ECON6066

Macro and Micro Economics

Week 5
The Theory of Consumer Choice
 Outline

 The Budget Constraint: What The Consumer Can Afford

 Preferences: What The Consumer Wants

 Optimization: What The Consumer Chooses

 The Budget Constraint:
What The Consumer Can Afford
 Budget Constraint

Budget constraint : the limit on the consumption bundles that

a consumer can afford
Budget constraint : Shows all possible commodity bundles that
can be purchased at given prices with a fixed money income
M PX
M  PX X  PY Y Y  X
PY PY
 Example : Pepsi and pizza

Table 4.1. The consumer’s budget constraint.

 Budget Constraint

Figure 4.1. The Consumer’s Budget Constraint

Preferences: What The Consumer

Wants
 Indifference Curve

Indifference curve:
shows consumption bundles that give the consumer the same level of
satisfaction

Figure 4.2 The consumer’s

preferences
The consumer’s preferences are
represented with indifference curves,
which show the combinations of Pepsi
and pizza that make the consumer
equally satisfied. Because the
consumer prefers more of a good,
points on a higher indifference curve
(I2 here) are preferred to points on
a lower indifference curve (I 1).
The marginal rate of substitution
(MRS) shows the rate at which the
consumer is willing to trade Pepsi for
pizza.
 The Marginal Rate of
Substitution

Marginal rate of substitution (MRS):

the rate at which a consumer is willing to trade one good for
another.

The consumer’s MRS is the amount of pepsi he would substitute

for another pizza.
MRS falls as you move down along an indifference curve.
 Four Properties of Indifference
Curves

Quantity
1. Higher indifference curves of Pepsi
are preferred to lower
ones.

The consumer prefers every

bundle on I2 (like C) to every
C
bundle on I1 (like A). D
He prefers every bundle on I1 (like A I2
A) to every bundle on I0 (like D). I1
I0
Quantity
of Pizza
 Four Properties of Indifference
Curves

Quantity
of Pepsi
2. Indifference curves
are downward-
sloping

If the quantity of pizza is reduced, B

the quantity of pepsi must be
increased to keep consumer
equally happy. A
I1

Quantity
of Pizza
 Four Properties of Indifference
Curves

Quantity
3. Indifference curves do not
of Pepsi
cross.

Suppose they did.

The consumer should prefer B to
C, since B has more of both B
goods.
Yet, the consumer is indifferent C
A
between B and C:
He likes C as much as A (both I1 I4
are on I4).
He likes A as much as B (both
are on I1). Quantity

of Pizza
 Four Properties of Indifference
Curves

Quantity
4. Indifference curves are of Pepsi
bowed inward.

A
The consumer is willing to give
up more pepsi for a pizza if he 6
has few pizza (A) than if he has
many (B). 1
B
2
1 I1

Quantity

of Pizza
Optimization: What The Consumer
Chooses
 THE CONSUMER’S OPTIMAL
CHOICES

Figure 4.4 THE CONSUMER’S

OPTIMUM
The consumer chooses the point
on his budget constraint that lies
on the highest indifference curve.
At this point, called the optimum,
the marginal rate of substitution
equals the relative price of the two
goods. Here the highest
indifference curve the consumer
can reach is I2. The consumer
prefers point A, which lies on
indifference curve I3, but the
consumer cannot afford this
bundle of Pepsi and pizza. By
contrast, point B is affordable, but
because it lies on a lower
indifference curve, the consumer
does not prefer it.
 References

N. Gregory Mankiw. (2018). Principles of Economics. 08. Cengage

Learning Asia Pte Ltd. Singapore. ISBN : 978-981-4780-35-3, Chapter

21.
Thank You