AGEC 251: AGRICULTURAL ECONOMICS

The Theory of Consumer Choice

THE THEORY OF CONSUMER CHOICE 1

 Introduction

People face tradeoffs.

 Buying more of one good leaves
less income to buy other goods.
 Working more hours means more income and
more consumption, but less leisure time.
 Reducing saving allows more consumption today
but reduces future consumption.
This chapter explores how consumers make
choices like these.

THE THEORY OF CONSUMER CHOICE 2

 Our basic assumptions about a
“rational” consumer:
 Consumers are utility maximizers
 Consumers prefer more of a good (thing) to less of it.
 Facing choices X and Y, a consumer would either
prefer X to Y or Y to X, or would be indifferent
between them.
 Transitivity: If a consumer prefers X to Y and Y to Z,
we conclude he/she prefers X to Z
 Diminishing marginal utility: As more and more of
good is consumed by a consumer, ceteris paribus,
beyond a certain point the utility of each additional
unit starts to fall.
THE THEORY OF CONSUMER CHOICE 3
 Utility
 The value a consumer places on a unit of a good or
service depends on the pleasure or satisfaction he or she
expects to derive from having or consuming it at the point
of making a consumption (consumer) choice.

 In economics the satisfaction or pleasure consumers

derive from the consumption of consumer goods is called
“utility”.

 Consumers, however, cannot have every thing they wish

to have because, their choices are constrained by their
incomes.

 Within the limits of their incomes, consumers make their

consumption choices by evaluating and comparing
consumer goods with regard to their “utilities.”
THE THEORY OF CONSUMER CHOICE 4
Total Utility versus Marginal Utility
 Marginal utility is the utility a consumer derives
from the last unit of a consumer good she or he
consumes (during a given consumption period),
ceteris paribus.
 Total utility is the total utility a consumer derives
from the consumption of all of the units of a good
or a combination of goods over a given
consumption period, ceteris paribus.
Total utility = Sum of marginal utilities

MU  U X
THE THEORY OF CONSUMER CHOICE 5
 The Law of Diminishing Marginal
Utility
 Over a given consumption period, the more of a
good a consumer has, or has consumed, the less
marginal utility an additional unit contributes to
his or her overall satisfaction (total utility).

 Alternatively, we could say: over a given

consumption period, as more and more of a good
is consumed by a consumer, beyond a certain
point, the marginal utility of additional units
begins to fall.
THE THEORY OF CONSUMER CHOICE 6
 Total and Marginal Utility for Ice
Cream
Q ($) TU ($) MU
0 0
1 40 40
2 85 45
3 120 35
4 140 20
5 150 10
6 157 7
7 160 3
8 160 0
9 155 -5
10 145 -10
145

THE THEORY OF CONSUMER CHOICE 7

 Total and Marginal Utility for Ice Cream
Total Utility Q ($) TU ($) MU
200 0 0
150 1 40 40
100 2 85 45
50 3 120 35
0
1 2 3 4 5 6 7 8 9 10 11
4 140 20
5 150 10
($) M U
6 157 7
50

40
7 160 3
30 8 160 0
9 155 -5
20

10

0
1 2 3 4 5 6 7 8 9 1 11
10 145 -10
-10

-2 0 145
THE THEORY OF CONSUMER CHOICE 8
 The Budget Constraint:
What the Consumer Can Afford
 Example:
Hurley divides his income between two goods:
fish and mangos.
 A “consumption bundle” is a particular combination
of the goods, e.g., 40 fish & 300 mangos.
 Budget constraint: the limit on the consumption
bundles that a consumer can afford

THE THEORY OF CONSUMER CHOICE 9

ACTIVE LEARNING 1
Budget Constraint
Hurley’s income: $1200
Prices: PF = $4 per fish, PM = $1 per mango
A. If Hurley spends all his income on fish,
how many fish does he buy?
B. If Hurley spends all his income on mangos,
how many mangos does he buy?
C. If Hurley buys 100 fish, how many mangos can
he buy?
D. Plot each of the bundles from parts A – C on a
graph that measures fish on the horizontal axis
and mangos on the vertical, connect the dots.
10
ACTIVE LEARNING 1
Answers D.
D. Hurley’s
Hurley’s budget
budget
Quantity
of Mangos constraint
constraint shows
shows
B the
the bundles
bundles he
he can
can
A. $1200/$4 afford.
afford.
= 300 fish
C
B. $1200/$1
= 1200
mangos
C. 100 fish
cost $400,
$800 left A
buys 800
Quantity
mangos of Fish
 The Slope of the Budget Constraint
From C to D, Quantity
of Mangos
“rise” =
–200 mangos
“run” =
+50 fish C

