Chapter 21 - The Theory of Consumer Choice

• There are many factors that contribute to the theory of consumer choice.
• People face trade-offs while making decisions.
• There are three questions while making household decisions:
  • Do all demand curves slope downward?
  • How do wages affect the labor supply?
  • How do interest rates affect household savings?

21-1 The Budget Constraint: What a Consumer Can Afford

• Constrained: to be limited (in this context, by income)

Representing Consumption Opportunities in a Graph

• Budget constraint: the limit on the consumption bundles a consumer can afford
• This slope measures the rate where the consumer can buy or trade one good for the other.
  • Ex: 4 pens, 3 pens 1 pencil, 2 pens 2 pencils, 1 pen 3 pencils, or 4 pencils
• Relative Price: the price of one good compared to another
  • Ex: Hardcover books cost more than soft-covered books.

Shifts in the Budget Constraint

• The budget constraint includes the consumer’s income and the prices of the two goods.
• If income or prices change, the constraint shifts. An increase in income causes a parallel shift. An expansion in consumer opportunities causes a rotational shift.

21-2 Preferences: What a Consumer Wants

Representing Preferences with Indifference Curves

• Indifference curve: a curve that shows consumption bundles that give the consumer the same level of satisfaction
• Consumers will choose products and services that give them more satisfaction.
• Marginal rate of substitution; the rate at which a consumer is willing to trade one good for another
• The marginal rate of substitution depends on the number of prior instruments
• Higher indifference curves are preferred to lower indifference curves.

Four Properties of Indifference Curves

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

Two Extreme Examples of Indifference Curves

• When goods are hard to substitute, indifference curves are very bowed.
• Perfect substitutes: two goods with straight-line indifference curves
• Perfect complements: two goods with right-angle indifference curves

21-3 Optimization: What a Consumer Chooses

The Consumer’s Optimal Choices

• Optimum: where the indifference curve and the budget constraint touches
• The optimum is the choice that will bring the most utility
• The indifference curve is tangent to the budget constraint at the optimum.
• The consumer chooses the quantities of the two goods so that the marginal rate of substitution equals the relative price.
• Market prices of different goods reflect how much consumers value that good.

How Changes in Income Affect the Consumer’s Choices

• Normal good: a good for which an increase in income raises the quantity demanded
• Inferior good: a good for which an increase in income reduces the quantity demanded

How Changes in Prices Affect the Consumer’s Choices

• When the price of a good falls, the consumer budget constraint shifts outward and changes slope.
• When it increases, it shifts inwards and changes the slope.

Income and Substitution Effects

• Income effect: the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve
• Substitution effect: the change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution
• The income effect is the change in consumption that results from the movement to a new indifference curve. The substitution effect is the change in consumption that results from moving to a new point on the same indifference curve with a different marginal rate of substitution.

Deriving the Demand Curve

• The demand curve reflects consumption decisions.
• A consumer’s demand curve is a summary of the optimums and decisions they can make.

21-4 Three Applications

Do All Demand Curves Slope Downward?

• Law of demand: when the price of good rises, people buy less of it
• Giffen goods: a good that violates the law of demand. These are inferior goods where the income effect dominates the substitution effect

How Do Wages Affect Labor Supply?

• The time-allocation problem is a trade-off between leisure and consumption.
• The chosen combination of consumption and leisure is called the optimum.

How Do Interest Rates Affect Household Saving?

• If the substitution effect of a higher interest rate is greater than the income effect, savings increase.
• If the substitution effect of a higher interest rate is greater than the substitution effect, savings decrease.

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