The Theory of Consumer Choice

Review
• The principle of equi-marginal utility
explains the behavior of a consumer in
distributing his limited income among
various goods and services. This law
states that how a consumer allocates his
money income between various goods so
as to obtain maximum satisfaction.
 Recall one of the Ten Principles

People face tradeoffs.

–“There is no such thing as free lunch”
–Buying more of one good leaves
less income to buy other goods.

THE THEORY OF CONSUMER

3
CHOICE
The Budget Constraint: What the
consumer can afford
Pedro’s income: 1200
Prices: PF = 4 per fish, PM = 1 per mango
Quantity of
Mangos D. Pedro’s budget line
B shows the bundles
A. 1200/4 he can afford.
= 300 fish
B. 1200/1 C
= 1200
mangoes
C. 100 fish cost
400,
800 left
buys 800 A
mangoes Quantity
of Fish
 The Slope of the Budget Line
From C to D, Quantity of
Mangos
“rise” =
–200 mangos
“run” =
+50 fish C
Slope = – 4 D
Pedro must
give up
4 mangos
to get one fish.

Quantity
THE THEORY OF CONSUMER
6
of Fish
CHOICE
 The Slope of the Budget Line

The slope of the budget constraint equals

– the rate at which Pedro
can trade mangos for fish
– the opportunity cost of fish in terms of mangos
– the price
relative
of price
fish of fish:
$4
= = 4 mangos per fish
price of mangos $1

THE THEORY OF CONSUMER

7
CHOICE
Preferences: What the Consumer
Wants
 Preferences: What the Consumer Wants

Indifference curve: Quantity One of Pedro’s

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
Pedro equally happy –
I1
he is indifferent between
them.
Quantity
of Fish
THE THEORY OF CONSUMER
10
CHOICE
 Four Properties of Indifference Curves

Quantity One of Pedro’s

1. Indifference curves of Mangos indifference curves
are downward-
sloping.

If the quantity of
fish is reduced, B

the quantity of
A
mangos must be
I1
increased to keep
Pedro equally happy.
Quantity
of Fish
THE THEORY OF CONSUMER
11
CHOICE
 Four Properties of Indifference Curves

Quantity A few of Pedro’s

2. Higher indifference of Mangos indifference curves
curves are preferred
to lower ones.

C
D
A I2
I1
I0
Quantity
of Fish
THE THEORY OF CONSUMER
12
CHOICE
 Four Properties of Indifference Curves

Quantity Pedro’s indifference

3. Indifference curves of Mangos curves
cannot cross.

Suppose they did.

Pedro should prefer B
B to C, since B has
more of both goods. C A

Yet, Pedro is indifferent I1 I4

between B and C:
Quantity
of Fish
THE THEORY OF CONSUMER
14
CHOICE
 Four Properties of Indifference Curves

Quantity
4. Indifference curves of Mangos
are bowed inward.
A
Pedro is willing to give
up more mangos for a 6
fish if he has few fish (A)
1
than if he has many (B).
B
2
1 I1

Quantity
of Fish
THE THEORY OF CONSUMER
15
CHOICE
 The Marginal Rate of Substitution

Marginal rate of Quantity MRS = slope of

substitution (MRS): of Mangos indifference curve
the rate at which a consumer
is willing to trade one good for A
another.
MRS = 6

1
MRS falls as you move down B
MRS = 2
along an indifference curve. 1 I1

Quantity
of Fish
THE THEORY OF CONSUMER
20
CHOICE
Optimization: What the Consumer
Chooses
 Optimization: What the Consumer Chooses
Quantity
of Mangos

1200

B
600
A

C
D

150 300 Quantity

THE THEORY OF CONSUMER of Fish
22
CHOICE
 Optimization: What the Consumer Chooses
Quantity
of Mangos
The optimum
is the bundle
Pedro most
A is the optimum:
1200 prefers out of all
the point on the
the bundles he
budget constraint
can afford.
that touches the
B
highest possible
600
A
indifference curve.
C
D

150 300 Quantity

THE THEORY OF CONSUMER of Fish
23
CHOICE
 Optimization: What the Consumer Chooses
Quantity
At the optimum, of Mangos
slope of the indifference
curve equals
slope of the budget 1200
constraint:

MRS = PF/PM A : MRS = PF/PM

600

marginal
price of fish
value of fish
(in terms of
(in terms of
mangos)
mangos) 150 300 Quantity
THE THEORY OF CONSUMER of Fish
24
CHOICE
Summary
• Budget Line
•Indifference Curve
•Optimization

MRS = PF/PM