Chapter

21

The Theory of
Consumer Choice
Budget Constraint: What the Consumer can Afford

• Budget constraint
– Limit on the consumption bundles that a
consumer can afford
• Trade-off between goods
• Slope of the budget constraint
• Rate at which the consumer can trade one good
for the other
• Change in the vertical distance
• Divided by the change in the horizontal distance
– Relative price of the two goods
2
Figure 1
The consumer’s budget constraint (table)
Number Pints Spending Spending Total
of Pizzas of Pepsi on Pizza on Pepsi spending
100 0 $1,000 $0 $1,000
90 50 900 100 1,000
80 100 800 200 1,000
70 150 700 300 1,000
60 200 600 400 1,000
50 150 500 500 1,000
40 300 400 600 1,000
30 350 300 700 1,000
20 400 200 800 1,000
10 450 100 900 1,000
0 500 0 1,000 1,000

The budget constraint shows the various bundles of goods that the consumer can buy
for a given income. Here the consumer buys bundles of pizza and Pepsi. The table and
graph show what the consumer can afford if his income is $1,000, the price of pizza is
$10, and the price of Pepsi is $2.
3
Figure 1
The consumer’s budget constraint (graph)
Quantity
of
Pepsi

500 B

C
250
Consumer’s
budget constraint

A
0 50 100 Quantity of Pizza
The budget constraint shows the various bundles of goods that the consumer can
buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The
table and graph show what the consumer can afford if his income is $1,000, the
price of pizza is $10, and the price of Pepsi is $2. 4
Preferences: What the Consumer Wants
• Indifference curve
– Shows consumption bundles that give the
consumer the same level of satisfaction
– Combinations of goods on the same curve
• Same satisfaction
• Slope of indifference curve
– Marginal rate of substitution
• Rate at which a consumer is willing to trade one
good for another
– Not the same at all points
5
Figure 2
The consumer’s preferences
Quantity
Of Pepsi

D
MRS I2
A
1 Indifference
curve, I1
0 Quantity of Pizza

The consumer’s preferences are represented with indifference curves, which show the
combinations of pizza and Pepsi that make the consumer equally satisfied. Because the
consumer prefers more of a good, points on a higher indifference curve (I 2 here) are
preferred to points on a lower indifference curve (I 1). The marginal rate of substitution
(MRS) shows the rate at which the consumer is willing to trade Pepsi for pizza. It measures
6
the quantity of Pepsi the consumer must be given in exchange for 1 pizza.
Preferences: What the Consumer Wants
• Four properties of indifference curves
1.Higher indifference curves are preferred to
lower ones
– Higher indifference curves – more goods
2.Indifference curves are downward sloping
3.Indifference curves do not cross
4.Indifference curves are bowed inward

7
Figure 3
The impossibility of intersecting indifference curves
Quantity
Of Pepsi

C
A

0 Quantity of Pizza

A situation like this can never happen. According to these indifference curves, the
consumer would be equally satisfied at points A, B, and C, even though point C has more
of both goods than point A.
8
 Figure 4
Bowed indifference curves
Indifference curves are usually
Quantity
bowed inward. This shape
Of Pepsi
implies that the marginal rate of
substitution (MRS) depends on
14 the quantity of the two goods
the consumer is consuming. At
point A, the consumer has little
MRS=8 pizza and much Pepsi, so he
requires a lot of extra Pepsi to
A induce him to give up one of
8 the pizzas: The marginal rate
1 of substitution is 6 pints of
Pepsi per pizza. At point B, the
consumer has much pizza and
4 Indifference
MRS=1 B little Pepsi, so he requires only
3 curve a little extra Pepsi to induce
1
him to give up one of the
pizzas: The marginal rate of
0 2 3 6 7 Quantity of Pizza substitution is 1 pint of Pepsi
per pizza.

