CHAPTER

8 In this chapter,
look for the answers to these questions:

 How does the budget constraint represent the

choices a consumer can afford?
The Theory of Consumer Choice  How do indifference curves represent the
consumer’s preferences?
 What determines how a consumer divides her
resources between two goods?
 How does the theory of consumer choice explain
decisions such as how much a consumer saves,
or how much labor she supplies?
© 2009 South-Western, a part of Cengage Learning, all rights reserved 1

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The Budget Constraint:

Introduction
What the Consumer Can Afford
 Recall one of the Ten Principles from Chapter 1:
People face tradeoffs.
 Example:
Hurley divides his income between two goods:
 Buying more of one good leaves fish and mangos.
less income to buy other goods.
 Working more hours means more income and  A “consumption bundle” is a particular combination
more consumption, but less leisure time. of the goods, e.g., 40 fish & 300 mangos.
 Reducing saving allows more consumption today  Budget constraint: the limit on the consumption
but reduces future consumption.
bundles that a consumer can afford
 This chapter explores how consumers make
choices like these.

THE THEORY OF CONSUMER CHOICE 2 THE THEORY OF CONSUMER CHOICE 3

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 ACTIVE LEARNING 1 ACTIVE LEARNING 1
Budget Constraint Answers D. Hurley’s budget
Quantity
Hurley’s income: $1200 of Mangos constraint shows
B the bundles he can
Prices: PF = $4 per fish, PM = $1 per mango
A. $1200/$4 afford.
A. If Hurley spends all his income on fish, = 300 fish
how many fish does he buy? C
B. $1200/$1
B. If Hurley spends all his income on mangos,
= 1200
how many mangos does he buy? mangos
C. If Hurley buys 100 fish, how many mangos can
C. 100 fish
he buy?
cost $400,
D. Plot each of the bundles from parts A – C on a $800 left
graph that measures fish on the horizontal axis A
buys 800
and mangos on the vertical, connect the dots. Quantity
mangos of Fish
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The Slope of the Budget Constraint The Slope of the Budget Constraint
From C to D, Quantity The slope of the budget constraint equals
of Mangos
“rise” =  the rate at which Hurley
–200 mangos can trade mangos for fish
“run” =  the opportunity cost of fish in terms of mangos
+50 fish C
 the relative price of fish:
Slope = – 4 D
Hurley must
give up
4 mangos
to get one fish.

Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 6 THE THEORY OF CONSUMER CHOICE 7

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 ACTIVE LEARNING 2 ACTIVE LEARNING 2
Budget constraint, continued. Answers, part A
Quantity A fall in income
Now, of Mangos shifts the budget
Show what happens to Hurley’s budget constraint if:
Hurley constraint down.
A. His income falls to $800. can buy

B. The price of mangos rises to $800/$4

PM = $2 per mango = 200 fish
or
$800/$1
= 800 mangos
or any
combination in
between. Quantity
of Fish
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ACTIVE LEARNING 2 Preferences: What the Consumer Wants

Answers, part B
Quantity An increase in the Indifference curve: Quantity One of Hurley’s
Hurley
of Mangos price of one good shows consumption of Mangos indifference curves
can still buy
pivots the budget bundles that give the
300 fish. constraint inward. consumer the same
But now he level of satisfaction
can only buy
B
$1200/$2 = A, B, and all other
600 mangos. bundles on I1 make A
Notice: Hurley equally happy –
I1
slope is smaller, he is indifferent
relative price of between them.
fish is now only Quantity
Quantity of Fish
2 mangos.
of Fish
THE THEORY OF CONSUMER CHOICE 11

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 Four Properties of Indifference Curves Four Properties of Indifference Curves

Quantity A few of Hurley’s Quantity One of Hurley’s

1. Higher indifference 2. Indifference curves
of Mangos indifference curves of Mangos indifference curves
curves are preferred are downward-
to lower ones. sloping.