Slope = – 4 D
Hurley must
give up
4 mangos
to get one fish.
Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 12
 The Slope of the Budget Constraint
The slope of the budget constraint equals
 the rate at which Hurley
can trade mangos for fish
 the opportunity cost of fish in terms of mangos
 the relative price of fish:

M PX
M  PX X  PY Y Y  X
PY PY
THE THEORY OF CONSUMER CHOICE 13
 Typical Budget Line

M
PY
•A

M PX
Y  X
Quantity of Y

PY PY

B
•
M
Quantity of X PX
THE THEORY OF CONSUMER CHOICE 14
ACTIVE LEARNING 2
Budget constraint, continued.
Show what happens to Hurley’s budget constraint if:
A. His income falls to $800.
B. The price of mangos rises to
PM = $2 per mango

15
ACTIVE LEARNING 2
Answers, part A
Quantity A
A fall
fall in
in income
income
Now, of Mangos shifts
shifts the
the budget
budget
Hurley constraint
constraint down.
down.
can buy
$800/$4
= 200 fish
or
$800/$1
= 800 mangos
or any
combination in
between. Quantity
of Fish
ACTIVE LEARNING 2
Answers, part B
Quantity An
An increase
increase in
in the
the
Hurley of Mangos price
price of
of one
one good
good
can still buy pivots
pivots the
the budget
budget
300 fish. constraint
constraint inward.
inward.
But now he
can only buy
$1200/$2 =
600 mangos.
Notice:
slope is smaller,
relative price of
fish is now only
2 mangos. Quantity
of Fish
 Preferences: What the Consumer Wants

Indifference curve: Quantity One of Hurley’s

of Mangos indifference curves
shows consumption
bundles that give the
consumer the same
level of satisfaction B
A, B, and all other
bundles on I1 make A
Hurley equally happy – I1
he is indifferent
between them.
Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 18

 Four Properties of Indifference Curves

Quantity One of Hurley’s

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

If the quantity of
B
fish is reduced,
the quantity of A
mangos must be
I1
increased to keep
Hurley equally
happy. Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 19

 Four Properties of Indifference Curves

Quantity A few of Hurley’s

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

Hurley prefers every

bundle on I2 (like C) C
D
to every bundle on I1 A I2
(like A). I1
He prefers every
bundle on I1 (like A) I0
to every bundle on I0 Quantity
of Fish
(like D).
THE THEORY OF CONSUMER CHOICE 20
 Four Properties of Indifference Curves

Quantity Hurley’s
3. Indifference curves of Mangos indifference curves
cannot cross.
Suppose they did.
Hurley should prefer
B to C, since B has B
more of both goods.
Yet, Hurley is indifferent C A
between B and C: I1 I4
He likes C as much as A
(both are on I4).
Quantity
He likes A as much as B of Fish
(both are on I1).
THE THEORY OF CONSUMER CHOICE 21
 Four Properties of Indifference Curves

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

Quantity
of Fish

THE THEORY OF CONSUMER CHOICE 22

 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
Hurley’s MRS is the
amount of mangos he 1
would substitute for B
MRS = 2
another fish. 1 I1
MRS falls as you move
down along an Quantity
indifference curve. of Fish

THE THEORY OF CONSUMER CHOICE 23

 One Extreme Case: Perfect Substitutes
Perfect substitutes: two goods with straight-
line indifference curves,
constant MRS
Example: nickels & dimes
Consumer is always willing to trade
two nickels for one dime (Nickel =5cents
and dime =10cents)

THE THEORY OF CONSUMER CHOICE 24

Another Extreme Case: Perfect Complements
Perfect complements: two goods with
right-angle indifference curves
Example: Left shoes, right shoes
{7 left shoes, 5 right shoes}
is just as good as
{5 left shoes, 5 right shoes}

THE THEORY OF CONSUMER CHOICE 25

Optimization: What the Consumer Chooses
A is the optimum: Quantity
of Mangos
The
The optimum
optimum
the point on the
is
is the
the bundle
bundle
budget constraint
Hurley
Hurley most
most
that touches the
1200 prefers
prefers outout of
of
highest possible
all
all the
the bundles
bundles
indifference curve.
he
he cancan afford.
afford.
Hurley prefers B to A, B
but he cannot afford B. 600
A

