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Chapter 21/The Theory of Consumer Choice ❖ 373
b. Second, the consumer shifts to higher indifference curve
I
2 by moving from point B to C.
indifference curve
I
1 at point B is equal to the slope of indifference curve
I
2 at point C.
F. Deriving the Demand Curve
2. We can view a consumer's demand curve as a summary of the optimal decisions that arise
from her budget constraint and indifference curves.
3. When the price of Pepsi falls from $2 per liter to $1, the consumer's budget constraint shifts
4. Note that at a price of $2, the consumer's quantity of Pepsi demanded is 50. At a price of $1,
quantity demanded is 150. These are two of the points on her demand curve for Pepsi.
IV. Three Applications
A. Do All Demand Curves Slope Downward?
3. Example: A consumer spends his entire budget on meat and potatoes. The price of potatoes
rises.
a. The budget constraint will shift in.
Figure 11
Figure 12
Students can learn to separate the substitution effects easily if they follow a simple
rule: Have them draw a line tangent to the original indifference curve but parallel to
the new budget constraint. Make sure that they realize that the substitution effect is
seen as the movement along one indifference curve (due to changes in relative
prices), and the income effect is seen as the movement from one budget constraint
to a parallel budget constraint (because the individual’s purchasing power has
changed).
374 ❖ Chapter 21/The Theory of Consumer Choice
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
b. The substitution effect suggests that the consumer will choose more meat and fewer
potatoes.
c. The income effect suggests that the individual has suffered a decline in purchasing
increase her consumption of inferior goods.
d. Suppose that potatoes are an inferior good. When the price of potatoes rises, the
potatoes rose.
4. Definition of Giffen good: a good for which an increase in the price raises the
quantity demanded.
5.
Case Study: The Search for Giffen Goods
b. Poor households exhibited Giffen behavior by purchasing less rice (a staple) when its
price fell and more when its price rose.
B. How Do Wages Affect Labor Supply?
1. Example: Carrie has 100 hours per week that she can devote to working or enjoying leisure.
2. We can show Carrie's budget constraint graphically.
consumption goods.
$5,000.
3. Carrie's optimum will occur where the highest possible indifference curve is tangent to the
budget constraint.
4. If Carrie's wage increases, her budget constraint will shift outward.
a. The budget constraint will become steeper, because Carrie can get more consumption for
every hour of leisure that she gives up.
Figure 13
Chapter 21/The Theory of Consumer Choice ❖ 375
c. The response of leisure to the change in Carrie's wage is not as straightforward. This
d. If the substitution effect is greater than the income effect, Carrie will decrease leisure
and work more hours if her wage rises. This results in an upward-sloping labor supply
curve.
curve.
5.
Case Study: Income Effects on Labor Supply: Historical Trends, Lottery Winners, and the
Carnegie Conjecture
b. The income effect can be isolated by examining the effects of winning the lottery on an
individual's labor supply. Studies have shown that lottery prizes lead to significant
lead his children to become unproductive.
C. How Do Interest Rates Affect Household Saving?
1. Example: Saul is planning ahead for retirement. There are two time periods. Currently, Saul
interest rate is 10 percent.
2. We can view "consumption while young" and "consumption while old" as the two goods that
Saul must choose between.
3. The interest rate determines the relative price of these two goods. For every dollar that Saul
4. We can draw Saul's budget constraint.
have "consumption while old."
Figure 14
Figure 15
376 ❖ Chapter 21/The Theory of Consumer Choice
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
b. If Saul saves nothing, he will consume $100,000 when he is young and zero when he is
old. Likewise, if he consumes nothing when he is young, he will be able to consume
$110,000 when he is old.
5. Saul's optimum occurs where his highest possible indifference curve is tangent to his budget
constraint.
6. If the interest rate rises to 20 percent, two possible outcomes could occur.
b. Because the increase in the interest rate means an increase in purchasing power, the
income effect suggests that Saul increase his consumption of normal goods. Because
c. Thus, the end result will depend on whether the income effect or the substitution effect
dominates. If the substitution effect is larger than the income effect, Saul will save more
when young.
7. Because of this ambiguity, it is not clear how changing the way interest income is taxed will
affect overall savings rates.
SOLUTIONS TO TEXT PROBLEMS:
Quick Quizzes
1. A person with an income of $1,000 could purchase $1,000/$5 = 200 liters of Pepsi if she
spent all of her income on Pepsi or she could purchase $1,000/$10 = 100 pizzas if she spent
all of her income on pizza. Thus, the point representing 200 liters of Pepsi and no pizzas is
the vertical intercept and the point representing 100 pizzas and no Pepsi is the horizontal
intercept of the budget constraint, as shown in Figure 1. The slope of the budget constraint
is the rise over the run, or -200/100 = -2.
Figure 16
Chapter 21/The Theory of Consumer Choice ❖ 377
Figure 1
2. Figure 2 shows indifference curves between Pepsi and pizza. The four properties of these
indifference curves are: (1) higher indifference curves are preferred to lower ones because
consumers prefer more of a good to less of it; (2) indifference curves are downward sloping
because if the quantity of one good is reduced, the quantity of the other good must increase
for the consumer to be equally happy; (3) indifference curves do not cross because if they
did, the assumption that more is preferred to less would be violated; and (4) indifference
curves are bowed inward because people are more willing to trade away goods that they
have in abundance and less willing to trade away goods of which they have little.
Figure 2
3. Figure 3 shows the budget constraint (
BC
1) and two indifference curves. The consumer is
point C where the new budget constraint is tangent to a lower indifference curve. To break
this move down into income and substitution effects requires drawing the dashed budget line
shown, which is parallel to the new budget constraint and tangent to the original indifference
378 ❖ Chapter 21/The Theory of Consumer Choice
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
curve at point B. The movement from A to B represents the substitution effect, while the
movement from B to C represents the income effect.
Figure 3
the income effect.
Questions for Review
of -1,000/500 = -2.
Chapter 21/The Theory of Consumer Choice ❖ 379
Figure 4
away wine if she has a lot of it and less willing to trade away wine if she has little of it.
Figure 5
380 ❖ Chapter 21/The Theory of Consumer Choice
Figure 6
marginal rate of substitution is $6/$3 = 2.
Figure 7
constraint out from
BC
1 to
BC
2. If both wine and cheese are normal goods, consumption of
Chapter 21/The Theory of Consumer Choice ❖ 381
Figure 8
Figure 9
shifts from
BC
1 to
BC
2 and her optimal choice changes from point A (
c
1 cheese,
w
1 wine) to
we draw in budget constraint
BC
3, which is parallel to
BC
2 but tangent to the consumer's
