chapter:

WHAT YOU WILL LEARN IN THIS CHAPTER

11
>> Consumer Preferences and
Consumer Choice

Krugman/Wells

©2009  Worth Publishers 1 of 47

 WHAT YOU WILL LEARN IN THIS CHAPTER
 Why economists use indifference curves to illustrate a
person’s preferences
 The importance of the marginal rate of substitution,
the rate at which a consumer is just willing to
substitute one good for another
 An alternative way of finding a consumer’s optimal
consumption bundle using indifference curves and the
budget line
 How the shape of indifference curves helps determine
whether goods are substitutes or complements
 An in-depth understanding of income and substitution
effects
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 Mapping the Utility Function
 A utility function determines a consumer’s total utility
given his or her consumption bundle.

 Using indifference curves, which represent a

consumer’s utility function, we will deepen our
understanding of the trade-off involved when
choosing the optimal consumption bundle and of
how the optimal consumption bundle itself changes
in response to changes in the prices of goods.

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Ingrid’s Utility Function
All combinations of 1,050 utils
rooms and restaurant
meals along this 900 utils
contour line yield 450
utils.
750 utils

600 utils

B 450 utils
A
300 utils
90
80 150 utils
70
Quantity of 60 0 utils
restaurants 50
40
9 10
30 8
6 7
20 5
10 3 4
1 2 Quantity of
0 rooms

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 Ingrid’s Utility Function
 Ingrid is indifferent between A and B: because A
and B yield the same total utility level, Ingrid is
equally well off with either bundle. Hence, a contour
line that maps consumption bundles yielding the
same amount of total utility is known as an
indifference curve.

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An Indifference Curve
Quantity of restaurant meals

90
An indifference curve is a
80
450 utils
contour line that shows all the
70 consumption bundles that
yield the same amount of total
60
utility for an individual.
50

40
A
30

B
15 Indifference
curve,

0 1 2 3 4 5 6 7 8 9 10
Quantity of rooms

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 An Indifference Curve Map
Quantity of
restaurant meals
Consumption Quantity of Quantity of Total utility
bundle rooms meals (utils)

90 A 3 30 450
80 B 6 15 450
70 391 utils C 5 10 391
60
D 4 45 519
D
45 450 utils
A 519 utils
30
B I3
15 I
10 2
C I1
0 1 2 3 4 5 6 7 8 9 10
Quantity of rooms

The entire utility function of an individual can be represented by an

indifference curve map, a collection of indifference curves in which each
curve corresponds to a different total utility level.
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FOR INQUIRING MINDS

Are Utils Useful?

 The indifference curve map tells us all we need to know in
order to find a consumer’s optimal consumption bundle.

 Economists say that bundle X is better than bundle Y. The

theory does not, however, require “cardinal” utility, which
actually assigns a specific number to the total utility yielded
by each bundle.

 So why introduce the concept of utils at all? The answer is

that it is much easier to understand the basis of rational
choice by using the concept of measurable utility.

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 Properties of Indifference Curves
 All indifference curve maps share two general
properties:
 indifference curves never cross
 the farther out an indifference curve is from the origin, the
higher the level of total utility it indicates

 In addition, indifference curves for most goods,

called ordinary goods, have two more properties:
 they are downward sloping
 are convex (bowed-in toward the origin) as a result of
diminishing marginal utility

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Properties of Indifference Curves
Properties
(a) of All Indifference Curves
Quantity Quantity
of of 200 utils
restaura 200 utils restaura
nt meals nt meals
B
100 utils
I2
A A 100 utils
I1
I2 I1

Quantity of rooms Quantity of rooms

Additional
(b) Properties of Indifference Curves for Ordinary Goods
Quantity Quantity
of of
restaura W restaura
nt meals nt meals
X A

Y Steeper
slope B
Z I
I Flatter
slope
Quantity of rooms Quantity of rooms
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 Indifference Curves and Consumer Choice
 We will use indifference curve maps to find the
utility-maximizing consumption bundle of a
consumer given his/her budget constraint.

 The optimal consumption bundle lies on the budget

line, and the marginal utility per dollar is the same
for every good in the bundle.

 The first component of our approach is a new

concept, the marginal rate of substitution.

