ECN 2100 – INTERMEDIATE

MICROECONOMICS

Lecture 1 Part 2
CONSUMER CHOICE
TOSHIA MC DONALD (JAMES), M.Sc.
Department of Economics
Faculty of Social Sciences, University of
Guyana
Consumer Choice

Structure:
• Lecture session
• Questions for Discussion
• Activity
• Reading requirements
Consumer Theory
- What is it?
economists assume that consumers choose the
best bundle of goods they can afford.
➢ What a consumer can afford implies budget
constraint
➢ The best bundle suggests that the consumer
has to make a choice hence they would have
preferences
Principles of Microeconomics Slide 3
Consumer Theory
- What is it?

Definition
“Consumer theory is the study of how people decide to spend
their money based on their individual preferences and budget
constraints. A branch of microeconomics, consumer theory shows
how individuals make choices, subject to how much income they
have available to spend and the prices of goods and services”

https://www.investopedia.com/terms/c/consumer-
theory.asp#:~:text=Consumer%20theory%20is%20the%20study,prices%20of%20goods%20and%20services.

Principles of Microeconomics Slide 4

Consumer Theory
- What is it?
Consumer theory follows 3 assumptions:
➢ Utility maximization: Individuals are said to make
calculated decisions when shopping, purchasing products
that bring them the greatest benefit, otherwise known as
maximum utility in economic terms
➢ Nonsatiation: People are seldom satisfied with one trip to
the shops and always want to consume more
➢ Decreasing marginal utility: Consumers lose satisfaction in
a product the more they consume it

Principles of Microeconomics Slide 5

Consumer Theory
- What is it?
Theory allows for
The analysis of the trade-offs and decisions consumers make
as prices and their income changes
……Hence We have to form an hypothesis as to why consumers
buy the things that they buy. What influences an individual’s
decision to spend on one good versus another good.
……Seek to example what cause a consumer to buy or not to
buy.
…..And based on consumer behaviour information marcro
economic policies are made.

Principles of Microeconomics Slide 6

 Budget
Constraint

In the Next Section we will examine:

• the budget constraint and the budget
line, 7 / 53

• how changes in income and prices

affect the budget line,
• how taxes, subsidies and rationing
affect the budget line.

()
Consumption
Bundle
For goods or services 1 and 2, the consumption bundle (x1, x2) shows how much
of each is consumed.

Suppose that we can observe

• the prices of the two goods or services (p1, p2)
8 / 53

• and the amount of money the consumer has to spend m

(income).

The budget constraint is therefore be written as p1x1 + p2x2 ≤ m.

The affordable consumption bundles are bundles that don’t cost more than
income.

The set of affordable consumption bundles is budget set of the consumer.

()
Two Goods

In reality there is often more than two goods or services to choose from, but for
graphical representation throughout, we will use two goods.

We often think of good 2 (say) as a composite good, representing money

9 / 53

to spend on other goods.

Composite good further explained

Budget constraint becomes p1x1 + x2 ≤ m.

Money spent on good 1 (p1x1) plus themoney spent on good 2 (x2) has to be
less than or equal to the available income (m).

()
 Budget Line
1
2 1
Budget line is p1x1 + p2x2 = m. It can be also
writtenas m p
x = − x
p2 p2
. Slope =
10 / 53
Opportunity Cost
Slope of budget line = opportunity cost of or “ the value of
the next-best
good 1. alternative when
a decision is
the budget line slopes downward and has a constant slope made”
along its entire length. If you buy more of one good, you are
going to have to buy less of the other good. The rate at which
you can trade one for the other is determined by the prices of
the two goods, and they (the rate) don’t change.

()
Change in Income

Increasing m makes parallel

shift out.
The vertical intercept
increases and the slope
remains the same.

()
Change in One Price
Increasing p1 makes the budget line
steeper.

The vertical intercept remains the

same and the slope changes.

()
Changes in More
Variables
1 1 2 2 1 1 22
t
Multiplying all prices by t is just like dividing income by t:
m
tp x + tp x = m ⇐⇒ p x + p x = .
13 / 53

Multiplying all prices and income by t doesn’t change budget line:

tp1x1 + tp2x2 = tm ⇐ ⇒ p1x1 + p2x2 = m.

