Professional Documents
Culture Documents
Theory
Theory
The Theory of
Consumer Choice
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21
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Consumers
budget constraint
A
0
100
Quantity
of Pizza
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250
C
Consumers
budget constraint
A
0
50
100
Quantity
of Pizza
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D
I2
A
Indifference
curve, I1
Quantity
of Pizza
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B
MRS
D
I2
1
A
Indifference
curve, I1
Quantity
of Pizza
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D
I2
A
Indifference
curve, I1
Quantity
of Pizza
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Indifference
curve, I1
0
Quantity
of Pizza
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Quantity
of Pizza
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4
3
MRS = 1
1
Indifference
curve
7
Quantity
of Pizza
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I1
0
I2
2
I3
3
Dimes
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I2
I1
Right Shoes
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Optimum
B
A
I3
I1
I2
Budget constraint
0
Quantity
of Pizza
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Quantity
of Pepsi
Initial
optimum
Initial
budget
constraint
I2
I1
0
2. . . . raising pizza consumption . . .
Quantity
of Pizza
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Quantity
of Pepsi
3. . . . but
Pepsi
consumption
falls, making
Pepsi an
inferior good.
Initial
optimum
New optimum
Initial
budget
constraint
I1
I2
0
2. . . . pizza consumption rises, making pizza a normal good . . .
Quantity
of Pizza
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New optimum
500
3. . . . and
raising Pepsi
consumption.
Initial optimum
Initial
budget
constraint
0
I1
I2
A
100
Quantity
of Pizza
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C New optimum
Income
effect
Substitution
effect
Initial
budget
constraint
Initial optimum
I2
I1
Substitution effect
Income effect
Quantity
of Pizza
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750
$2
I2
250
Demand
I1
0
Initial budget
constraint
Quantity
of Pizza
250
750
Quantity
of Pepsi
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THREE APPLICATIONS
Do all demand curves slope downward?
Demand curves can sometimes slope upward.
This happens when a consumer buys more of a
good when its price rises.
Giffen goods
Economists use the term Giffen good to describe a good
that violates the law of demand.
Giffen goods are goods for which an increase in the price
raises the quantity demanded.
The income effect dominates the substitution effect.
They have demand curves that slope upwards.
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D
E
2. . . . which
increases
potato
consumption
if potatoes
are a Giffen
good.
New budget
constraint
0
I2
A
I1
Quantity
of Meat
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THREE APPLICATIONS
How do wages affect labor supply?
If the substitution effect is greater than the income
effect for the worker, he or she works more.
If income effect is greater than the substitution
effect, he or she works less.
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Consumption
$5,000
Optimum
I3
2,000
I2
I1
0
60
100
Hours of Leisure
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Labor
supply
1. When the wage rises . . .
BC1
BC2 I2
I1
0
2. . . . hours of leisure decrease . . .
Hours of
Leisure
Hours of Labor
Supplied
3. . . . and hours of labor increase.
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BC2
1. When the wage rises . . .
Labor
supply
BC1
I1
I2
0
2. . . . hours of leisure increase . . .
Hours of
Leisure
Hours of Labor
Supplied
3. . . . and hours of labor decrease.
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THREE APPLICATIONS
How do interest rates affect household saving?
If the substitution effect of a higher interest rate is
greater than the income effect, households save
more.
If the income effect of a higher interest rate is
greater than the substitution effect, households save
less.
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55,000
Optimum
I3
I2
I1
$50,000
100,000
Consumption
when Young
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BC2
BC2
1. A higher interest rate rotates
the budget constraint outward . . .
BC1
BC1
I2
I1
I2
I1
0
2. . . . resulting in lower
consumption when young
and, thus, higher saving.
Consumption
when Young
0
2. . . . resulting in higher
consumption when young
and, thus, lower saving.
Consumption
when Young
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THREE APPLICATIONS
Thus, an increase in the interest rate could
either encourage or discourage saving.
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Summary
A consumers budget constraint shows the
possible combinations of different goods he can
buy given his income and the prices of the
goods.
The slope of the budget constraint equals the
relative price of the goods.
The consumers indifference curves represent
his preferences.
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Summary
Points on higher indifference curves are
preferred to points on lower indifference
curves.
The slope of an indifference curve at any point
is the consumers marginal rate of substitution.
The consumer optimizes by choosing the point
on his budget constraint that lies on the highest
indifference curve.
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Summary
When the price of a good falls, the impact on
the consumers choices can be broken down
into an income effect and a substitution effect.
The income effect is the change in consumption
that arises because a lower price makes the
consumer better off.
The income effect is reflected by the movement
from a lower to a higher indifference curve.
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Summary
The substitution effect is the change in
consumption that arises because a price change
encourages greater consumption of the good
that has become relatively cheaper.
The substitution effect is reflected by a
movement along an indifference curve to a
point with a different slope.
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Summary
The theory of consumer choice can explain:
Why demand curves can potentially slope upward.
How wages affect labor supply.
How interest rates affect household saving.
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