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 The Changing Slope of an Indifference Curve
Consumptio Quantity Quantity
n bundle of rooms of
Quantity restaurant
of meals
restaurant Ingrid trades 10 V 2 30
meals restaurant
V meals W 3 20
30
. . . for 1 room.
X 4 15
–10
Ingrid trades 2 Y 5 12
W restaurant
20 Z 6 10
+1 meals
X . . . for 1 room.
15 Y
12 Z
–2
10 I
+1

0 2 3 4 5 6
Quantity of rooms

The terms of the trade-off between the reduced consumption of

restaurant meals for increased consumption of housing changes
as the consumer moves from V to W. Why?
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 Two Opposing Effects on Total Utility
 Moving down the indifference curve—reducing
restaurant meal consumption and increasing
housing consumption—will produce two opposing
effects on Ingrid’s total utility:
 Lower restaurant meal consumption will reduce her total
utility,
 but higher housing consumption will raise her total utility.

 And since we are moving down the indifference

curve, these two effects must exactly cancel out.

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 Two Opposing Effects on Total Utility
 Hence, we can calculate the change in total utility
generated by a change in the consumption bundle
using the following equations:

 Change in total utility arising from a change in

consumption of restaurant meals = MUM × ∆QM

 Change in total utility arising from a change in

consumption of rooms = MUR × ∆QR

Along the indifference curve:

−MUM × ∆QM = MUR × ∆QR
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 Marginal Rate of Substitution
 The following equation would also hold along the
indifference curve:

−MUR / MUM = ∆QM /∆QR

 Economists have a special name for the ratio of the

marginal utilities in the LHS of this equation and it is
called the marginal rate of substitution, MRS.

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 Diminishing Marginal Rate of Substitution
 The flattening of indifference curves as you slide
down them to the right—which reflects the same
logic as the principle of diminishing marginal utility—
is known as the principle of diminishing marginal
rate of substitution.

 It says that an individual who consumes only a little

bit of good A and a lot of good B will be willing to
trade off a lot of B in return for one more unit of A;
an individual who already consumes a lot of A and
not much B will be less willing to make that trade-off.

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 Diminishing Marginal Rate of Substitution

 The principle of diminishing marginal rate of

substitution states that the more of good R a
person consumes in proportion to good M, the less
M he or she is willing to substitute for another unit
of R.
 Two goods, R and M, are ordinary goods in a
consumer’s utility function when (1) the consumer
requires additional units of R to compensate for
less M, and vice versa: and (2) the consumer
experiences a diminishing marginal rate of
substitution when substituting one good in place of
another.
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 The Optimal Consumption Bundle
Quantity
of
restaurant Optimal
meals consumption
80 bundle

70 B

60

50
I
A 3
40

30 I
2
20
C
10 I
1
BL
0 2 4 6 8 10 12 14 16

Quantity of rooms
The tangency condition between the indifference curve and the budget line
holds when the indifference curve and the budget line just touch. This condition
determines the optimal consumption bundle when the indifference curves have
the typical convex shape.
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 The Slope of the Budget Line
 The relative price of good R in terms of good M is
equal to PR /PM, the rate at which R trades for M in
the market.

 The relative price rule says that at the optimal

consumption bundle, the marginal rate of
substitution between two goods is equal to their
relative price.

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 Prices and the Marginal Rate of Substitution

 At the optimal consumption point, the slope of the

indifference curve is just equal to the slope of the
budget line:
 Slope of indifference curve = −MUR /MUM

 Slope of budget line = − (N/PM)/(N/PR) = − PR /PM

 Putting these two equations together, we arrive at
the relative price rule.
 At the optimal consumption bundle:
 −MUR /MUM = − PR /PM

 Optimal consumption rule: MUR / PR= MUM /PM

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 Understanding the Relative Price Rule
Quantity of At the optimal consumption bundle:
restaurant
meals
−MUR /MUM = − PR /PM
80

70 B At the optimal
consumption
60 bundle, MRS is
equal to the
relative price.
50
A
40

30 I
2
20
C
10 I
1
BL
0 2 4 6 8 10 12 14 16

Quantity of rooms
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 Preferences and Choices
 When we say that two consumers have different
preferences, we mean that they have different utility
functions.

 This, in turn, means that they will have indifference

curve maps with different shapes.

