21 The Theory of Consumer Choice

PRINCIPLES OF

ECONOMICS
FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

In this chapter, look for the answers to
these questions:
 How does the budget constraint represent the
choices a consumer can afford?
 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?
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 2
 Introduction
 Recall one of the Ten Principles:
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.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 3

 The Budget Constraint:
What the Consumer Can Afford
 Two goods: pizza and Pepsi
 A “consumption bundle” is a particular combination
of the goods, e.g., 40 pizzas & 300 pints of Pepsi.
 Budget constraint: the limit on the consumption
bundles that a consumer can afford

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 4

A C T I V E L E A R N I N G 1:
Budget constraint
The consumer’s income: $1000
Prices: $10 per pizza, $2 per pint of Pepsi
A. If the consumer spends all his income on pizza,
how many pizzas does he buy?
B. If the consumer spends all his income on Pepsi,
how many pints of Pepsi does he buy?
C. If the consumer spends $400 on pizza,
how many pizzas and Pepsis does he buy?
D. Plot each of the bundles from parts A-C on a
diagram that measures the quantity of pizza on
the horizontal axis and quantity of Pepsi on the
vertical axis, then connect the dots.
5
A C T I V E L E A R N I N G 1:
Answers D.
D. The
The consumer’s
consumer’s
Pepsis
budget
budget constraint
constraint
A. $1000/$10 B shows
shows the
the bundles
bundles
500
= 100 pizzas that
that the
the consumer
consumer
400 can
can afford.
afford.
B. $1000/$2
= 500 Pepsis C
300
C. $400/$10
= 40 pizzas 200
$600/$2
= 300 Pepsis 100
A
0
0 20 40 60 80 100 Pizzas
6
 The Slope of the Budget Constraint
From C to D, Pepsis

“rise” = –100 500

Pepsis
400
“run” = +20
pizzas 300 C

Slope = –5 D
200
Consumer must
give up 5 Pepsis 100
to get another
pizza. 0
0 20 40 60 80 100 Pizzas
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 7
 The Slope of the Budget Constraint
 The slope of the budget constraint equals
• the rate at which the consumer
can trade Pepsi for pizza
• the opportunity cost of pizza in terms of Pepsi
• the relative price of pizza:

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 8

A C T I V E L E A R N I N G 2:
Exercise
Pepsis
Show what 500
happens to the
budget constraint 400
if:
300
A. Income falls to
$800 200
B. The price of
Pepsi rises to 100
$4/pint.
0
0 20 40 60 80 100 Pizzas
9
A C T I V E L E A R N I N G 2A:
Answers
Pepsis AA fall
fall in
in income
income
Consumer shifts
shifts the
the budget
budget
can buy 500 constraint
constraint inward.
inward.
$800/$10
400
= 80 pizzas
or $800/$2 300
= 400 Pepsis
200
or any
combination 100
in between.
0
0 20 40 60 80 100 Pizzas
10
A C T I V E L E A R N I N G 2B:
Answers An
Pepsis An increase
increase in
in the
the price
price
Consumer of
of one
one good
good pivots
pivots the
the
can still buy 500 budget
budget constraint
constraint inward.
inward.
100 pizzas.
400
But now,
can only buy 300
$1000/$4
= 250 Pepsis. 200

Notice: slope is 100

smaller, relative
price of pizza 0
now only 4 Pepsis. 0 20 40 60 80 100 Pizzas
11
 Preferences: What the Consumer Wants

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

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 12

 Preferences: What the Consumer Wants
Marginal rate of substitution
(MRS): the rate at which a
consumer is willing to trade
one good for another
Also, the slope of the
indifference curve

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 13

 Four Properties of Indifference Curves
1. Higher indifference curves
are preferred to lower ones.
2. Indifference curves are
downward sloping.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 14

 Four Properties of Indifference Curves
3. Indifference curves do not cross.

If they did, like here,

then the consumer would be
indifferent between A and C.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 15

 Four Properties of Indifference Curves
4. Indifference curves are bowed inward.

The less pizza the consumer has,

the more Pepsi he is willing to
trade for another pizza.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 16

 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.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 17

Another Extreme Case: Perfect Complements
Perfect substitutes: 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}

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 18

Optimization: What the Consumer Chooses
The optimal bundle is at the point
where the budget constraint touches
the highest indifference curve.
MRS = relative price
at the optimum:
The indiff curve and
budget constraint
have the same slope.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 19

 The Effects of an Increase in Income

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 20

A C T I V E L E A R N I N G 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 pizza is a normal good
but Pepsi is an inferior good.
 Use a diagram to show the effects of
an increase in income on the consumer’s
optimal bundle of pizza and Pepsi.

