UNIT 2 (Topic 3- Consumer Theory)

PPT3.1: BL and IC

Budget constraint
Indifference curves,
Consumer choice
Income and substitution effects;
Derivation of demand curve from indifference curve and budget
constraint.

THE THEORY OF CONSUMER CHOICE 1

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

2
 Introduction
 Recall one of the Ten Principles from Chapter 1:
People face tradeoffs.
 Buying more of one good leaves
less income to buy other goods.
 Working more hours means more income and
more consumption, but less leisure time.
 Reducing saving allows more consumption today
but reduces future consumption.
 This chapter explores how consumers make
choices like these.

THE THEORY OF CONSUMER CHOICE 3

 The Budget Constraint:
What the Consumer Can Afford
 Example:
Ashok divides his income between two goods:
fish and mangos.
 A “consumption bundle” is a particular combination
of the goods, e.g., 40 fish & 300 mangos.
 Budget constraint: the limit on the consumption
bundles that a consumer can afford

THE THEORY OF CONSUMER CHOICE 4

ACTIVE LEARNING 1
Budget Constraint
Ashok’s income: $1200
Prices: PF = $4 per fish, PM = $1 per mango
A. If Ashok spends all his income on fish,
how many fish does he buy?
B. If Ashok spends all his income on mangos,
how many mangos does he buy?
C. If Ashok buys 100 fish, how many mangos can
he buy?
D. Plot each of the bundles from parts A – C on a
graph that measures fish on the horizontal axis
and mangos on the vertical, connect the dots.
5
ACTIVE LEARNING 1
Answers D. Ashok’s budget
Quantity
of Mangos constraint shows
B the bundles he can
A. $1200/$4 afford.
= 300 fish
B. $1200/$1 C
= 1200
mangos
C. 100 fish
cost $400,
$800 left
A
buys 800
mangos Quantity
of Fish
The Slope of the Budget Line/ Constraint
From C to D, Quantity
of Mangos

–200 mangos

+50 fish C

Slope = – 4 D
Ashok must
give up
4 mangos
to get one fish.
Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 7
 The Slope of the Budget Constraint
The slope of the budget constraint equals
 the rate at which Ashok
can trade mangos for fish
 the opportunity cost of fish in terms of mangos
 Slope of budget line = - (Px / Py)
 the relative price of fish:

THE THEORY OF CONSUMER CHOICE 8

ACTIVE LEARNING 2
Budget constraint, continued.
Show what happens to Ashok’s budget constraint if:
A. His income falls to $800.
B. The price of mangos rises to
PM = $2 per mango

9
ACTIVE LEARNING 2
Answers, part A
Quantity A fall in income
Now, of Mangos shifts the budget
Ashok constraint down.
can buy
$800/$4
= 200 fish
or
$800/$1
= 800 mangos
or any
combination in
between. Quantity
of Fish
ACTIVE LEARNING 2
Answers, part B
Quantity An increase in the
Ashok of Mangos price of one good
can still buy pivots the budget
300 fish. constraint inward.
But now he
can only buy
$1200/$2 =
600 mangos.
Notice:
slope is smaller,
relative price of
fish is now only
2 mangos. Quantity
of Fish
 Preferences: What the Consumer Wants

Indifference curve: Quantity One of Ashok’s

of Mangos indifference curves
shows consumption
bundles that give the
consumer the same
level of satisfaction B
A, B, and all other
bundles on I1 make A
Ashok equally happy – I1
he is indifferent
between them.
Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 12

 Four Properties of Indifference Curves

Quantity One of Ashok’s

1. Indifference curves of Mangos indifference curves
are downward-
sloping.

If the quantity of
B
fish is reduced,
the quantity of A
mangos must be
I1
increased to keep
Ashok equally
happy. Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 13

 Four Properties of Indifference Curves

Quantity A few of Ashok’s

2. Higher indifference of Mangos indifference curves
curves are preferred
to lower ones.

Ashok prefers every

bundle on I2 (like C) C
D
to every bundle on I1 A I2
(like A). I1
He prefers every
bundle on I1 (like A) I0
to every bundle on I0 Quantity
of Fish
(like D).
THE THEORY OF CONSUMER CHOICE 14
 Four Properties of Indifference Curves

Quantity Ashok’s
3. Indifference curves of Mangos indifference curves
cannot cross.
Suppose they did.
Ashok should prefer
B to C, since B has B
more of both goods.
Yet, Ashok is indifferent C A
between B and C: I1 I4
He likes C as much as A
(both are on I4).
Quantity
He likes A as much as B of Fish
(both are on I1).
THE THEORY OF CONSUMER CHOICE 15
 Four Properties of Indifference Curves

Quantity
4. Indifference curves of Mangos
are bowed inward.
A
Ashok is willing to give
up more mangos for a 6
fish if he has few fish
1
(A) than if he has
B
many (B). 2
1 I1

Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 16

 The Marginal Rate of Substitution

Marginal rate of Quantity MRS = slope of

substitution (MRS):
of Mangos indifference curve
the rate at which a consumer
is willing to trade one good for A
another.
MRS = 6
Ashok’s MRS is the
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 17

 Explanation
 At A, Ashok has few fish, so an additional fish is very valuable
to him.
 At B, Ashok already has lots of fish, so an additional one is not
as valuable to him.