 And those different maps will translate into different

consumption choices, even among consumers with
the same income who face the same prices.

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 Differences in Preferences
Ingrid’s
(a) Preference and Her Optimal Consumption Bundle
Quantity
of
restauran
t meals 80
Ingrid’s Ingrid and Lars have different
optimal
70 consumptio preferences. They choose
60 n bundle
50 different consumption
I3
40 bundles.
30 I2
20
I1 Both of them have an income
10
BL of $2,400 and face prices of
0 2 4 6 8 10 12 14 16
Quantity of rooms $30 per meal and $150 per
(b) Lars’s Preference and His Optimal Consumption Bundleroom.
Quantity
of Lars’s While Ingrid’s consumption
restauran optimal
t meals 80 consumptio choice is 8 rooms and 40
70 n bundle restaurant meals, Lars
60
50 I3 consumes fewer rooms and
40 I2 more restaurant meals even
30
20 I1 though he has the same
10 budget line.
BL
0 2 4 6 8 10 12 14 16
Quantity of rooms
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►ECONOMICS IN ACTION
Rats and Rational Choice
 The theory of consumer choice does not bear much resemblance
to the way most of us think about our consumption decisions. The
purpose of the theory to help economists think systematically
about how a rational consumer would behave. The practical
consumers actually behave rationally.
 Economists have conducted experiments in which rats are
presented with a “budget constraint”—a limited number of times
per hour they can push either of two levers. One of the levers
yields small cups of water; the other yields pellets of food. After the
rats’ choices have been observed, the budget constraint is
changed by varying the number of lever pushes required to get
each good. Sure enough, the rats satisfy the rule for rational
choice.
 If rats are rational, can people be far behind?
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 A Test for Rationality

Quantity of
Y

B
A
C

BL BL
1 2
Quantity of X

A consumer has the budget line BL1 and chooses the bundle A. If that
consumer is now given a new budget line—BL2, it would be irrational to choose
a bundle such as B; the consumer could have afforded that bundle before but
chose A instead. A rational consumer would always at least stay at A or choose
a new bundle that was not affordable before, such as C. It’s difficult to test
people in this way—but it works for rats!
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Using Indifference Curves: Substitutes and Complements

 What determines whether two goods are substitutes

or complements?

 It depends on the shape of a consumer’s

indifference curves.

 This relationship can be illustrated with two extreme

cases: the cases of perfect substitutes and perfect
complements.

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 Perfect Substitutes

Quantity
of peanut
butter
cookies
12

10

2
I1 I2
0 2 4 6 8 10 12
Quantity of chocolate chip cookies

Two goods are perfect substitutes if the marginal rate of

substitution of one good in place of the other good is constant,
regardless of how much of each an individual consumes.
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 Consumer Choice Between Perfect Substitutes
Cokie
(a) Buys Only Peanut Butter Cookies Cokie
(b) Buys Only Chocolate Chip Cookies

Quantity of Quantity
peanut of peanut
butter butter
cookies A cookies 12 I 2
12

10 10 I 1
BL
8 8

6 6

4 4

2 BL 2
I1 I2 B
0 2 4 6 8 10 12 0 2 4 6 8 10 12
Quantity of Quantity of
chocolate chip chocolate chip
cookies cookies

When two goods are perfect substitutes, small price changes can
lead to large changes in the consumption bundle.
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 Perfect Complements
Quantity
of milk
(glasses)

A
5
B C
4 I
4
3 I
3
2 I
2
1 I
1
BL
0 1 2 3 4 5
Quantity of cookies

Two goods are perfect complements when a consumer

wants to consume the goods in the same ratio regardless of
their relative price.
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►ECONOMICS IN ACTION
Publicity or Piracy?
 When the practice of audio file-sharing took off in the late 1990s,
a controversy erupted at the same time.
 Musicians argued that the widespread sharing of audio files was
a modern version of theft.
 On the other hand, there were those who argued that instead of
serving as a substitute for buying the CD, file-sharing actually
acted as a compliment. After hearing one or two tracks from a
CD via file sharing, a listener was more likely to go out and buy
the CD. They argued that file-sharing acted like free publicity.
 However, the music industry was right because once most
people had downloaded the songs they wanted, they did not
purchase the CD.
 So file sharing and CD purchases are substitutes not
compliments.

