $10,000 Performance

Consumer Choice

 Once a company knows preferences, it can design a production and

marketing plan.
 Company can then make a sensible strategic business decision on how to
allocate performance and styling on new cars.
How Changes in Income Affect the
Consumer’s Choices

 An increase in income…
 … shifts the budget constraint outward.
 The consumer is able to choose a better combination of goods on a higher
indifference curve.
 Quantity
of Clothing
New budget constraint

1. An increase in income shifts the

budget constraint outward . . .

New optimum

3. . . . and
Clothing
consumption. Initial
optimum I2

Initial
budget
I1
constraint

An Increase
0 in Income Quantity
of Food
2. . . . raising Food consumption . . .
How Changes in Income Affect the
Consumer’s Choices

If a consumer buys more of a good when his or her

income rises the good is called
a normal good.

If a consumer buys less of a good when his or her

income rises, the good is called
an inferior good.
 Quantity
of Clothing New budget constraint

1. When an increase in income shifts the

3. . . . but budget constraint outward . . .
Initial
Clothing
optimum
consumption
falls, making
New optimum
Clothing an
inferior good.

Initial
budget I1 I2
constraint

An Inferior
0 Good Quantity
of Food
2. . . . Food consumption rises, making Food a normal good . . .
How Changes in Prices Affect Consumer’s
Choices

 A fall in the price of any good…

… rotates the budget constraint outward and changes the slope of the budget
constraint.
 Quantity
of Clothing

New budget constraint

1,000 D

New optimum
B 1. A fall in the price of Clothing rotates
500
the budget constraint outward . . .
3. . . . and
raising Clothing Initial optimum
consumption.
Initial I2
budget I1
constraint A
0 100 Quantity
of Food
2. . . . reducing Food consumption . . .

A Change in Price
Deriving the Demand Curve

 A consumer’s demand curve can be viewed as a summary of the optimal

decisions that arise from his or her budget constraint and indifference
curves.
 ’ s Optimum
(a) The Consumer (b) The Demand Curve for Pepsi
Quantity Price of
of Clothing Clothing

New budget constraint

B A
750 $2

I2
B
1
A
250 Demand
I1

0 Initial budget Quantity 0 250 750 Quantity

of Food of Clothing

Deriving the demand curve

constraint
END