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

Premium PowerPoint® Slides

by Ron Cronovich
2008 update
© 2008 South-Western, a part of Cengage Learning, 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 1

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 2

1
The Budget Constraint:
What the Consumer Can Afford
§ Two goods: pizza and Pepsi
§ A “consumption bundle” is

e.g., 40 pizzas & 300 pints of Pepsi.

§ Budget constraint:

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 3

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.
4

A C T I V E L E A R N I N G 1:
Answers
Pepsis

500

400

300

200

100

0
0 20 40 60 80 100 Pizzas
5

2
The Slope of the Budget Constraint
From C to D, Pepsis

“rise” = 500

400
“run” =
300
Slope =
200

Consumer must 100

give up
0
0 20 40 60 80 100 Pizzas
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 6

The Slope of the Budget Constraint

§ The slope of the budget constraint equals

price of pizza
=
price of Pepsi
CHAPTER 21 THE THEORY OF CONSUMER CHOICE 7

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
8

3
A C T I V E L E A R N I N G 2A:
Answers
Pepsis

500

400

300

200

100

0
0 20 40 60 80 100 Pizzas
9

A C T I V E L E A R N I N G 2B:
Answers
Pepsis

500

400

300

200

100

0
0 20 40 60 80 100 Pizzas
10

Preferences: What the Consumer Wants

Indifference curve:

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 11

4
Preferences: What the Consumer Wants
Marginal rate of substitution
(MRS):

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 12

Four Properties of Indifference Curves

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 13

Four Properties of Indifference Curves

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 14

5
Four Properties of Indifference Curves

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 15

One Extreme Case: Perfect Substitutes

Perfect substitutes:

Example: nickels & dimes

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 16

Another Extreme Case: Perfect Complements

Perfect complements: two goods with right-
angle indifference curves
Example: left shoes, right shoes

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 17

6
Optimization: What the Consumer Chooses
The optimal bundle is at the point
where

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 18

The Effects of an Increase in Income

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 19

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.

20

7
A C T I V E L E A R N I N G 3:
Answers

The Effects of a Price Change

22

The Income and Substitution Effects

A fall in the price of Pepsi has two effects on the
optimal consumption of both goods.
• Income effect

• Substitution effect

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 23

8
Income and
Substitution Effects

24

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?

25

The Substitution Effect for

Substitutes and Complements
§ The substitution effect is _______ when the goods
are very close substitutes.

§ The substitution effect is ________ when goods

are nearly perfect complements.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 27

9
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 28

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:
• income effect:
§ If
then potatoes are a Giffen good,

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 29

Application 1:
Giffen Goods

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 30

10
Application 2: Wages and Labor Supply
Budget constraint

• The relative price of an hour of leisure is

Indifference curve
• Shows “bundles” of

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 31

Application 2: Wages and Labor Supply

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 32

Application 2: Wages and Labor Supply

An increase in the wage has two effects
on the optimal quantity of labor supplied.
• Substitution effect (SE):

• Income effect (IE):

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 33

11
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 34

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 35

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 36

12
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

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 37

Application 3: Interest Rates and Saving

Budget constraint shown is for 10% interest rate.

At the optimum,

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 38

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.

39

13
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 41

Application 3: Interest Rates and Saving

In
In this
this case,
case,
SE
SE << IEIE and
and
saving
saving falls
falls

42

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 43

14