Theory of Consumer Choice

1
Chapter 21

• Theory of Consumer Choice
• Ratna K. Shrestha

2
Theory of Consumer Choice

• ... addresses the following questions and
  links them in understanding
• How do wages affect labor supply?
• How do interest rates affect household saving?
• Do the poor prefer to receive cash or in-kind
  transfers?

3
The Budget Constraint

• Shows what combination of goods the consumer can
  afford given his income and the prices of the two
  goods.
• Assume I 1000
• Ppizza 10
• Ppepsi 2

4
The Budget Constraint
Pepsi (2)

• I 1000
• Ppizza 10 Ppepsi 2
• I PpizzaPizza PpepsiPepsi
• Assume Pizza X and Pepsi Y, then rewriting
• Y I/PY PX/PY X

B
500
A
Pizza (10)
100
5
The Budget Constraint
Pepsi (2)
Any point on the budget constraint line equals
1,000, the income available to spend on the two
products.
B
500
Slope Ppizza /Ppepsi 10/2 5
C
250
A
Pizza (10)
50
100
6
Preferences

• Indifference curves illustrate consumers
  preference between different bundles of goods and
  services.
• An indifference curve depicts bundles of goods
  that make the consumer equally well-off. It
  shows the combinations of goods that give the
  consumer the same level of utility.
• In the next slide, the levels of utility that the
  consumer can derive from three bundles A or B or
  C, which are on the same curve, are equal.
• The bundle D provides higher utility than bundle
  A, B or C.

7
Indifference Curves
Pepsi
.
Utility I2 gt Utility I1
C
.
.
.
B
D
I2
I1
A
Pizza
8
Indifference Curves
Pepsi
.
Slope between points A and B (MRS). Tradeoff
between the two bundles.
C
.
.
.
B
D
I2
I1
A
Pizza
9
Marginal Rate of Substitution

• The rate at which consumers are willing to trade
  one good for another is called the marginal rate
  of substitution (MRS).
• MRS measures how many Pepsi you have to
  sacrifice to get one more Pizza and be equally
  well off as before.
• MRS ?Pepsi / ?Pizza

10
Properties of Indifference Curves

• Higher indifference curves are preferred to lower
  ones.
• Indifference curves are downward sloping.
• Indifference curves do not cross.
• Indifference curves are bowed inward.

11
(1) Higher indifference curves are preferred to
lower ones
Properties of Indifference Curves

• Because consumers prefer more consumption to
  less, higher indifference curves are preferred to
  lower ones.
• Indifference curves farther from the origin
  represent higher levels of well-being or utility.

12
Indifference Curves
Pepsi
At both B and D, you have equal Pepsi. But at D
you have more Pizza ? I2 gt I1
.
C
.
.
D
.
B
I2 gt I1
I1
A
Pizza
13
Properties of Indifference Curves

• (2) Indifference curves are downward sloping
• The fact that the consumer is willing to give up
  one of the goods only if he/she is given some
  more of the other good results in the
  indifference curve being downward sloping.

• (3) Indifference curves do not cross
• In order for preference rankings to be
  consistent, indifference curves cannot intersect
  or cross.
• If indifference curves were to cross the
  assumption that more is preferred to less would
  be violated.

14
Indifference curves do not cross.
Properties of Indifference Curves
C
A
B
0
15
(4) Indifference curves are bowed inward.
Properties of Indifference Curves
When Pizza 2, you give up 6 Pepsi to have one
more pizza. But when Pizza 6, you give up only
1 Pepsi to have one more pizza.
0
16
Perfect Substitutes
Nickels
6
Nickel and dimes are perfect substitutes 2
Nickel 1 dime all the time.
4
2
I3
I2
I1
Dimes
3
2
1
17
Perfect Complements
Left Shoes
I2
1
I1
Right Shoes
1
18
Consumers Optimal Choice
Pepsi
Consumers indifference curves, based on
personal preferences.
I3
I2
I1
Pizza
19
Consumers Optimal Choice
Pepsi
Budget constraint.
B
At both A and B you spend the same income. Which
point will you choose?
A
I3
I2 gt I1
I1
Pizza
20
Consumers Optimal Choice
Pepsi
.
Optimal Choice
QPepsi
I3
I2
I1
Pizza
QPizza
21
Consumers Optimal Choice