Hurley can afford C C

and D, D
but A is on a higher
indifference curve. 150 300 Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 26
Optimization: What the Consumer Chooses
Quantity
At the optimum, of Mangos Consumer
Consumer
slope of the optimization
optimization isis
indifference curve another
another example
example
equals 1200 of
of “thinking
“thinking at
at the
the
slope of the budget margin.”
margin.”
constraint:
MRS = PF/PM A
600

marginal
price of fish
value of fish
(in terms of
mangos)
(in terms of 150 300 Quantity
mangos) of Fish
THE THEORY OF CONSUMER CHOICE 27
 Utility Maximization
 Utility maximization subject to a limited money
income occurs at the combination of goods for
which the indifference curve is just tangent to the
budget line
Y MU X PX
MRS    
X MUY PY
 Consumer allocates income so that the marginal
utility per dollar spent on each good is the same
for all commodities purchased
MU X MUY

PX PY
THE THEORY OF CONSUMER CHOICE 28
 The Effects of an Increase in Income
Quantity
of Mangos
An increase in
income shifts the
budget constraint
outward.
B
If both goods are A
“normal,” Hurley
buys more of each.

Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 29
ACTIVE LEARNING 3
Inferior vs. normal goods
 An increase in income increases the quantity
demanded of normal goods and reduces the
quantity demanded of inferior goods.
 Suppose fish is a normal good
but mangos are an inferior good.
 Use a diagram to show the effects of
an increase in income on Hurley’s optimal
bundle of fish and mangos.

30
ACTIVE LEARNING 3
Answers Quantity
of Mangos

If mangos are
inferior, the new
optimum will
contain fewer
mangos.
A
B

Quantity
of Fish
31
 The Effects of a Price Change
Quantity
Initially,
of Mangos
PF = $4
1200
PM = $1 initial
optimum

PF falls to $2 new
optimum
budget constraint 600
500
rotates outward,
Hurley buys
more fish and
fewer mangos.
150 300 600 Quantity
350 of Fish

THE THEORY OF CONSUMER CHOICE 32

 The Income and Substitution Effects
A fall in the price of fish has two effects on
Hurley’s optimal consumption of both goods.
 Income effect
A fall in PF boosts the purchasing power of Hurley’s
income, allows him to buy more mangos and more
fish.
 Substitution effect
A fall in PF makes mangos more expensive relative
to fish, causes Hurley to buy fewer mangos & more
fish.
Notice: The net effect on mangos is ambiguous.
THE THEORY OF CONSUMER CHOICE 33
• The Income and Substitution Effects, contd
Initial Quantity
optimum at A. of Mangos

PF falls.

Substitution effect:
from A to B,
buy more fish and A
C
fewer mangos.
B
Income effect:
from B to C,
buy more of both Quantity
goods.
of Fish
THE THEORY OF CONSUMER CHOICE 34
 Deriving Hurley’s Demand Curve for Fish
A: When PF = $4, Hurley demands 150 fish. B: When PF = $2,
Hurley demands 350 fish.
Quantity Price of
of Mangos Fish

A
$4
A
B
B
$2
DFish

150 350 Quantity 150 350 Quantity

of Fish of Fish
35
 Application 1: Giffen Goods
 Do all goods obey the Law of Demand?
 Suppose the goods are potatoes and meat,
and potatoes are an inferior good.
 If price of potatoes rises,
 substitution effect: buy less potatoes
 income effect: buy more potatoes
 If income effect > substitution effect,
then potatoes are a Giffen good, a good for which
an increase in price raises the quantity demanded.

THE THEORY OF CONSUMER CHOICE 36

 Application 1:
Giffen Goods

THE THEORY OF CONSUMER CHOICE 37

 Application 2: Wages and Labor Supply
Budget constraint
 Shows a person’s tradeoff between consumption
and leisure.
 Depends on how much time she has to divide
between leisure and working.
 The relative price of an hour of leisure is the amount
of consumption she could buy with an hour’s wages.
Indifference curve
 Shows “bundles” of consumption and leisure
that give her the same level of satisfaction.

THE THEORY OF CONSUMER CHOICE 38

 Application 2: Wages and Labor Supply
At
At the
the optimum,
optimum,
the
the MRS
MRS between
between
leisure
leisure and
and
consumption
consumption
equals
equals thethe wage.
wage.

THE THEORY OF CONSUMER CHOICE 39

 Application 2: Wages and Labor Supply
An increase in the wage has two effects
on the optimal quantity of labor supplied.
 Substitution effect (SE): A higher wage makes
leisure more expensive relative to consumption.
The person chooses less leisure,
i.e., increases quantity of labor supplied.
 Income effect (IE): With a higher wage,
she can afford more of both “goods.”
She chooses more leisure,
i.e., reduces quantity of labor supplied.

