Premium CH 21 The Theory of Consumer Choice

N.
GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eighth Edition
CHAPTER The Theory of

21 Consumer Choice
Premium PowerPoint Slides by:
V. Andreea CHIRITESCU
Eastern Illinois University
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning
1
management system for classroom use.
Look for the answers to these questions:
ngân sách
• 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?
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 2
Introduction
• 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.
The Budget Constraint:
What the Consumer Can Afford
• Budget constraint:
– The limit on the consumption bundles that
a consumer can afford
• Example:
– Hurley divides his income between two
goods: fish and mangos.
giỏ hàng hoá tiêu dùng
– A “consumption bundle” is a particular

combination of the goods, e.g., 40 fish &
300 mangos
Active Learning 1 The budget constraint
Hurley’s income: $1200
Prices: PF = $4 per fish, PM = $1 per mango
A. If Hurley spends all his income on fish, how many
fish does he buy? $300
B. If Hurley spends all his income on mangos, how
many mangos does he buy? $1200
C. If Hurley buys 100 fish, how many mangos can he
buy? 800
D. Plot each of the bundles from parts A – C on a

graph that measures fish on the horizontal axis
and mangos on the vertical; connect the dots.
Active Learning 1 Answers
A. $1200/$4 Quantity D. Hurley’s budget
of Mangos constraint shows
= 300 fish B
the bundles he can
B. $1200/$1 afford.
= 1200 C
mangos
C. 100 fish cost
$400,
$800 left buys
800 mangos A
Quantity
of Fish
Active Learning 1 The Slope of the Budget Constraint
The slope of the
From C to D, of Quantity
Mangos budget constraint
“rise” = equals the relative
–200 mangos price of the good
on the X axis.
“run” = C
+50 fish rise
D
Slope = – 4 run
Hurley must slope = rise / run
give up
4 mangos
to get one fish. Quantity
of Fish
Active Learning 2 The budget constraint, continued
Initial problem:
Hurley’s income: $1200
Prices: PF = $4 per fish, PM = $1 per mango
Show what happens to Hurley’s budget
constraint if:
A. His income falls to $800.
B. The price of mangos rises to PM = $2 per
mango
Active Learning 2 Answers, part A
Quantity
Now, of Mangos
Hurley A fall in income
can buy shifts the budget
constraint down.
$800/$4
= 200 fish
or
$800/$1
= 800 mangos
or any
combination in Quantity
of Fish
between.
Active Learning 2 Answers, part B
Hurley Quantity
can still buy of Mangos
An increase in the
300 fish. price of one good
pivots the budget
But now he
constraint inward.
can only buy
$1200/$2 =
600 mangos.
Notice: slope is
smaller, relative
price of fish is now
only 2 mangos Quantity
of Fish
Preferences: What the Consumer Wants
Indifference curve: One of Hurley’s

Quantity
shows consumption of Mangos indifference curves
bundles that give the
consumer the same
level of satisfaction
B
A, B, and all other
bundles on I1 make A
Hurley equally happy: I1
he is indifferent
between them.
Quantity
of Fish
Four Properties of Indifference Curves
1. Indifference curves are downward-
sloping. Quantity One of Hurley’s
of Mangos indifference curves
If the quantity of
fish is reduced,
the quantity of
mangos must be B
increased to keep
Hurley equally A
happy. I1
Quantity
of Fish
2. Higher indifference curves are preferred
to lower ones. Quantity A few of Hurley’s
Hurley prefers
every bundle on I2
(like C) to every
bundle on I1 (like
C
A). D
He prefers every A I2
bundle on I1 (like I1
A) to every bundle I0
on I0 (like D). Quantity
of Fish
3. Indifference curves cannot cross.
Suppose they did. Quantity Hurley’s
Hurley should prefer
B to C, since B has
more of both goods.
Yet, Hurley is indifferent B
between B and C:
C A
He likes C as much as A
(both are on I4). I1 I4
He likes A as much as B
(both are on I1). Quantity
of Fish
4. Indifference curves are bowed inward.
Quantity
of Mangos
Hurley is willing to
give up more
A
mangos for a fish if
he has few fish (A) 6
than if he has many
1
(B). B
2
1 I1
Quantity
of Fish
The Marginal Rate of Substitution
Marginal rate of tỷ lệ thay thế biên
substitution (MRS): Quantity MRS = slope of
the rate at which a of Mangos indifference curve
consumer is willing to
trade one good for another. A
MRS = 6
Hurley’s MRS is the
amount of mangos he 1
would substitute for another B
fish. MRS = 2
1 I1
MRS falls as you
move down along
Quantity
an indifference curve. of Fish
One Extreme Case: Perfect Substitutes
Perfect substitutes: two goods with
straight-line indifference curves,
constant MRS thay thế hoàn hảo
Example: nickels and dimes

