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The Theory of Consumer Choice
The Theory of Consumer Choice
Consumer Choice
Chapter 21
Copyright 2001 by Harcourt, Inc.
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0
50
100
150
200
250
300
350
400
450
500
Number of
Pizzas
100
90
80
70
60
50
40
30
20
10
0
Spending
on Pepsi
$ 0
100
200
300
400
500
600
700
800
900
1,000
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Spending
on Pizza
Total
Spending
$1,000
900
800
700
600
500
400
300
200
100
0
$1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
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Consumers
budget constraint
0
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A
100
Quantity
of Pizza
Alternately, the
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250
C
Consumers
budget constraint
50
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A
100
Quantity
of Pizza
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Preferences:
What the Consumer Wants
A consumers preference among
consumption bundles may be
illustrated with indifference curves.
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D
I2
A
0
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Indifference
curve, I1
Quantity
of Pizza
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D
I2
MRS 1
A
0
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Indifference
curve, I1
Quantity
of Pizza
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D
I2
A
0
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Indifference
curve, I1
Quantity
of Pizza
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Indifference
curve, I1
0
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Quantity
of Pizza
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0
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Quantity
of Pizza
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4
3
0
MRS = 1
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B
1
7
Indifference
curve
Quantity
of Pizza
substitutes
Perfect complements
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Perfect Substitutes
Two
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Perfect Substitutes
Nickels
6
4
2
I1
1
I2
I3
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Dimes
Perfect Complements
Two goods with right-angle
indifference curves are perfect
complements.
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Perfect Complements
Left
Shoes
I2
I1
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Right Shoes
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Optimum
B
A
I3
I1
I2
Budget constraint
0
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Quantity
of Pizza
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combination of goods on a
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An Increase in Income...
Quantity
of Pepsi
3. and Pepsi
consumption.
Initial
optimum
I2
Initial
budget
constraint
I1
0
2. raising pizza
Quantity
of Pizza
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An Inferior Good...
Quantity
of Pepsi
3. ... but
Pepsi
consumption
falls, making
Pepsi an
inferior
good.
Initial
optimum
Initial
budget
constraint
I1
I2
Quantity
2. ... pizza consumption rises, of Pizza
making pizza a normal good...
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A Change in Price...
Quantity
of Pepsi
1,000
3. and
raising Pepsi
consumptio
n.
500
Initial budget
constraint
0
New optimum
1. A fall in the price of
Pepsi rotates the budget
constraint outward
I2
I1
100
2. reducing pizza
Quantity of Pizza
An income effect
A substitution effect
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A Change in Price:
Substitution Effect
A price change first causes the
consumer to move from one point
on a indifference curve to another
on the same curve.
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A Change in Price:
Income Effect
After moving from one point to
another on the same curve, the
consumer will move to another
indifference curve.
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C New optimum
Income effect
Initial optimum
Substitutio
n effect
Initial
budget
constraint 0
I2
I1
Substitution effect
Income effect
Quantity of Pizza
I ncome Effect
Substitution Effect
Total Effect
Pepsi
Consumer is richer,
so he buys more Pepsi.
Pepsi is relatively
cheaper, so consumer
buys more Pepsi.
Income and
substitution
effects act in
same direction,
so consumer buys
more Pepsi.
Pizza
Consumer is richer,
so he buys more pizza.
Pizza is relatively
more expensive,
so consumer buys
less pizza.
Income and
substitution
effects act in
opposite directions,
so the total effect
on pizza consumption
is ambiguous.
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New budget
constraint
150
$2
I2
B
1
50
A
I1
0
Initial budget
constraint
Quantity
of Pizza
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50
150 Quantity
of Pepsi
upward.
This happens when a consumer buys
more of a good when its price rises.
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Giffen Goods
Economists use the term Giffen good to
describe a good that violates the law of
demand.
Giffen goods are inferior goods for which
the income effect dominates the
substitution effect.
They have demand curves that slope
upwards.
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Quantity of
Potatoes
A Giffen Good...
Initial budget constraint
2...which
D
increases
potato
consumptio
n if
potatoes
are a Giffen
good.
New budget
constraint
0
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I2
A
I1
Quantity
of Meat
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Optimum
I3
2,000
I2
I1
0
60
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100
Hours of
Leisure
Consumption
Wage
1. When the
wage rises
I2
BC1
BC2
I1
Hours of 0
Hours of
Labor
2. hours of leisure Leisure
3. ...and hours of labor
increase.
Supplied
decrease
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Consumption
Wage
BC2
1. When the
wage rises
I2
BC1
I1
0
Hours of 0
Hours of
Leisure
Labor
2. hours of leisure
3. ...and hours of labor
decrease.