Hurley prefers every If the quantity of

B
bundle on I2 (like C) C fish is reduced,
D
to every bundle on I1 the quantity of
A I2 A
(like A). mangos must be
I1 I1
He prefers every increased to keep
bundle on I1 (like A) I0 Hurley equally
to every bundle on I0 Quantity happy. Quantity
(like D). of Fish of Fish

THE THEORY OF CONSUMER CHOICE 12 THE THEORY OF CONSUMER CHOICE 13

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Four Properties of Indifference Curves Four Properties of Indifference Curves

Quantity Hurley’s Quantity

3. Indifference curves 4. Indifference curves
of Mangos indifference curves of Mangos
cannot cross. are bowed inward.
Suppose they did. A
Hurley is willing to give
Hurley should prefer
B to C, since B has up more mangos for a 6
B
more of both goods. fish if he has few fish
1
Yet, Hurley is indifferent C (A) than if he has
A B
between B and C: many (B). 2
I1 I4
He likes C as much as A 1 I1
(both are on I4).
He likes A as much as B Quantity Quantity
of Fish of Fish
(both are on I1).
THE THEORY OF CONSUMER CHOICE 14 THE THEORY OF CONSUMER CHOICE 15

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 The Marginal Rate of Substitution One Extreme Case: Perfect Substitutes
Marginal rate of Quantity MRS = slope of Perfect substitutes: two goods with
substitution (MRS): of Mangos indifference curve straight-line indifference curves,
the rate at which a consumer constant MRS
is willing to trade one good for A Example: nickels & dimes
another.
MRS = 6 Consumer is always willing to trade
Hurley’s MRS is the two nickels for one dime.
amount of mangos he 1
would substitute for B
MRS = 2
another fish. 1 I1
MRS falls as you move
down along an Quantity
indifference curve. of Fish

THE THEORY OF CONSUMER CHOICE 16 THE THEORY OF CONSUMER CHOICE 17

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Another Extreme Case: Perfect Complements Less Extreme Cases:

Perfect complements: two goods with
Close Substitutes and Close Complements
right-angle indifference curves
Quantity Indifference Quantity Indifference
Example: Left shoes, right shoes of Pepsi curves for close of hot curves for
{7 left shoes, 5 right shoes} dog buns close
substitutes are
is just as good as not very bowed complements
{5 left shoes, 5 right shoes} are very
bowed

Quantity Quantity
of Coke of hot dogs
THE THEORY OF CONSUMER CHOICE 18

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 Optimization: What the Consumer Chooses Optimization: What the Consumer Chooses
A is the optimum: Quantity Quantity
The optimum At the optimum, Consumer
the point on the of Mangos of Mangos
is the bundle slope of the optimization is
budget constraint
Hurley most indifference curve another example
that touches the
1200 prefers out of equals 1200 of “thinking at the
highest possible
all the bundles slope of the budget margin.”
indifference curve.
he can afford. constraint:
Hurley prefers B to A, B
MRS = PF/PM
but he cannot afford B. 600
A 600
A

Hurley can afford C C marginal

and D, price of fish
D value of fish
but A is on a higher (in terms of
(in terms of
indifference curve. mangos)
150 300 Quantity mangos) 150 300 Quantity
of Fish of Fish
THE THEORY OF CONSUMER CHOICE 20 THE THEORY OF CONSUMER CHOICE 21

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The Effects of an Increase in Income ACTIVE LEARNING 3

Quantity Inferior vs. normal goods
of Mangos
 An increase in income increases the quantity
An increase in
demanded of normal goods and reduces the
income shifts the
budget constraint quantity demanded of inferior goods.
outward.  Suppose fish is a normal good
B but mangos are an inferior good.
If both goods are
A
“normal,” Hurley  Use a diagram to show the effects of
buys more of each. an increase in income on Hurley’s optimal
bundle of fish and mangos.

Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 22 23

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 ACTIVE LEARNING 3 The Effects of a Price Change
Answers Quantity Quantity
Initially,
of Mangos of Mangos
PF = $4
If mangos are PM = $1
1200
initial
inferior, the new optimum
optimum will
PF falls to $2 new
contain fewer optimum
mangos. budget constraint 600
A rotates outward, 500
B
Hurley buys
more fish and
fewer mangos.
150 300 600 Quantity
350 of Fish
Quantity
of Fish
24 THE THEORY OF CONSUMER CHOICE 25

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Deriving Hurley’s Demand Curve for Fish

A: When
B: WhenPPFF == $2,
$4, Hurley
Hurley demands
demands 350
150 fish.
fish.

Quantity Price of
of Mangos Fish

A Thank You!
$4
A
B
B
$2
DFish

150 350 Quantity 150 350 Quantity

of Fish of Fish
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