363
WHAT’S NEW IN THE SEVENTH EDITION:
There are no major changes to this chapter.
LEARNING OBJECTIVES:
By the end of this chapter, students should understand:
how a budget constraint represents the choices a consumer can afford.
how indifference curves can be used to represent a consumer’s preferences.
how a consumer’s optimal choices are determined.
how a consumer responds to changes in income and changes in prices.
how to decompose the impact of a price change into an income effect and a substitution effect.
how to apply the theory of consumer choice to three questions about household behavior.
CONTEXT AND PURPOSE:
number of questions about how the economy works.
THE THEORY OF CONSUMER
CHOICE
21
364 ❖ Chapter 21/The Theory of Consumer Choice
KEY POINTS:
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.
good for the other.
The consumer optimizes by choosing the point on her budget constraint that lies on the highest
indifference curve. At this point, the slope of the indifference curve (the marginal rate of substitution
between the goods) equals the slope of the budget constraint (the relative price of the goods), and
When the price of a good falls, the impact on the consumer’s choices can be broken down into an
income effect and a substitution effect. The income effect is the change in consumption that arises
because a lower price makes the consumer better off. The substitution effect is the change in
consumption that arises because a price change encourages greater consumption of the good that
The theory of consumer choice can be applied in many situations. It explains why demand curves can
potentially slope upward, why higher wages could either increase or decrease the quantity of labor
supplied, and why higher interest rates could either increase or decrease saving.
CHAPTER OUTLINE:
A. Example: A consumer has an income of $1,000 per month to spend on pizza and Pepsi. The price
of a pizza is $10 and the price of a liter of Pepsi is $2.
B. If the consumer spends all of her income on pizza, she can buy 100 pizzas per month. If the
This chapter is an advanced treatment of consumer choice using indifference curve
analysis. This chapter is much more difficult than the other chapters in the text. Most
undergraduate principles students will find this material challenging.
The best way to develop this model is to use specific examples with definite
quantities, prices, and levels of income.
Chapter 21/The Theory of Consumer Choice ❖ 365
C. Definition of budget constraint: the limit on the consumption bundles that a consumer
can afford.
D. Using this information, we can draw the consumer’s budget constraint.
a. The slope of the budget constraint measures the rate at which the consumer can trade
one good for another.
be traded for 5 liters of Pepsi).
Activity 1—You Can’t Always Get What You Want
Type: In-class activity
Topics: Budget constraints
Materials needed: None
Time: 5 minutes
Class limitations: Works in any size class
Purpose
This activity shows consumers are restricted by their limited incomes and by the prices of
goods.
Figure 1
Although the book does it later, now might be a good time to show the effects of
price and income changes. Show mathematically and graphically how a doubling (or
halving) of the price of one good will cause its intercept to change. Also show what
happens to the vertical and horizontal intercepts when income changes. Emphasize
that the budget depicts the consumption possibilities available to the individual. The
consumer can be on or within the budget constraint, but not beyond it.
366 ❖ Chapter 21/The Theory of Consumer Choice
II. Preferences: What the Consumer Wants
A. Representing Preferences with Indifference Curves
1. A consumer is indifferent between two bundles of goods and services if the two bundles suit
her tastes equally well.
2. Definition of indifference curve: a curve that shows consumption bundles that give
the consumer the same level of satisfaction.
4. Definition of marginal rate of substitution: the rate at which a consumer is willing
to trade one good for another.
5. The marginal rate of substitution is equal to the slope of the indifference curve at any point.
Instructions
Ask the students to think about maximizing their own utility.
Specifically, ask them to assume that billionaire Bill Gates offers to buy them the one thing
that would increase their happiness by the greatest amount. It cannot be money or a financial
instrument, but he will buy them any single thing they feel would make them happy. Have
them write down their requested item.
Ask a few students what they chose. Then ask the class, “Why don’t you buy that item for
yourself? Isn’t it the one thing that will increase your happiness by the largest amount? Why
not buy it today?”
The answer, of course, is they cannot afford it. Consumers’ purchases are constrained by
their incomes.
However, that is not the only constraint. Ask them to estimate the cost of their selected items
and write it next to the items. Now, have them assume Bill Gates is too busy to go shopping,
so he gives them the money instead. He does not put any restrictions on the use of the cash;
all he wants is to see them maximize their happiness.
This eliminates the income barrier. Ask the class how many of them would spend the entire
amount of money buying that single good.
Some students would buy that item, but most would buy a variety of things. Using the money
for a single expensive item may not be the best way to allocate their newfound wealth.
Buying several cheap things may give a higher level of happiness.
Points for Discussion
1) Consumers have limited income.
Together these things determine the consumer’s budget constraint.
Chapter 21/The Theory of Consumer Choice ❖ 367
a. Because these indifference curves are not straight lines, the marginal rate of substitution
is not the same at all points on a given indifference curve.