Supplied
increase
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55,000
Optimum
I3
I2
I1
0
$50,000
100,000
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Consumption
when Young
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BC2
BC1
I2
Consumption
when Old
Consumption
when Old
BC2
1. A higher
interest rate
rotates the
budget constraint
outward...
1. A higher
interest rate
rotates the
budget constraint
outward...
I2
BC1
I1
I1
0
0
Consumption
2. resulting in lower
when Young
consumption when young
and, thus, higher saving.
Hours of
2. resulting in higher Leisure
consumption when young
and, thus, lower saving.
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Food
In-Kind Transfer
Food
BC1
BC1
B
$1,000
B
I2
I2
$1,000
I1
0
Nonfood
Consumption
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I1
Nonfood
Consumption
Food
BC1
BC1
$1,000
B
A
In-Kind Transfer
Food
I1
$1,000
I2
0
Nonfood
Consumption
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B
A
I1
I2
I3
Nonfood
Consumption
Summary
A consumers
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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
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Graphical
Review
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Consumers
budget constraint
0
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A
100
Quantity
of Pizza
250
C
Consumers
budget constraint
50
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A
100
Quantity
of Pizza
D
I2
A
0
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Indifference
curve, I1
Quantity
of Pizza
D
I2
MRS 1
A
0
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Indifference
curve, I1
Quantity
of Pizza
D
I2
A
0
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Indifference
curve, I1
Quantity
of Pizza
Indifference
curve, I1
0
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Quantity
of Pizza
0
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Quantity
of Pizza
4
3
0
MRS = 1
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B
1
7
Indifference
curve
Quantity
of Pizza
Perfect Substitutes
Nickels
6
4
2
I1
1
I2
I3
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Dimes
Perfect Complements
Left
Shoes
I2
I1
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Right Shoes
Optimum
B
A
I3
I1
I2
Budget constraint
0
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Quantity
of Pizza
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An Increase in Income...
Quantity
of Pepsi
3. and Pepsi
consumption.
Initial
optimum
I2
Initial
budget
constraint
I1
0
2. raising pizza
Quantity
of Pizza
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An Inferior Good...
Quantity
of Pepsi
3. ... but
Pepsi
consumption
falls, making
Pepsi an
inferior
good.
Initial
optimum
Initial
budget
constraint
I1
I2
Quantity
2. ... pizza consumption rises, of Pizza
making pizza a normal good...
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A Change in Price...
Quantity
of Pepsi
1,000
3. and
raising Pepsi
consumptio
n.
500
Initial budget
constraint
0
New optimum
1. A fall in the price of
Pepsi rotates the budget
constraint outward
I2
I1
100
2. reducing pizza
Quantity of Pizza
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C New optimum
Income effect
Initial optimum
Substitutio
n effect
Initial
budget
constraint 0
I2
I1
Substitution effect
Income effect
Quantity of Pizza
New budget
constraint
150
$2
I2
B
1
50
A
I1
0
Initial budget
constraint
Quantity
of Pizza
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50
150 Quantity
of Pepsi
Quantity of
Potatoes
A Giffen Good...
Initial budget constraint
2...which
D
increases
potato
consumptio
n if
potatoes
are a Giffen
good.
New budget
constraint
0
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I2
A
I1
Quantity
of Meat
Optimum
I3
2,000
I2
I1
0
60
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100
Hours of
Leisure
Consumption
Wage
1. When the
wage rises
I2
BC1
BC2
I1
Hours of 0
Hours of
Labor
2. hours of leisure Leisure
3. ...and hours of labor
increase.
Supplied
decrease
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Consumption
Wage
BC2
1. When the
wage rises
I2
BC1
I1
0
Hours of 0
Hours of
Leisure
Labor
2. hours of leisure
3. ...and hours of labor
decrease.
Supplied
increase
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55,000
Optimum
I3
I2
I1
0
$50,000
100,000
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Consumption
when Young
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BC2
BC1
I2
Consumption
when Old
Consumption
when Old
BC2
1. A higher
interest rate
rotates the
budget constraint
outward...
1. A higher
interest rate
rotates the
budget constraint
outward...
I2
BC1
I1
I1
0
0
Consumption
2. resulting in lower
when Young
consumption when young
and, thus, higher saving.
Hours of
2. resulting in higher Leisure
consumption when young
and, thus, lower saving.
Food
In-Kind Transfer
Food
BC1
BC1
B
$1,000
B
I2
I2
$1,000
I1
0
Nonfood
Consumption
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I1
Nonfood
Consumption
Food
BC1
BC1
$1,000
B
A
In-Kind Transfer
Food
I1
$1,000
I2
0
Nonfood
Consumption
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B
A
I1
I2
I3
Nonfood
Consumption