Transcript The theory of consumer choice

PowerPoint Presentations for
Principles of Microeconomics
Sixth Canadian Edition
by Mankiw/Kneebone/McKenzie
Adapted for the
Sixth Canadian Edition by
Marc Prud’homme
University of Ottawa
THE THEORY
OF CONSUMER
CHOICE
Chapter 21
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THE THEORY OF CONSUMER CHOICE
 In this chapter a theory is developed that
describes how consumers make decisions
about what to buy.
 The theory examines the tradeoffs that
people face in their role as consumers.
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THE THEORY OF CONSUMER CHOICE
 After developing the basic theory of consumer
choice, three questions about household
decisions are developed:
1. Do all demand curves slope downward?
2. How do wages affect labour supply?
3. How do interest rates affect household
saving?
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THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD
 The study of consumer choice starts by
examining the link between income and
spending.
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THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD
 What is the decision facing a consumer who
buys
two goods?
 Pepsi
 Pizza
 Suppose an income of $1000/month.
 His entire income each month is spent on Pepsi
and pizza.
 The price of a litre of Pepsi is $2, and the price of
a pizza is $10.
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THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD
 Budget constraint: the limit on the
consumption bundles that a consumer can
afford
 It shows the tradeoff between Pepsi and
pizza that the consumer faces.
 The slope of the budget constraint equals the
relative price of the two goods: the price of
one good compared to the price of the
other.
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FIGURE 21.1:
The Consumer’s Budget Constraint
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QuickQuiz
Draw the budget constraint for a person with
income of $1000 if the price of Pepsi is $5 per
litre and the price of a pizza is $10.
What is the slope of this budget constraint?
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Active Learning
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.
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Active Learning
Answers
Quantity
of Mangos
B
A. $1200/$4
= 300 fish
B. $1200/$1
= 1200
mangos
C
D. Hurley’s budget
constraint shows
the bundles he can
afford.
C. 100 fish
cost $400,
$800 left
buys 800
mangos
A
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PREFERENCES:
WHAT THE CONSUMER WANTS
 The consumer’s choices, however, depend
not only on his budget constraint but also on
his preferences regarding the two goods.
 Therefore, the consumer’s preferences are
the next piece of our analysis.
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Representing Preferences
with Indifference Curves
Indifference curve: a curve that shows
consumption bundles that give the
consumer the same level of satisfaction
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FIGURE 21.2:
The Consumer’s Preferences
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Representing Preferences
with Indifference Curves
Marginal rate of substitution: the rate
at which a consumer is willing to trade
one good for another
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Four Properties of Indifference Curves
1. Higher indifference curves are preferred to
lower ones.
2. Indifference curves are downward sloping.
3. Indifference curves do not cross.
4. Indifference curves are bowed inward.
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FIGURE 21.3:
The Impossibility of Intersecting Indifference Curves
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FIGURE 21.4:
Bowed Indifference Curves
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Two Extreme Examples of
Indifference Curves
 The shape of an indifference curve tells us
about the consumer’s willingness to trade one
good for the other.
 Perfect substitutes: two goods with straight-line
indifference curves
 Perfect complements: two goods with rightangle indifference curves
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FIGURE 21.5:
Perfect Substitutes and Perfect Complements
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QuickQuiz
Draw some indifference curves for Pepsi and
pizza.
Explain the four properties of these
indifference curves.
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OPTIMIZATION:
WHAT THE CONSUMER CHOOSES
 The goal of this chapter is to understand
how a consumer makes choices.
 We have the two pieces necessary for this
analysis:
1. The consumer’s budget constraint
2. The consumer’s preferences
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The Consumer’s Optimal Choices
 The consumer would like to end up with the
best possible combination of Pepsi and pizza.
 But the consumer must also end up on or
below his budget constraint.
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FIGURE 21.6:
The Consumer’s Optimum
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How Changes in Income
Affect the Consumer’s Choices
 Suppose that income increases so that the
consumer can now afford more of both
goods.
 The increase in income, therefore, shifts the
budget constraint outward.