9
Preferences: What the Consumer Wants
• Two extreme examples of indifference curves
• Perfect substitutes
– Two goods with straight-line indifference
curves
– Marginal rate of substitution – constant
• E.g.: nickels and dimes bundles
• Perfect complements
– Two goods with right-angle indifference curves
• E.g.: right shoe and left shoe bundle

10
 Figure 5
Perfect substitutes and perfect complements
(a) Perfect Substitutes (b) Perfect Complements

Nickels Left
shoes

4 7 I2

5 I1
2

I1 I2 I3

0 1 2 3 Dimes 0 5 7 Right
shoes
When two goods are easily substitutable, such as nickels and dimes, the indifference curves
are straight lines, as shown in panel (a). When two goods are strongly complementary, such
as left shoes and right shoes, the indifference curves are right angles, as shown in panel (b). 11
Optimization: What the Consumer Chooses
• The consumer’s optimal choices
• Optimum
– Point where indifference curve and budget
constraint touch
– Best combination of goods available to the
consumer
– Slope of indifference curve
• Equals slope of budget constraint
• Marginal rate of substitution = relative price
12
 Figure 6
The consumer’s optimum
Quantity
of
Pepsi
Budget constraint

Optimum

A
B

I3

I2
I1
0 Quantity of Pizza
The consumer chooses the point on his budget constraint that lies on the highest indifference
curve. At this point, called the optimum, the marginal rate of substitution equals the relative
price of the two goods. Here the highest indifference curve the consumer can reach is I 2. The
consumer prefers point A, which lies on indifference curve I 3, but the consumer cannot afford
this bundle of pizza and Pepsi. By contrast, point B is affordable, but because it lies on a lower 13
indifference curve, the consumer does not prefer it.
Optimization: What the Consumer Chooses
• How changes in income affect the
consumer’s choices
• Higher income
– Consumer can afford more of both goods
– Shifts the budget constraint outward
– New optimum

14
 Figure 7
An Increase in Income
Quantity
New budget constraint
of
Pepsi 1. An increase in income shifts the
budget constraint outward . . .

3. . . . and
Pepsi
consumption
New optimum

Initial
optimum
I2
2. . . . raising
pizza
consumption . . . I1
Initial
budget
constraint
0 Quantity of Pizza

When the consumer’s income rises, the budget constraint shifts out. If both goods are normal
goods, the consumer responds to the increase in income by buying more of both of them.
Here the consumer buys more pizza and more Pepsi. 15
Optimization: What the Consumer Chooses
• How changes in income affect the
consumer’s choices
• Normal good
– Good for which an increase in income raises
the quantity demanded
• Inferior good
– Good for which an increase in income reduces
the quantity demanded

16
 Figure 8
An inferior good
Quantity
New budget constraint
of
Pepsi 1. When an increase in income shifts the
budget constraint outward . . .

3. . . . but Pepsi
consumption falls,
making Pepsi an Initial
inferior good optimum
New optimum

I1
I2 2. . . . pizza consumption rises,
Initial budget making pizza a normal good. . .
constraint
0 Quantity of Pizza

A good is an inferior good if the consumer buys less of it when his income rises. Here Pepsi is
an inferior good: When the consumer’s income increases and the budget constraint shifts
outward, the consumer buys more pizza but less Pepsi. 17
Optimization: What the Consumer Chooses
• How changes in prices affect the consumer’s
choices
• Price of one good falls
– Rotates the budget constraint outward
• Steeper slope
• Change in relative price
– Income effect
– Substitution effect

18
 Figure 9
A change in price
Quantity
of Pepsi
New budget
D constraint
1,000

New optimum
1. A fall in the price of Pepsi rotates
B the budget constraint outward. . .
500
3. . . . and
raising Pepsi Initial I2
consumption budget
constraint Initial optimum

I1
A 2. . . . reducing pizza consumption

0 100 Quantity of Pizza

When the price of Pepsi falls, the consumer’s budget constraint shifts outward and changes
slope. The consumer moves from the initial optimum to the new optimum, which changes his
purchases of both pizza and Pepsi. In this case, the quantity of Pepsi consumed rises, and the
quantity of pizza consumed falls.
19
Optimization: What the Consumer Chooses
• Income effect
– Change in consumption
– When a price change moves the consumer
• To a higher or lower indifference curve
• Substitution effect
– Change in consumption
– When a price change moves the consumer
• Along a given indifference curve
• To a point with a new marginal rate of
substitution
20
Table 1
Income and substitution effects when the price of Pepsi falls

Good Income effect Substitution effect Total effect

Pepsi Consumer is richer, Pepsi is relatively Income and substitution
so he buys more Pepsi cheaper, so consumer effects act in same
buys more Pepsi direction, so consumer
buys more Pepsi

Pizza Consumer is richer, Pizza is relatively Income and substitution

so he buys more pizza More expensive, effects act in opposite
so consumer buys directions, so the
less pizza. total effect on pizza
consumption is
ambiguous.

