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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