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FIGURE 21.7:
An Increase in Income
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How Changes in Income
Affect the Consumer’s Choices
 The indifference curves in Figure 21.7 are
drawn under the assumption that both Pepsi
and pizza are normal goods.
 Normal good: a good for which, other things
equal, an increase in income leads to an
increase in demand
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How Changes in Income
Affect the Consumer’s Choices
 Figure 21.8 shows an example in which an
increase in income induces the consumer to
buy more pizza but less Pepsi.
 Inferior good: a good for which, other things
equal, an increase in income leads to a
decrease in demand
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FIGURE 21.8:
An Inferior Good
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How Changes in Prices
Affect the Consumer’s Choices
 Let’s now use this model of consumer choice
to consider how a change in the price of one
of the goods alters the consumer’s choices.
 Suppose, in particular, that the price of Pepsi
falls from $2 to $1 per litre.
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FIGURE 21.9:
A Change in Price
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Income and Substitution Effects
 The impact of a change in the price of a good on
consumption can be decomposed into two effects:
1. Income effect: the change in consumption that
results when a price change moves the
consumer to a higher or lower indifference
curve
2. Substitution effect: the change in consumption
that results when a price change moves the
consumer along a given indifference curve to a
point with a new marginal rate of substitution
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Income and Substitution Effects
 How might our consumer respond when he learns that
the price of Pepsi has fallen?
 “Great news! Now that Pepsi is cheaper, my income
has greater purchasing power. I am, in effect, richer
than I was. Because I am richer, I can buy both more
Pepsi and more pizza.” (This is the income effect.)
 “Now that the price of Pepsi has fallen, I get more litres
of Pepsi for every pizza that I give up. Because pizza is
now relatively more expensive, I should buy less pizza
and more Pepsi.” (This is the substitution effect.)
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TABLE 21.1:
Income and Substitution Effects When the Price of Pepsi Falls
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FIGURE 21.10:
Income and Substitution Effects
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Deriving the Demand Curve
 The demand curve for any good reflects
these consumption decisions.
 A consumer’s demand curve is a summary
of the optimal decisions that arise from his
budget constraint and indifference curves.
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FIGURE 21.11:
Deriving the Demand Curve
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QuickQuiz
Draw a budget constraint and indifference
curves for Pepsi and pizza.
Show what happens to the budget constraint
and the consumer’s optimum when the price
of pizza rises.
In your diagram, decompose the change into
an income effect and a substitution effect.
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THREE APPLICATIONS
 The basic theory of consumer choice can be
used to shed light on three questions about how
the economy works.
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Do All Demand Curves Slope Downward?
 As a matter of economic theory, demand
curves can sometimes slope upward.
 In other words, consumers can sometimes
violate the law of demand and buy more of
a good when the price rises.
 Giffen good: a good for which an increase in
the price raises the quantity demanded
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FIGURE 21.12:
A Giffen Good
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How Do Wages Affect Labour Supply?
The theory of consumer choice can be
used to analyze how a person decides
to allocate his time between work and
leisure.
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FIGURE 21.13:
The Work–Leisure Decision
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FIGURE 21.14:
An Increase in the Wage
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FIGURE 21.14 (continued):
An Increase in the Wage
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How Do Interest Rates
Affect Household Saving?
 We can use the theory of consumer choice to
analyze how people make this decision and
how the amount they save depends on the
interest rate their savings will earn.
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FIGURE 21.15:
The Consumption–Saving Decision
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FIGURE 21.16:
An Increase in the Interest Rate
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QuickQuiz
Explain how an increase in the wage can
potentially decrease the amount that a
person wants to work.
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Classroom Activity
You Can’t Always Get What You Want
• Think about maximizing your own utility.
• Specifically, assume that billionaire Bill Gates offers to buy
you the one thing that would increase your happiness by the
greatest amount. It can’t be money, or a financial instrument,
but he will buy for you any single thing that you feel would
makes you happy. Write your requested item.
• What did you choose? “Why don’t you buy that item for
yourself? Isn’t it the one thing that will increase your
happiness by the largest amount? Why not buy it today?”
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THE END
Chapter 21
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