Chapter 21 The Theory of Consumer Choice The Budget Constraint What the Consumer Can Afford Consumer only buys pizza and pepsi for a month income 1000 per month Pizza 10 and pepsi 2 Budget constraint the limit on the consumption bundles that a consumer can afford o The slope of the budget constraint measures the rate at which the consumer can trade one good for the other o Slope is the same as the relative price of the 2 goods 2 5 10 slope 5 Preferences What the Consumer Wants If 2 bundles suit the consumer equally well then we say that the consumer is indifferent between the 2 bundles Indifference curves a curve that shows consumption bundles that give the consumer the same level of satisfaction Marginal rate of substitution the rate at which a consumer is willing to trade one good for another since indifference curves are not straight lines the marginal rate of substitution changes depending on the point so therefore it depends on the amount of goods the consumer is already consuming ex if the consumer is already consuming a lot of pizza then he is thirstier and not hungry so the marginal rate of substitution is low to trade pizza for pepsi Higher indifference curves are preferred to lower ones A consumer s set of indifference curves gives a complete ranking of the consumer s preferences we can rank any combination of pizza and pepsi Properties of indifference curves o 1 Higher indifference curves are preferred to lower ones higher curves represent larger quantities of goods o 2 Indifference curves are downward sloping decrease in the quantity of 1 good must be followed with an increase in the quantity of the other good to keep the consumer happy o 3 Indifference curves do not cross o 4 Indifference curves are bowed inward ppl are more willing to trade away goods for which they have an abundance and less willing to trade goods for which they have a limit Indifference curves tell us about the consumer s willingness to trade one good for the other when goods are easy to substitute the indifference curves are less bowed but when they are hard to substitute the indifference curves are very bowed o Perfect substitutions 2 goods with straight line indifference curves ex trading 2 nickels for 1 dime marginal rate of substitution will always be the same constant o Perfect complements 2 goods with right angle indifference curves ex having 5 left shoes and 5 right shoes is just as good as having 5 left shoes and 7 right shoes b c in both combinations we can only make 5 pairs of shoes Optimization What the Consumer Chooses Consumer wants to be on his highest possible indifference curve while remaining under his budget constraint Optimum point at which the budget constraint and highest indifference curve meet here the slope of the indifference curves the slope of the budget constraint therefore the indifference curve is tangent to the budget constraint The consumer chooses consumption of the two goods so that the marginal rate of substitution slope of indifference curve equals the relative price slope of budget constraint Relative price is the rate at which the market is willing to trade one good for the other whereas the marginal rate of substitution is the rate at which a consumer is willing to trade one good for another At the consumer s optimum the consumer s valuation of the 2 goods as measured by the marginal rate of substitution equals the market s valuation as measured by the relative price Change in income increase in income shifts budget constraint outward parallel shift keeps same slope can now choose a combination of pizza pepsi on a higher indifference curve o Normal goods a good for which an increase in income raises the o Inferior goods a good for which an increase in income reduces the quantity demanded quantity demanded Change in price decrease in the price of a good shifts the budget constraint outward however this time the budget constraint changes its slope o Ex price of pepsi goes from 2 to 1 o If we spent our entire income on pizza this change in price doesn t matter so it s the same point on the new and old budget constraint new budget constraint has a steeper slope o Income effect the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve Ex price of pepsi decreases consumer buys more pizza AND pepsi o 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 Ex price of pepsi decreases consumption of pepsi has become less expensive relative to consumption of pizza consumer chooses less pizza and more pepsi Demand curve arises naturally from the theory of consumer choice
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