• The point at which the indifference curve and the
  budget constraint touch (i.e. are tangent)
  maximizes consumers utility for the given
  income.
• That is, consumer chooses the two goods so that
  the marginal rate of substitution equals the
  relative price (or Price Ratio).

22
An Increase in Income...
Initial optimum
Initial budget constraint
I1
0
23
An Inferior Good...
Quantity
of Pepsi
Initial optimum
Initial budget constraint
I1
Quantity
0
of Pizza
24
A Change in Price...
I 1000 PPepsi 2 to 1 PPizza 10
Quantity of Pepsi
1,000
B
500
A
Initial budget constraint
Quantity of Pizza
100
0
25
Income and Substitution Effects

• The price effect can be divided into
• an income effect
• a substitution effect

26
Income and Substitution Effects...
Initial optimum
A
I1
Initial budget constraint
Quantity of Pizza
0
27
Deriving demand curve The Consumers Optimal
choices when Ppepsi falls from 2 to 1 (say I
200)
Quantity of Pepsi
Price of Pepsi
A
B
2
150
I2
New budget constraint
B
1
A
50
I1
0
0
Quantity of Pizza
Quantity of Pepsi
50
150
Initial budget constraint
28
Applications(1) How do increase in wages
affect labor supply?
29
Work-Leisure Decision...
Consumption
Available hour 100 w 50 The optimum
work-leisure choice is where BL is tangent to ID
curve.
5,000
Optimum
3,000
I3
2,000
I2
I1
Hours of Leisure
0
100
60
40
30
An Increase in the Wage...
(a) Stronger preferences for consumption
(substitution effectgt Income effect)
the labor supply curve slopes upward.
Wage
Consumption
S
B
B
I2
A
BC1
A
BC2
I1
0
0
Hours of Labor Supplied
Hours of Leisure
31
An Increase in the Wage...
(b) Stronger preferences for leisure (Income
effectgtSubstitution effect)
Wage
. .the labor supply curve slopes backward.
Consumption
BC2
B
B
A
A
I2
BC1
I1
0
0
Hours of Labor Supplied
Hours of Leisure
32
(2) How do interest rates affect household
saving?

• An increase in the interest rate could either
  encourage or discourage saving.

33
Consumption-Saving Decision...
Consumption
Budget constraint
when Old
110,000
Optimum
55,000
I3
I2
I1
Consumption
0
50,000
100,000
when Young
34
An Increase in the Interest Rate...
(a) Higher Interest Rate Raises Saving
(b) Higher Interest Rate Lowers Saving
Consumption when Old
Consumption when Old
BC2
BC2
B
B
I2
BC1
A
I2
BC1
A
I1
I1
Consumption when young
0
0
Consumption when Young
35
(3) Cash Vs. In Kind Transfer
36
Cash versus In-Kind Transfers...
(a) The Constraint Is Not Binding
Cash Transfer
In-Kind Transfer
Food
Food
(with 1,000 cash)
BC2
BC2
(with 1,000 food stamps)
BC1
BC1
B
B
I2
I2
1,000
1,000
A
A
I1
I1
0
0
Nonfood
Nonfood
Consumption
Consumption
37
Cash versus In-Kind Transfers...
(b) The Constraint Is Binding
Cash Transfer
In-Kind Transfer
Food
Food
BC2
(with 1,000 cash)
BC2
(with 1,000 food stamps)
BC1
BC1
I3
I2
I1
1,000
1,000
B
C
B
A
A
I2
I1
0
0
Nonfood
Nonfood
Consumption
Consumption