21
Figure 10
Income and substitution effects
Quantity
of Pepsi The effect of a change in
New budget price can be broken down
constraint into an income effect and a
substitution effect. The
substitution effect—the
movement along an
C indifference curve to a point
New optimum with a different marginal rate
Income
of substitution—is shown
effect B here as the change from
Initial I2 point A to point B along
Substitution indifference curve I1. The
budget
effect A income effect—the shift to a
constraint Initial optimum
higher indifference curve—is
I1 shown here as the change
from point B on indifference
curve I1 to point C on
0 Quantity
Substitution effect indifference curve I2.
of Pizza

Income effect
22
Optimization: What the Consumer Chooses
• Deriving the demand curve
– Quantity demanded of a good for any given
price
– Initial optimum point
• Initial price of the good
• Initial quantity of the good
– A change in price of the good (new price)
• New optimum
• New optimum quantity

23
 Figure 11
Deriving the demand curve
(a) The Consumer’s Optimum (b) The Demand Curve for Pepsi

Quantity Price of
of Pepsi Pepsi
New budget constraint

B A
750 $2

I2
B
1
A
250 Demand
I1

0 Initial budget Quantity 0 250 750 Quantity

constraint of Pizza of Pepsi

Panel (a) shows that when the price of Pepsi falls from $2 to $1, the consumer’s optimum moves
from point A to point B, and the quantity of Pepsi consumed rises from 250 to 750 pints. Demand
curve in panel (b) reflects this relationship between the price and the quantity demanded. 24
 Three Applications
• Do all demand curves slope downward?
• Law of demand
– When the price of a good rises, people buy
less of it
• Downward slope of the demand curve
• Giffen good
– An increase in the price of the good raises the
quantity demanded
• Income effect dominates the substitution effect
• Demand curve – slopes upward
25
 Figure 12
A Giffen good
Quantity of
Potatoes Initial budget
constraint 1. An increase in the price of potatoes
B rotates the budget constraint inward . . .

D Optimum with high

price of potatoes
New
2. . . . which budget
constraint E
increases Optimum with low
potato C
price of potatoes
consumption
if potatoes I1
are a Giffen I2
good. 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.
26
 The search for Giffen goods

• Potatoes - Giffen good during the Irish potato

famine of the 19th century
– Price of potatoes rose
• Large income effect
• People – cut back on the luxury of meat
• Buy more of the staple food of potatoes
• Chinese province of Hunan, rice
– Poor households exhibited Giffen behavior
• Lower price of rice (with subsidy voucher)
– Households - reduce their consumption of rice
• Higher price of rice (remove the subsidy)
– Households – increase consumption of rice
27
 Three Applications
• How do wages affect labor supply?
• Trade-off between leisure and consumption
• Bundle of goods: leisure and work
– Given wage
– Budget constraint
– Optimum

28
 Figure 13
The work-leisure decision
Consumption
$5,000

Optimum

I3
2,000
I2
I1

0 60 100 Hours of leisure

This figure shows Sally’s budget constraint for deciding how much to work, her indifference
curves for consumption and leisure, and her optimum.
29
 Three Applications
• How do wages affect labor supply?
• Increase in wage
– Budget constraint shifts outward
• Steeper
• New optimum
– If enjoy less leisure
• Work more
• Upward-sloping labor supply curve
• Substitution effect dominates

30
 Three Applications
• How do wages affect labor supply?
• Increase in wage
– Budget constraint shifts outward
• Steeper
• New optimum
– If enjoy more leisure
• Work less
• Backward-sloping labor supply curve
• Income effect dominates

31
 Figure 14
An increase in the wage (a)
(a) For a person with these preferences . . . . . . the labor supply curve slopes upward.
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 . . . 3. . . . and hours of labor increase Supplied

