Lecture 11

Chapter 21

Consumer Choice: Maximizing

Utility and Behavioral
Economics
 Income and Substitution Effects
• A person’s real income, or purchasing power, rises if with a given
absolute income, he or she can purchase more goods and services.
• A fall in the relative price of a good will, and a rise in real income
can, lead to greater purchases of the good.
• The portion of the change in the quantity demanded that is
attributable to a change in its relative price is referred to as the
substitution effect.
• The portion of the change in the quantity demanded that is
attributable to a change in real income, brought about by a change
in absolute price, is referred to as the income effect.
Income and Substitution Effects
 Budget Constraint

Budget constraint: All combinations of two goods a

person can purchase, given certain amount of income and
prices of two goods.

Example: Suppose price of a concert is 30 and price of movie is

10. Budget 150.
 Budget Set
Budget Set: All combinations of goods that lie
on or inside the budget line
No. of
movies 15
per
month Not affordable

affordable
5 No. of concerts per month
 Indifference Curve:

IC: All Combinations of two Goods that yield the same level of
utility (Make the consumers equally well off.)

No. of movies After giving you an

per Month additional concert, how
B many movies could we take
D away from you and leave
you no better or worse off
than D?
E
A
C
U0

0 No. of concerts per month

6
 Diminishing Marginal Utility

As No. of concert increases, takes away decreasing

amounts of movies to leave utility unchanged
No. of movies Along an indifference curve,
per month
As No. of movies decreases and No. of
concerts increases, Marginal utility from an
ΔM1 additional movie increases and Marginal
ΔM2 utility from an additional concert decreases.
ΔM3

U0

0 No. of concerts per month

ΔC ΔC ΔC
7
 Ranking Indifference Curves
No. of
movies per Any point on a
month higher
indifference
B curve is
preferred to
A anyUpoint on a
1
C lower one.
U0
U-1

0 No. of concerts per month

8
 Combine budget line with indifference
curve
No. of
movies
per The optimal combination of
month 15 Goods for a consumer is the
Point on the budget line where
an indifference curve is tangent
C
to the budget line.
B

U2
A U1
U0
0 5 No. of concerts per month
 Changes in Price

No. of The drop in the price of

movies concert rotates Max’s
per budget line ______.
month Based on his difference
15 curves, he will choose
___. What if we dropped
the price of concert again?
B How can we derive
C Max’s individual demand
curve for concert?
U2
A U1
U0
0 5 10
10
No. of concerts per month