Consumer is always willing to
trade two nickels for one dime.
Another Extreme Case: Perfect Complements
Perfect complements: two goods
with right-angle
góc vuông
indifference curves
Example: Left shoes, right shoes
{7 left shoes, 5 right shoes}
is just as good as
{5 left shoes, 5 right shoes}
Less Extreme Cases:
Close Substitutes and Close Complements
Quantity Indifference Quantity Indifference
of Pepsi curves for close of hot curves for
dog buns close
substitutes are
not very bowed complements
are very
bowed
Quantity Quantity
of Coke of hot dogs
Optimization: What the Consumer Chooses
Quantity
A is the optimum: of Mangos
The optimum
the point on the budget is the bundle
constraint that touches Hurley most
the highest possible 1200 prefers out of
indifference curve. all the bundles
he can afford.
Hurley prefers B to A, B
but he cannot afford B. 600
A
C
Hurley can afford C and
D
D, but A is on a higher
indifference curve. 150 300 Quantity
of Fish
Optimization: What the Consumer Chooses
Quantity
of Mangos Consumer
At the optimum, optimization is
slope of the another example
indifference curve 1200 of “thinking at the
equals slope of the margin.”
budget constraint:
600
A
MRS = PF / PM
marginal
price of fish
value of fish
(in terms of
(in terms of 150 300 Quantity
mangos)
mangos) of Fish
The Effects of an Increase in Income
Quantity
An increase in of Mangos
income shifts the
budget constraint
outward.
If both goods are B

“normal,” Hurley A
buys more of each.
Quantity
of Fish
Active Learning 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 fish is a normal good
but mangos are an inferior good.
• Use a diagram to show the effects of
an increase in income on Hurley’s optimal
bundle of fish and mangos.
Quantity
of Mangos
• If mangos are
inferior, the
new optimum
will contain
fewer mangos. A
B
Quantity
of Fish
The Effects of a Price Change
Initially, Quantity
PF = $4 of Mangos
PM = $1 1200
initial
optimum
PF falls to $2 new
optimum
budget constraint 600
rotates outward, 500
Hurley buys
more fish and
fewer mangos.
150 300 600 Quantity
350 of Fish
The Income and Substitution Effects
A fall in the price of fish has two effects on
Hurley’s optimal consumption of both goods
• Income effect
– A fall in PF boosts the purchasing power of
Hurley’s income: buy more mangos and more fish
• Substitution effect
– A fall in PF makes mangos more expensive
relative to fish: Hurley buys fewer mangos and
more fish
không rõ ràng
The net effect on mangos is ambiguous.

The Income and Substitution Effects
Quantity
Initial optimum at A. of Mangos
In this example,
PF falls. the net effect
on mangos is
Substitution effect: negative.
from A to B,
buy more fish and
A
fewer mangos. C
Income effect: B
from B to C,
buy more of both Quantity
goods. of Fish
Active Learning 4 The substitution effect in two cases
Do you think the substitution effect would be

bigger for substitutes or complements?
• Draw an indifference curve for Coke and
Pepsi, and, on a separate graph, one for hot
dogs and hot dog buns.
• On each graph, show the effects of a
relative price change (keeping the consumer
on the initial indifference curve).
But the substitution effect is bigger for substitutes than for
complements.
In both graphs, the relative price changes by the same amount.
Quantity
of Pepsi Quantity of
hot dog buns
A
B B
Quantity of Coke Quantity of hot dogs

Deriving Hurley’s Demand Curve for Fish
A: When PF = $4, Hurley demands 150 fish.
B: When PF = $2, Hurley demands 350 fish.
Quantity Price of
of Mangos Fish
A
$4
A
B
B
$2
DFish
150 350 Quantity 150 350 Quantity

of Fish of Fish
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: buy less potatoes
• Income effect: buy more potatoes
– If income effect > substitution effect,
then potatoes are a Giffen good, a good
for which an increase in price raises the
quantity demanded.
Application 1: A Giffen Good
Quantity of
Potatoes Initial budget
1. An increase in the price of potatoes
B constraint rotates the budget constraint inward . . .
D Optimum with high