The two panels of this figure show how a person might respond to an increase in the wage. The graphs on the
left show the consumer’s initial budget constraint, BC 1, and new budget constraint, BC2, as well as the
consumer’s optimal choices over consumption and leisure. The graphs on the right show the resulting labor-
supply curve. Because hours worked equal total hours available minus hours of leisure, any change in leisure
implies an opposite change in the quantity of labor supplied. In panel (a), when the wage rises, consumption
rises and leisure falls, resulting in a labor-supply curve that slopes upward.
32
 Figure 14
An increase in the wage (b)
(b) For a person with these preferences . . . . . . the labor supply curve slopes backward
Consumption Wage

BC2

1. When the wage rises . . .

I2
Labor supply
I1

BC1
0 0
Hours of Leisure Hours of Labor
2. . . . hours of leisure increase . . . 3. . . . and hours of labor decrease Supplied

The two panels of this figure show how a person might respond to an increase in the wage. The graphs on the
left show the consumer’s initial budget constraint, BC 1, and new budget constraint, BC2, as well as the
consumer’s optimal choices over consumption and leisure. The graphs on the right show the resulting labor-
supply curve. Because hours worked equal total hours available minus hours of leisure, any change in leisure
implies an opposite change in the quantity of labor supplied. In panel (b), when the wage rises, both 33
consumption and leisure rise, resulting in a labor-supply curve that slopes backward.
 Income effects on labor supply: historical
trends, lottery winners,& Carnegie conjecture

• Labor- supply curve, over long periods

– Slope backward
• A hundred years ago
– People worked six days a week
• Today
– Five-day workweeks
– Length of the workweek has been falling
– Wage of the typical worker (adjusted for inflation)
has been rising

34
 Income effects on labor supply: historical
trends, lottery winners,& Carnegie conjecture

• Explanation: Advances in technology

– Higher worker productivity
– Increase in demand for labor
• Higher equilibrium wages
• Greater reward for working
• Income effect dominates substitution effect
• More leisure
• Less work

35
 Income effects on labor supply: historical
trends, lottery winners,& Carnegie conjecture

• Winners of lotteries
– Large increase in incomes
– Large outward shifts in budget constraints
• Same slope
• No substitution effect
– Income effect on labor supply
• Substantial
• People who win the lottery – tend to quit their jobs

36
 Income effects on labor supply: historical
trends, lottery winners,& Carnegie conjecture

• Andrew Carnegie, 19th century

– “The parent who leaves his son enormous wealth
generally deadens the talents and energies of the
son, and tempts him to lead a less useful and less
worthy life than he otherwise would”
– Income effect on labor supply – substantial

37
 Three Applications
• How do interest rates affect household saving?
• Income decision
– Consume today or Save for future
• Bundle of goods
– Consumption today and Consumption in the
future
– Relative price = interest rates
– Optimum: Budget constraint & Indifference
curves
38
 Figure 15
The consumption-saving decision
Consumption
when Old
$110,000

Optimum
55,000
I3

I2
I1

0 $50,000 100,000 Consumption

when Young

This figure shows the budget constraint for a person deciding how much to consume in the two
periods of his life, the indifference curves representing his preferences, and the optimum.
39
 Three Applications
• How do interest rates affect household saving?
• Increase in interest rates
– Budget constraint – shifts outward
• Steeper
– Consumption in the future – rises
– If consume less today
• Substitution effect dominates; Save more
– If consume more today
• Income effect dominates; Save less

40
 Figure 16
An increase in the interest rate
(a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving
Consumption Consumption
When When
old BC2 old BC2 1. A higher interest rate rotates
1. A higher interest rate rotates
the budget constraint outward . . .
the budget constraint outward . . .

I2
I2
I1
BC1

I1 BC1
0 0
Consumption Consumption
when Young when Young
2. . . . resulting in lower consumption 2. . . . resulting in higher consumption
when young and, thus, higher saving. when young and, thus, lower saving.

In both panels, an increase in the interest rate shifts the budget constraint outward. In panel (a), consumption
when young falls, and consumption when old rises. The result is an increase in saving when young. In panel
(b), consumption in both periods rises. The result is a decrease in saving when young. 41