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 Prices, Income, and Demand
 How would our consumption choice change if either
the prices of goods or our income change?

 First, let’s see the effects of a price increase

illustrated in the following figure.

 Then, we will consider the impact of a change in

income.

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PITFALLS

“Other Things Equal,” Revisited

 One of the biggest sources of confusion and error in
economics—both in the classroom and in the real
world—is failure to keep in mind the principle that all
economic relationships are defined “other things
equal.”

 The law of demand, which says that increasing the

price of a good reduces the quantity demanded, is only
an “other things equal” proposition; a higher price
results in a lower quantity demanded, holding other
prices and income constant.

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 Effects of a Price Increase on the Budget Line
Quantity
of An increase in the price
restauran New BL: of rooms, holding the
t meals price of
80 rooms = price of restaurant
$600 An increase in the meals constant,
70 relative price of
rooms rotates the increases the relative
60
budget line price of rooms in terms
inward.
50 Original BL: of restaurant meals. As
price of rooms a result, Ingrid’s original
40 = $150 budget line, BL1, rotates
30 inward to BL2.
20 Her maximum possible
purchase of restaurant
10
BL BL meals is unchanged, but
2 1
0 2 4 6 8 10 12 14 16
her maximum possible
Quantity of rooms
purchase of rooms is
reduced.

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 Responding to a Price Increase
Quantity
of New Ingrid responds to the
restauran
t meals
optimal
consumptio
higher relative price of
80 n bundle rooms by choosing a
new consumption bundle
70
Original
with fewer rooms and
3. … and
60 C optimal more restaurant meals.
increases consumptio
restaurant 50 n bundle Her new bundle, C,
meal A contains 1 room instead
consumptio 40
n.
I
of 8 and 60 restaurant
2
30 meals instead of 40.
20

10 I
BL 1 BL
2 1
0 1 2 4 6 8 10 12 14 16
Quantity of rooms

2. … reduces 1.An increase in the

housing relative price of
consumption rooms rotates the
… budget line…
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Effect of a Change in Income on the Budget
Line
Quantity of
restaurant
meals

100
A fall in income
results in a parallel
inward shift of the
80 budget line.

A rise in income
results in a parallel
40
outward shift of the
budget line.

BL
3
BL BL
2 1
0 8 16 20
Quantity of rooms
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 Income and Consumption: Normal Goods
Quantity At a monthly income of $1,200,
$2,400,
of Optimal
restaurant consumption Ingrid
she chooses
choosesbundle
bundle B,A,
meals bundle income at of
$1,200 consisting of 48 rooms and 20 40
80
restaurant meals. Since
When
Optimal
70 consumption relative consumption
Ingrid’s price remainsof both
bundle at income
60 of $2,400 unchanged,meals
restaurant a fall and
in income
rooms
50
shiftswhen
falls her budget
her income
line inward
falls, to
A BL2. goods are normal goods.
both
3. … and a 40
fall in
consumpti 30 I
on of 2
restaurant B
meals 20

10 I
1
BL BL
2 1
0 2 4 6 8 10 12 14 16
Quantity of rooms

2. … 1. A fall in
resulting in income
a fall in shifts the
consumptio budget line
n of inward, …
rooms…
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 Income and Consumption: An Inferior Good
Quantity
of When Ingrid’s income falls
restauran
t meals Optimal consumption from $2,400 to $1,200, her
bundle at income of
$2,400 optimal consumption
bundle changes from D to
D
E. Her consumption of
second-hand furniture
Optimal
I
2 consumptio increases, implying that
3...and a
fall in n bundle at second-hand furniture is
consumptio income of
n of $1,200 an inferior good. In
restaurant
meals contrast, her consumption
E of restaurant meals falls,
implying that restaurant
I
BL
meals are a normal good.
BL 1
2 1

Quantity of second-hand
furniture
2. … resulting in a 1. A fall in
rise in income shifts
consumption of the budget
second-hand line inward, …
furniture
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 Income and Substitution Effects
 The change in a consumer’s optimal consumption
bundle caused by a change in price can be
decomposed into two effects: the substitution effect,
due to the change in relative price, and the income
effect, due to the change in purchasing power.