21
A C T I V E L E A R N I N G 3:
Answers
The Effects of a Price Change

23
 The Income and Substitution Effects
A fall in the price of Pepsi has two effects on the
optimal consumption of both goods.
• Income effect
A fall in the price of Pepsi boosts the purchasing
power of the consumer’s income, allowing him to
reach a higher indifference curve.
• Substitution effect
A fall in the price of Pepsi makes pizza more
expensive relative to Pepsi, causes consumer to
buy less pizza & more Pepsi.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 24

 Income and
Substitution Effects

25
A C T I V E L E A R N I N G 4:
Income & substitution effects
 The two goods are skis and ski bindings.
 Suppose the price of skis falls.
Determine the effects on the consumer’s
demand for both goods if
• income effect > substitution effect
• income effect < substitution effect
 Which case do you think is more likely?

26
A C T I V E L E A R N I N G 4:
Answers
A fall in the price of skis
 Income effect:
demand for skis rises
demand for ski bindings rises
 Substitution effect:
demand for skis rises
demand for ski bindings falls
 The substitution effect is likely to be small,
because skis and ski bindings are complements.

27
 The Substitution Effect for
Substitutes and Complements
 The substitution effect is huge when the goods are
very close substitutes.
• If Pepsi goes on sale, people who are nearly
indifferent between Coke and Pepsi will buy
mostly Pepsi.
 The substitution effect is tiny when goods are
nearly perfect complements.
• If software becomes more expensive relative to
computers, people are not likely to buy less
software and use the savings to buy more
computers.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 28
 Deriving the Demand Curve for Pepsi
Left graph: price of Pepsi falls from $2 to $1
Right graph: Pepsi demand curve

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 29

 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.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 30

 Application 1:
Giffen Goods

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 31

 Application 2: Wages and Labor Supply
Budget constraint
• Shows a person’s tradeoff between consumption
and leisure.
• Depends on how much time she has to divide
between leisure and working.
• The relative price of an hour of leisure is the amount
of consumption she could buy with an hour’s wages.
Indifference curve
• Shows “bundles” of consumption and leisure
that give her the same level of satisfaction.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 32

 Application 2: Wages and Labor Supply
At
At the
the optimum,
optimum,
the
the MRS
MRS between
between
leisure
leisure and
and
consumption
consumption
equals
equals thethe wage.
wage.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 33

 Application 2: Wages and Labor Supply
An increase in the wage has two effects
on the optimal quantity of labor supplied.
• Substitution effect (SE): A higher wage makes
leisure more expensive relative to consumption.
The person chooses less leisure,
i.e., increases quantity of labor supplied.
• Income effect (IE): With a higher wage,
she can afford more of both “goods.”
She chooses more leisure,
i.e., reduces quantity of labor supplied.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 34

 Application 2: Wages and Labor Supply

For
For this
this person,
person, So
So her
her labor
labor supply
supply
SE
SE >> IE
IE increases
increases with
with the
the wage
wage

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 35

 Application 2: Wages and Labor Supply

For
For this
this person,
person, So
So his
his labor
labor supply
supply falls
falls
SE
SE << IE
IE when
when thethe wage
wage rises
rises

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 36

 Could This Happen in the Real World???
Cases where the income effect on labor supply is
very strong:
• Over last 100 years, technological progress has
increased labor demand and real wages.
The average workweek fell from 6 to 5 days.
• When a person wins the lottery or receives an
inheritance, his wage is unchanged – hence no
substitution effect.
But such persons are more likely to work fewer
hours, indicating a strong income effect.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 37

Application 3: Interest Rates and Saving
 A person lives for two periods.
• Period 1: young, works, earns $100,000
consumption = $100,000 minus amount saved
• Period 2: old, retired
consumption = saving from Period 1
plus interest earned on saving
 The interest rate determines
the relative price of consumption when young
in terms of consumption when old.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 38

 Application 3: Interest Rates and Saving
Budget constraint shown is for 10% interest rate.

At
At the
the optimum,
optimum,
the
the MRS
MRS between
between
current
current and
and future
future
consumption
consumption equals
equals
the
the interest
interest rate.
rate.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 39

A C T I V E L E A R N I N G 5:
Effects of an interest rate increase
 Suppose the interest rate rises.
 Determine the income and substitution effects on
current and future consumption, and on saving.

40
A C T I V E L E A R N I N G 5:
Answers
The interest rate rises.
Substitution effect
• Current consumption becomes more expensive
relative to future consumption.
• Current consumption falls, saving rises,
future consumption rises.
Income effect
• Can afford more consumption in both the present
and the future. Saving falls.

41
Application 3: Interest Rates and Saving
In
In this
this case,
case,
SE
SE >> IEIE and
and
saving
saving rises
rises

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 42

Application 3: Interest Rates and Saving
In
In this
this case,
case,
SE
SE << IEIE and
and
saving
saving falls
falls

43
 CONCLUSION:
Do People Really Think This Way?
 Most 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
metaphor for how consumers make decisions.
 It does fairly well at explaining consumer behavior
in many situations, and provides the basis for
more advanced economic analysis.
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 44
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.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 45

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.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 46

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.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 47

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.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 48

CHAPTER SUMMARY
 The theory of consumer choice can be applied in
many situations. It can explain why demand
curves can potentially slope upward, why higher
wages could either increase or decrease labor
supply, and why higher interest rates could either
increase or decrease saving.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 49