 Therefore, MRS = marginal value of the good on the X-axis

(fish) in terms of the good on Y-axis (mangos), decreases.

 Therefore, MRS decreases as we move down an IC.

18
 One Extreme Case: Perfect Substitutes
Perfect substitutes: two goods with
straight-line indifference curves,
constant MRS
Example: nickels & dimes
Consumer is always willing to trade
two nickels for one dime.

THE THEORY OF CONSUMER CHOICE 19

Another Extreme Case: Perfect Complements
Perfect complements: two goods with
right-angle indifference curves
Example: Left shoes, right shoes
{7 left shoes, 5 right shoes}
is just as good as
{5 left shoes, 5 right shoes}

THE THEORY OF CONSUMER CHOICE 20

 Less Extreme Cases:
Close Substitutes and Close Complements

Quantity Indifference Quantity Indifference

of Pepsi curves for close of hot curves for
dog buns
substitutes are close
not very bowed complements
are very
bowed

Quantity Quantity
of Coke of hot dogs
Optimization: What the Consumer Chooses
A is the optimum: Quantity
of Mangos
The optimum
the point on the
is the bundle
budget constraint
Ashok most
that touches the
1200 prefers out of
highest possible
all the bundles
indifference curve.
he can afford.
Ashok prefers B to A, B
but he cannot afford B. 600
A

Ashok can afford C C

and D, D
but A is on a higher
indifference curve. 150 300 Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 22
Optimization: What the Consumer Chooses
Quantity
At the optimum, of Mangos Consumer
slope of the optimization is
indifference curve another example
equals 1200 of “thinking at the
slope of the budget margin.”
constraint:
MRS = PF/PM A
600

marginal
price of fish
value of fish
(in terms of
mangos)
(in terms of 150 300 Quantity
mangos) of Fish
THE THEORY OF CONSUMER CHOICE 23
 Explanation
 Consumer optimization is another example of “thinking at the
margin.”

 Remember that MRS = marginal value of the good on the X-

axis (fish) in terms of the good on Y-axis (mangos).

 If MRS > Pf/Pm, the value of another fish is greater than its
cost, so Ashok can make himself happier by decreasing his
mango purchases and using the income saved to buy another
fish.
 If MRS < Pf/Pm, the value of another fish is less than its cost,
so Ashok should move along his budget line to a bundle with
less fish and more mangos to make himself happier.
24
 The Effects of an Increase in Income on
choice of the consumer
Quantity
of Mangos
An increase in
income shifts the
budget constraint
outward.
B
If both goods are A
“normal,” Ashok
buys more of each.

Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 25
ACTIVE LEARNING 3
Inferior vs. normal goods
 An increase in income increases the quantity
demanded of normal goods and reduces the
quantity demanded of inferior goods.
 Suppose fish is a normal good
but mangos are an inferior good.
 Use a diagram to show the effects of
an increase in income on Ashok’s optimal
bundle of fish and mangos.

26
ACTIVE LEARNING 3
Answers Quantity
of Mangos

If mangos are
inferior, the new
optimum will
contain fewer
mangos.
A
B

Quantity
of Fish
27
 The Effects of a Price Change
Quantity
Initially,
of Mangos
PF = $4
1200
PM = $1 initial
optimum

PF falls to $2 new
optimum
budget constraint 600
500
rotates outward,
Ashok buys
more fish and
fewer mangos.
150 300 600 Quantity
350 of Fish

THE THEORY OF CONSUMER CHOICE 28

 The Income and Substitution Effects
The price effect is the sum of income and substitution effects.

A fall in the price of fish has two effects on

Ashok’s optimal consumption of both goods.
 Income effect
A fall in PF boosts the purchasing power of Ashok’s income,
allows him to buy more mangos and more fish.
 Substitution effect
A fall in PF makes mangos more expensive relative to fish,
causes Ashok to buy fewer mangos & more fish.
Notice: The net effect on mangos is ambiguous / unclear.