6. A consumer’s set of indifference curves gives a complete ranking of the consumer’s
preferences.
7. Any point on indifference curve
I
2 will be preferred to any point on indifference curve
I
1.
pizza and more Pepsi.
b. We can tell, though, that point D is also preferred to point C because point D is on a
higher indifference curve.
B. Four Properties of Indifference Curves
2. Indifference curves are downward sloping.
b. If the quantity of one good increases, the quantity of the other good must fall in order
for the consumer to remain equally satisfied.
3. Indifference curves do not cross.
Figure 2
368 ❖ Chapter 21/The Theory of Consumer Choice
consumer equally happy.
consumer equally happy.
d. But this should imply that points A and C make the consumer equally happy, even
to point A).
4. Indifference curves are bowed inward.
one good for another.
b. Because people are more willing to trade away goods that they have in abundance and
C. Two Extreme Examples of Indifference Curves
1. Perfect Substitutes
a. Examples: bundles of nickels and dimes.
c. Definition of perfect substitutes: two goods with straight-line indifference
curves.
Figure 3
Figure 4
Figure 5
Chapter 21/The Theory of Consumer Choice ❖ 369
d. Because the marginal rate of substitution is the same no matter how many dimes and
nickels the consumer has, the slope of the indifference curve is constant. Thus, the
indifference curve is a straight line.
2. Perfect Complements
a. Example: right shoes and left shoes.
d. Definition of perfect complements: two goods with right-angle indifference
curves.
III. Optimization: What the Consumer Chooses
A. The Consumer’s Optimal Choices
also stay within her budget.
2. The highest indifference curve the consumer can reach is the one that just barely touches
3. The optimum point represents the best combination of Pepsi and pizza available to the
consumer.
outside of her budget constraint.
b. The consumer could afford bundle B, but it lies on a lower indifference curve and
therefore provides less satisfaction.
Figure 6
370 ❖ Chapter 21/The Theory of Consumer Choice
4. At the optimum, the slope of the budget constraint is equal to the slope of the indifference
curve.
a. The indifference curve is tangent to the budget constraint at this point.
b. At this point, the marginal rate of substitution is equal to the relative price of the two
goods.
c. The relative price is the rate at which the
market
is willing to trade one good for the
other, while the marginal rate of substitution is the rate at which the
consumer
is willing
to trade one good for the other.
B.
FYI: Utility: An Alternative Way to Describe Preferences and Optimization
1. Utility is an abstract measure of the satisfaction that a consumer receives from a bundle of
goods and services.
2. A consumer will prefer bundle A to bundle B if bundle A provides more utility.
3. Indifference curves and utility are related.
a. Bundles of goods in higher indifference curves provide a higher level of utility.
b. Bundles of goods on the same indifference curve all provide the same level of utility.
c. The slope of the indifference curve reflects the marginal utility of one good compared to
the marginal utility of the other good.
4. A consumer can maximize her utility if she ends up on the highest indifference curve
possible.
a. This occurs when
MRS
=
PX
/
PY
.
b. Because
MRS
=
MUX
/
MUY
, optimization occurs where
MUX
/
MUY
=
PX
/
PY
.
c. This can be rewritten as
MUX
/
PX
=
MUY
/
PY
.
good
X
equals the marginal utility per dollar spent on good
Y
.
1. A change in income shifts the budget constraint.
b. Because the relative price of the two goods has not changed, the slope of the budget
constraint remains the same.
2. An increase in income means that the consumer can now reach a higher indifference curve.
Figure 7
Chapter 21/The Theory of Consumer Choice ❖ 371
3. Because the consumer increased her consumption of both goods when her income increased,
both Pepsi and pizza must be normal goods.
a. Definition of normal good: a good for which an increase in income raises the
quantity demanded.
quantity demanded.
D. How Changes in Prices Affect the Consumer’s Choices
a. If the consumer spends her entire income on pizza, the change in the price of Pepsi will
not affect her ability to buy pizza, so point A on the budget constraint remains the same.
b. If the consumer spends her entire income on Pepsi, she will now be able to buy 1,000
B to point D.
c. The slope of the budget constraint changes as well. Because the price of Pepsi has fallen,
the relative price of the two goods has changed. The consumer can now trade a pizza for
10 liters of Pepsi instead of 5. Therefore, the budget constraint has become steeper.
on the consumer’s preferences.
Figure 8
Figure 9
372 ❖ Chapter 21/The Theory of Consumer Choice
E. Income and Substitution Effects
1. Definition of income effect: the change in consumption that results when a price
change moves the consumer to a higher or lower indifference curve.
a new marginal rate of substitution.
3. Suppose that the price of Pepsi falls.
b. At the same time, the consumption of Pepsi has become less expensive relative to the
consumption of pizza. This is the substitution effect and it will tend to make the
consumer want to purchase more Pepsi and less pizza.
and the substitution effect.
Figure 10
Table 1