price of potatoes
New
2. . . . which budget
E
increases potato constraint Optimum with low
consumption if C
price of potatoes
potatoes are a
Giffen good. I1
I2
A
0 Quantity of Meat
In this example, when the price of potatoes rises, the consumer’s optimum shifts from point
C to point E. In this case, the consumer responds to a higher price of potatoes by buying less
meat and more potatoes.
Application 2:
Wages and Labor Supply
• Budget constraint
– Shows a person’s tradeoff between
consumption and leisure
– Depends on how much time she has to divide
between leisure and working
– The relative price of an hour of leisure is the
amount of consumption she could buy with an
hour’s wages
• Indifference curve
– Shows “bundles” of consumption and leisure
that give her the same level of satisfaction
Application 2: Wages and Labor Supply
Consumption
$5,000
At the optimum,
the MRS between
leisure and
Optimum
consumption
I3 equals the wage.
2,000
I2
I1
0 60 100
Hours of leisure
Application 2:
Wages and Labor Supply
• An increase in the wage has two effects
on the optimal quantity of labor supplied:
– Substitution effect (SE): A higher wage makes
leisure more expensive relative to
consumption.
• The person chooses less leisure (increases
quantity of labor supplied)
– Income effect (IE): With a higher wage,
she can afford more of both “goods.”
• She chooses more leisure (reduces quantity of
labor supplied)
For this person, So her labor supply
SE > IE increases with the wage
Consumption Wage
BC2
Labor supply
I2
1. When the wage rises . . .
BC1 A
I1
0 0
Hours of Leisure Hours of Labor
2. . . . hours of leisure decrease . . . Supplied
3. . . . and hours of labor increase
For this person, So his labor supply falls
SE < IE when the wage rises
Consumption Wage
BC2
Labor supply
1. When the wage rises . . .
I2
I1
BC1
0 0
Hours of Leisure Hours of Labor
2. . . . hours of leisure increase . . . Supplied
3. . . . and hours of labor decrease
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
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 the relative price of
consumption when young in terms of
consumption when old
Application 3: Interest Rates and Saving
Consumption Budget constraint
when Old
shown is for 10%
$110,000 interest rate.
At the optimum,
the MRS between
Optimum
55,000 current and future
I3
consumption
I2 equals the interest
I1
rate.
0 $50,000 100,000
Consumption when Young
Active Learning 5 A change in the interest rate
Suppose the interest rate rises.

• Describe the income and substitution effects
on current and future consumption, and on
saving.
The interest rate rises.
• Substitution effect
– Current consumption becomes more expensive
relative to future consumption.
– Current consumption falls, saving rises,
future consumption rises.
• Income effect
– Can afford more consumption in both the
present and the future.
– Saving falls.
(a) Higher Interest Rate Raises Saving

Consumption
when 1. A higher interest rate
old BC2
rotates the budget
constraint outward . . . In this case,
SE > IE and
I2
2. . . . resulting in saving rises
lower consumption
when young and,
thus, higher saving.
BC1
I1
0
(b) Higher Interest Rate Lowers Saving
Consumption
when 1. A higher interest rate
old BC2
rotates the budget
constraint outward . . . In this case,
SE < IE and
saving falls
I2
2. . . . resulting in
higher consumption
I1
when young and,
thus, lower saving.
BC1
0
Conclusion:
Do People Really Think This Way?
• 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 explains consumer behavior fairly well in many
situations and provides the basis for more
advanced economic analysis.
Summary
• 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.
• An increase in income shifts the budget
constraint outward.
• A change in the price of one of the goods
pivots the budget constraint.
Summary
• A consumer’s indifference curves represent her
preferences.
• An indifference curve shows all the bundles that
give the consumer a certain level of happiness.
• The consumer prefers points on higher
indifference curves to points on lower ones.
• The slope of an indifference curve at any point
is the marginal rate of substitution
• MRS = rate at which the consumer is willing to
trade one good for the other.
Summary
• The consumer optimizes by choosing the
point on her budget constraint that lies on the
highest indifference curve.
• At this point, the marginal rate of substitution
equals the relative price of the two goods.
• When the price of a good falls, the impact on
the consumer’s choices can be broken down
into two effects, an income effect and a
substitution effect.
Summary
• The income effect is the change in
consumption that arises because a lower
price makes the consumer better off.
• Movement from a lower indifference curve to
a higher one.
• The substitution effect is the change that
arises because a price change encourages
greater consumption of the good that has
become relatively cheaper.
• Movement along an indifference curve.
Summary
• The theory of consumer choice can be
applied in many situations.
• It can explain why demand curves can
potentially slope upward, why higher wages
could either increase or decrease labor
supply, and why higher interest rates could
either increase or decrease saving.

Premium CH 21 The Theory of Consumer Choice

Uploaded by

Copyright:

Available Formats

Premium CH 21 The Theory of Consumer Choice

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Premium CH 21 The Theory of Consumer Choice

Uploaded by

Copyright:

Available Formats

N.

CHAPTER The Theory of

• How does the budget constraint represent

– A “consumption bundle” is a particular

D. Plot each of the bundles from parts A – C on a

Hurley must slope = rise / run

Indifference curve: One of Hurley’s

Example: nickels and dimes

If both goods are B

The net effect on mangos is ambiguous.

Do you think the substitution effect would be

Quantity of Coke Quantity of hot dogs

150 350 Quantity 150 350 Quantity

D Optimum with high

Suppose the interest rate rises.

(a) Higher Interest Rate Raises Saving

You might also like