 The substitution effect refers to the substitution of

the good that is now relatively cheaper for the good
that is now relatively more expensive, holding the
utility level constant. It is represented by movement
along the original indifference curve.

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 Income and Substitution Effects
 When a price change alters a consumer’s
purchasing power, the resulting change in
consumption is the income effect. It is represented
by a movement to a new indifference curve, keeping
the relative price unchanged.
 For normal goods, the income and substitution
effects work in the same direction; so their demand
curves always slope downward.
 Although these effects work in opposite directions for
inferior goods, their demand curves usually slope
downward as well because the substitution effect is
typically stronger than the income effect. The
exception is the case of a Giffen good.
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Income and Substitution Effects
Quantity of
restaurant
meals
Hypothetical
180 optimal
consumption
bundle
160

140
B New
120
optimal
consumptio
100 n bundle Original
optimal
80 consumption
bundle
60
C A
40 I
BL 2
20 S
BL I BL
2 1 1
0 1 2 4 6 8 10 12 14 16

Quantity of rooms

Income effect Substitution effect

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►ECONOMICS IN ACTION
How Much Housing?
 To illustrate the substitution effect, an example was given
where an individual moves form Cincinnati to San Jose,
gaining higher income but facing a higher price of housing.
Also, the cost of living in San Jose is about twice that in
Cincinnati. So, on average, families live about as well in the
two metropolitan areas.

 But they don’t live the same way because the relative prices
are different. Houses are typically smaller in San Jose, with
fewer rooms and fewer square feet. Most noticeably, the great
majority of new homes in the Cincinnati area are single-family
houses on big lots; in San Jose, people are much more likely
to live in townhouses or apartments.

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SUMMARY

1. Preferences can be represented by an indifference curve

map, a series of indifference curves. Each curve shows
all the consumption bundles that yield a given level of total
utility. Indifference curves never cross, and greater
distance from the origin indicates higher total utility levels.
The indifference curves of ordinary goods slope downward
and are convex in shape.

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SUMMARY

2. The marginal rate of substitution, or MRS, of R in place

of M—the rate at which a consumer is willing to substitute
more R for less M—is equal to MUR/MUM and is also
equal to minus the slope of the indifference curve when R is
on the horizontal axis and M is on the vertical axis. Convex
indifference curves get flatter as you move to the right
along the horizontal axis and steeper as you move upward
along the vertical axis because of diminishing marginal
utility: a consumer requires more and more units of R to
substitute for a forgone unit of M as the amount of R
consumed rises relative to the amount of M consumed.
3. Most goods are ordinary goods, goods for which a
consumer requires additional units of some other good as
compensation for giving up some of the good and for which
there is diminishing marginal rate of substitution.
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SUMMARY

4. A consumer maximizes utility by moving to the highest

indifference curve his or her budget constraint allows.
Using the tangency condition, the consumer chooses the
bundle at which the indifference curve just touches the
budget line. At this point, the relative price of R in terms of
M, PR/PM (which is equal to minus the slope of the budget
line when R is on the horizontal axis and M is on the
vertical axis) is equal to the marginal rate of substitution of
R in place of M, MUR/MUM (which is equal to minus the
slope of the indifference curve). This gives us the relative
price rule: at the optimal consumption bundle, the relative
price is equal to the marginal rate of substitution.

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SUMMARY

5. When the marginal rate of substitution is constant, two

goods are perfect substitutes and indifference curves are
straight lines: there is only one relative price at which the
consumer is willing to purchase both goods. When a
consumer wants to consume the two goods in the same
ratio, regardless of the relative price, the goods are
perfect complements. In this case, the indifference
curves form right angles and the marginal rate of
substitution is undefined.

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SUMMARY

6. The effect of a change in price on consumer choice can be

decomposed into the substitution effect and the income
effect. The substitution effect is shown by a movement
along the original indifference curve in response to the
change in relative price, as the consumer substitutes more
of the relatively cheaper good in place of the relatively
more expensive good. The income effect is shown by a
change to a new indifference curve, reflecting the fact that
a change in a good’s price alters the purchasing power of
a given level of income.
7. The income and substitution effects work in the same
direction for normal goods, ensuring that demand curves
slope downward.

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 The End of Chapter 11

Coming attraction:
Chapter 12:
Behind the Supply Curve:
Inputs and Costs

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