THE THEORY OF CONSUMER CHOICE 40

 Application 2: Wages and Labor Supply
For
For this
this person,
person, So
So her
her labor
labor supply
supply
SE
SE >> IE
IE increases
increases with
with the
the wage
wage

THE THEORY OF CONSUMER CHOICE 41

 Application 2: Wages and Labor Supply
For
For this
this person,
person, So
So his
his labor
labor supply
supply falls
falls
SE
SE << IE
IE when
when thethe wage
wage rises
rises

THE THEORY OF CONSUMER CHOICE 42

Could This Happen in the Real World???
Case where the income effect on labor supply is very
strong:
 When a person wins the lottery or receives an
inheritance, his wage is unchanged – hence no
substitution effect.
But such persons are more likely to work fewer
hours, indicating a strong income effect.

THE THEORY OF CONSUMER CHOICE 43

 Application 3: Interest Rates and Saving
 A person lives for two periods.
 Period 1: young, works, earns $100,000
consumption = $100,000 minus amount saved
 Period 2: old, retired
consumption = saving from Period 1
plus interest earned on saving
 The interest rate determines
the relative price of consumption when young
in terms of consumption when old.

THE THEORY OF CONSUMER CHOICE 44

 Application 3: Interest Rates and Saving
Budget constraint shown is for 10% interest rate.

At
At the
the optimum,
optimum,
the
the MRS
MRS between
between
current
current and
and future
future
consumption
consumption equals
equals
the
the interest
interest rate.
rate.

THE THEORY OF CONSUMER CHOICE 45

ACTIVE LEARNING 5
Effects of a change in the interest rate
 Suppose the interest rate rises.
 Describe the income and substitution effects on
current and future consumption, and on saving.

46
ACTIVE LEARNING 5
Answers
The interest rate rises.
Substitution effect
 Current consumption becomes more expensive
relative to future consumption.
 Current consumption falls, saving rises,
future consumption rises.
Income effect
 Can afford more consumption in both the
present and the future. Saving falls.

47
 Application 3: Interest Rates and Saving
In
In this
this case,
case,
SE
SE >> IEIE and
and
saving
saving rises
rises

THE THEORY OF CONSUMER CHOICE 48

 Application 3: Interest Rates and Saving
In
In this
this case,
case,
SE
SE << IEIE and
and
saving
saving falls
falls

THE THEORY OF CONSUMER CHOICE 4949

 CONCLUSION:
Do People Really Think This Way?
 People do not make spending decisions
by writing down their budget constraints and
indifference curves.
 Yet, they try to make the choices that maximize
their satisfaction given their limited resources.
 The theory in this chapter is only intended as a
metaphor for how consumers make decisions.
 It explains consumer behavior fairly well in many
situations and provides the basis for more
advanced economic analysis.
THE THEORY OF CONSUMER CHOICE 50
CHAPTER SUMMARY

 A consumer’s budget constraint shows the

possible combinations of different goods she can
buy given her income and the prices of the goods.
The slope of the budget constraint equals the
relative price of the goods.
 An increase in income shifts the budget constraint
outward. A change in the price of one of the goods
pivots the budget constraint.

51
CHAPTER SUMMARY

 A consumer’s indifference curves represents her

preferences. An indifference curve shows all the
bundles that give the consumer a certain level of
happiness. The consumer prefers points on higher
indifference curves to points on lower ones.
 The slope of an indifference curve at any point is
the marginal rate of substitution – the rate at which
the consumer is willing to trade one good for the
other.
52
CHAPTER SUMMARY

 The consumer optimizes by choosing the point on

her budget constraint that lies on the highest
indifference curve. At this point, the marginal rate
of substitution equals the relative price of the two
goods.
 When the price of a good falls, the impact on the
consumer’s choices can be broken down into two
effects, an income effect and a substitution effect.

53
CHAPTER SUMMARY

 The income effect is the change in consumption

that arises because a lower price makes the
consumer better off. It is represented by a
movement from a lower indifference curve to a
higher one.
 The substitution effect is the change that arises
because a price change encourages greater
consumption of the good that has become
relatively cheaper. It is represented by a
movement along an indifference curve.
54
CHAPTER SUMMARY

 The theory of consumer choice can be applied in

many situations. It can explain why demand
curves can potentially slope upward, why higher
wages could either increase or decrease labor
supply, and why higher interest rates could either
increase or decrease saving.

55