A perfectly balanced inflation doesn’t change consumption

possibilities.

()
Changes in More
Variables
1 1 2 2 1 1 22
t
Effects of a decrease in income effect
The budget line shifts inwards.
14 / 53

()
Numeraire
We can arbitrarily assign one price or income a value of 1 and adjust the other variables so as
to describe the same budget set. Goods expressed relatively for analysis purposes.

Budget line: p1x1 + p2x2 = m

The same budget line for p2 = 1:
p1
x1 + x2 =
15 / 53
m
.
p2 p2

The same budget line for m = 1:

p1
x1 + p2
x2 = 1.
m m
The price adjusted to 1 is called the numeraire price.

Useful when measuring relative prices; e.g. English pounds per dollar, 1987 dollars versus 1974
dollars, etc. ()
Numeraire
Example:
P1 = 2
P2 = 3
M = 12

Budget line: 2x1 + 3 x2 = 12 16 / 53

The same budget line for p2 = 1 or making good 2 the numeraire

2
x1 + x2 = .
12
p1
x1 + x2 = .
m
3 3
p2 p2
It means that 2/3 is the price of good 1 relative to the price of good 2, and 4 is the disposable income relative to
the price of good 2.

()
Taxes

Three types of taxes:

• quantity tax – consumer pays amount t for each unit
purchased.
→ Price of good 1 increases to p1 + t.
17 / 53

• value tax (or ad valorem tax) – consumer pays a proportion of

the price τ.
→ Price of good 1 increases to p1 + τp1 = (1 + τ)p1.
• lump-sum tax – amount of tax is independent of the
consumer’s choices.
→ The income of consumer decreases by the amount of thetax.

()
Taxes

How do Taxes affect the budget line?

• Taxes are like higher prices thus, a tax only changes the price of a
good
18 / 53

()
Subsidies

Subsidies – opposite effect than the taxes

• quantity subsidy of s on good 1
→ Price price of good 1 decreases to p1 − s.
ad valorem subsidy at a rate of σ on good 1
19 / 53

•
→ Price price of good 1 decreases to p1 − σp1 = (1 − σ)p1.
• lump-sum subsidy
→ The income increases by the amount of thesubsidy.

()
 Rationing

Rationing – can’t consume more than a

certain amount of somegood.
Good 1 is rationed, no more than x¯units of
good 1 can be consumed by any consumer.

()
Taxing Consumption
Greater than x¯1
Taxed only consumption of good 1 in
excess of x¯1,the budget line becomes
steeper right of x¯1

21 / 53

()
 22 / 53

()
 Summary
• The budget set consists of bundles of goods that the
consumer can afford at given prices and income. Typically
assume only 2 goods – one of the goods might be
composite good.
• The budget line can be written as
23 / 53

p1x1 + p2x2 = m.
• Increasing income shifts the budget line outward.
Increasing price of one good changes the slope of the
budget line.
• Taxes, subsidies, and rationing change the position
and slope of the budget line.

()
EXERCISE
Define a budget constraint
Discuss the interpretation of the slope of the budget line
Illustrate how changes in prices and income alter the budget constraint and budget line
Illustrate how coupons, vouchers and taxes alter the budget constraint and budget line

Principles of Microeconomics Slide 24

Our Next Class
• Our next class we will be continuing
Consumer Choice by looking at:
– Preferences
– Utility
– Consumer Optimization

25
Questions

• Open

26
References
• [HV2] Varian, H. (2006). Intermediate Microeconomics: A Modern Approach, W. W. Norton & Company,
7th edition. Chapters 2, 3 & 4
• https://open.oregonstate.education/intermediatemicroeconomics/chapter/module-
3/#:~:text=The%20budget%20constraint%20is%20the,a%20consumer%20has%20a%20budget., Oregan
State University, accessed on 21st September, 2022
• https://www.investopedia.com/terms/c/consumer-theory.asp , Investopdedia, accessed on 21st September,
2022