29
 Explanation
 On the previous slide, the fall in the price of fish caused a
net decrease in Ashok’s demand for mangos: the
substitution effect is greater than the income effect, as
depicted on the following slide.

 However, it could have gone the other way: if the income

effect were greater than the substitution effect, then
Ashok’s demand for mangos would have risen.

 Exercise: draw the diagram and explain when income

effect is greater than the substitution effect
30
 The Income and Substitution Effects
Initial Quantity
In this example,
optimum at A. of Mangos
the net effect
PF falls. on mangos is
negative.
Substitution effect:
from A to B,
buy more fish and A
C
fewer mangos.
B
Income effect:
from B to C,
buy more of both Quantity
goods.
of Fish
THE THEORY OF CONSUMER CHOICE 31
 This diagram decomposes / splits the
movement from the old optimum (A) to the
new one (C) into two parts.
 The first part, from A to B, represents the
substitution effect. It shows the change in
the optimal bundle due to the relative price
change, holding constant the consumer’s
level of well-being / real income.
 The second part, from B to C, represents
the income effect. It shows the change in
the optimal bundle due to the increase in
the purchasing power of the consumer’s
income. The dashed line through point B
is parallel to the new budget line through
point C, indicating that we are holding
relative prices constant to see how the
increase in income affects the optimal
bundle.
32
 How to derive the Individual’s Demand Curve
from indifference Curve Analysis?

 Contemplate a person consuming apples (X1 )and

bananas (X2 ), whose income is M and market prices of
X1 and X2 are P1 and P2 accordingly.
 Figure (a) portrays his or her consumption equilibrium at
point C, where he or she buys X1 and X2 quantities of
apples and bananas respectively.
 In figure (b), we plot P1 against X1 which is the first point
on the demand curve for X1
 Similarly, we get other points on the demand curve.

THE THEORY OF CONSUMER CHOICE 34

 Deriving Ashok’s Demand Curve for Fish
B: When PF = $2, Ashok demands 350 fish.
A: When PF = $4, Ashok demands 150 fish.

Quantity Price of
of Mangos Fish

A
$4
A
B
B
$2
DFish

150 350 Quantity 150 350 Quantity

of Fish of Fish
35
 Application 1: Giffen Goods
 Do all goods obey the Law of Demand?
 Suppose the goods are potatoes and meat,
and potatoes are an inferior good.
 If price of potatoes rises,
 substitution effect: buy less potatoes
 income effect: buy more potatoes
 If income effect > substitution effect,
then potatoes are a Giffen good, a good for which
an increase in price raises the quantity demanded.
 The demand curve will be upward sloping.
THE THEORY OF CONSUMER CHOICE 36
 CONCLUSION:
Do People Really Think This Way?
 People do not make spending decisions
by writing down their budget constraints and
indifference curves.
 Yet, they try to make the choices that maximize
their satisfaction given their limited resources.
 The theory in this chapter is only intended as a
indicator for how consumers make decisions.
 It explains consumer behavior fairly well in many
situations and provides the basis for more
advanced economic analysis.
THE THEORY OF CONSUMER CHOICE 37
 CHAPTER SUMMARY
 A consumer’s budget constraint shows the
possible combinations of different goods she can
buy given her income and the prices of the
goods. The slope of the budget constraint
equals the relative price of the goods.
 An increase in income shifts the budget
constraint outward. A change in the price of one
of the goods pivots the budget constraint.

THE THEORY OF CONSUMER CHOICE 38

 CHAPTER SUMMARY
 A consumer’s indifference curves represent her
preferences. An indifference curve shows all the
bundles that give the consumer a certain level of
happiness. The consumer prefers points on
higher indifference curves to points on lower
ones.
 The slope of an indifference curve at any point is
the marginal rate of substitution – the rate at
which the consumer is willing to trade one good
for the other.

THE THEORY OF CONSUMER CHOICE 39

 CHAPTER SUMMARY
 The consumer optimizes by choosing the point
on her budget constraint that lies on the highest
indifference curve. At this point, the marginal
rate of substitution equals the relative price of the
two goods.
 When the price of a good falls, the impact on the
consumer’s choices can be broken down into two
effects, an income effect and a substitution
effect.

THE THEORY OF CONSUMER CHOICE 40

 CHAPTER SUMMARY
 The income effect is the change in consumption
that arises because a lower price makes the
consumer better off. It is represented by a
movement from a lower indifference curve to a
higher one.
 The substitution effect is the change that arises
because a price change encourages greater
consumption of the good that has become
relatively cheaper. It is represented by a
movement along an indifference curve.

THE THEORY OF CONSUMER CHOICE 41