Course Outline

Chapters from book: Economics by N. Gregory Mankiw

Ch 21: The Theory of Consumer Choice
PLUS
NOTES PROVIDED
THE BUDGET CONSTRAINT: WHAT THE
CONSUMER CAN AFFORD
The budget constraint depicts the limit on the
consumption “bundles” that a consumer can afford.
People consume less than they desire because their
spending is constrained, or limited, by their income.
THE BUDGET CONSTRAINT: WHAT THE
CONSUMER CAN AFFORD
The budget constraint shows the various
combinations of goods the consumer can afford given
his or her income and the prices of the two goods.
THE BUDGET CONSTRAINT: WHAT THE
CONSUMER CAN AFFORD
The Consumer’s Budget Constraint
Any point on the budget constraint line indicates the
consumer’s combination or tradeoff between two
goods.
For example, if the consumer buys no pizzas, he can
afford 500 pints of Pepsi (point B). If he buys no Pepsi,
he can afford 100 pizzas (point A).
Quantity
of Pepsi
B
500

Consumer’s
budget constraint

A
0 100 Quantity
of Pizza
THE BUDGET CONSTRAINT: WHAT THE
CONSUMER CAN AFFORD
The Consumer’s Budget Constraint
Alternately, the consumer can buy 50 pizzas and 250
pints of Pepsi.
Quantity
of Pepsi
B
500

C
250

Consumer’s
budget constraint

A
0 50 100 Quantity
of Pizza
THE BUDGET CONSTRAINT: WHAT THE
CONSUMER CAN AFFORD
The slope of the budget constraint line equals the
relative price of the two goods, that is, the price of one
good compared to the price of the other.
It measures the rate at which the consumer can trade
one good for the other.
PREFERENCES: WHAT THE
CONSUMER WANTS
A consumer’s preference among consumption
bundles may be illustrated with indifference curves.
Representing Preferences with Indifference
Curves
An indifference curve is a curve that shows
consumption bundles that give the consumer the
same level of satisfaction.
Quantity
of Pepsi
C

B D
I2
Indifference
A
curve, I1
0 Quantity
of Pizza
Representing Preferences with Indifference
Curves
The Consumer’s Preferences
The consumer is indifferent, or equally happy, with the
combinations shown at points A, B, and C because they
are all on the same curve.
The Marginal Rate of Substitution
The slope at any point on an indifference curve is the
marginal rate of substitution.
 It is the rate at which a consumer is willing to trade one good
for another.
 It is the amount of one good that a consumer requires as
compensation to give up one unit of the other good.
Quantity
of Pepsi
C

B D
MRS I2
1
Indifference
A
curve, I1
0 Quantity
of Pizza
Four Properties of Indifference Curves
Higher indifference curves are preferred to lower
ones.
Indifference curves are downward sloping.
Indifference curves do not cross.
Indifference curves are bowed inward.
Four Properties of Indifference Curves
Property 1: Higher indifference curves are preferred to
lower ones.
Consumers usually prefer more of something to less of
it.
Higher indifference curves represent larger quantities
of goods than do lower indifference curves.
Quantity
of Pepsi
C

B D
I2
Indifference
A
curve, I1
0 Quantity
of Pizza
Four Properties of Indifference Curves
Property 2: Indifference curves are downward
sloping.
A consumer is willing to give up one good only if he or
she gets more of the other good in order to remain
equally happy.
If the quantity of one good is reduced, the quantity of
the other good must increase.
For this reason, most indifference curves slope
downward.
Quantity
of Pepsi

Indifference
curve, I1
0 Quantity
of Pizza
Four Properties of Indifference Curves
Property 3: Indifference curves do not cross.
Points A and B should make the consumer equally
happy.
Points B and C should make the consumer equally
happy.
This implies that A and C would make the consumer
equally happy.
But C has more of both goods compared to A.
Quantity
of Pepsi

0 Quantity
of Pizza
Four Properties of Indifference Curves
Property 4: Indifference curves are bowed inward.
People are more willing to trade away goods that they
have in abundance and less willing to trade away goods
of which they have little.
These differences in a consumer’s marginal substitution
rates cause his or her indifference curve to bow inward.
Quantity
of Pepsi

14

MRS = 6

A
8
1

4 B
MRS = 1
3
1
Indifference
curve

0 2 3 6 7 Quantity
of Pizza
OPTIMIZATION: WHAT THE
CONSUMER CHOOSES
Consumers want to get the combination of goods on
the highest possible indifference curve.
However, the consumer must also end up on or below
his budget constraint.
The Consumer’s Optimal Choices
Combining the indifference curve and the budget
constraint determines the consumer’s optimal choice.
Consumer optimum occurs at the point where the
highest indifference curve and the budget constraint
are tangent.
The Consumer’s Optimal Choice
The consumer chooses consumption of the two goods
so that the marginal rate of substitution equals the
relative price.
Slope of IC curve = Slope of Budget constraint
The Consumer’s Optimal Choice
At the consumer’s optimum, the consumer’s
valuation of the two goods equals the market’s
valuation.
Slope of IC curve = Slope of Budget constraint
Quantity
of Pepsi

Optimum

B
A

I3
I2
I1

Budget constraint
0 Quantity
of Pizza
How Changes in Income Affect the Consumer’s
Choices
An increase in income shifts the budget constraint
outward.
The consumer is able to choose a better combination of
goods on a higher indifference curve.
 Quantity
of Pepsi New budget constraint

1. An increase in income shifts the

budget constraint outward . . .

New optimum

3. . . . and
Pepsi
consumption. Initial
optimum I2

Initial
budget
I1
constraint

0 Quantity
of Pizza
2. . . . raising pizza consumption . . .
How Changes in Income Affect the Consumer’s
Choices
Normal versus Inferior Goods
If a consumer buys more of a good when his or her
income rises, the good is called a normal good.
If a consumer buys less of a good when his or her
income rises, the good is called an inferior good.
 Quantity
of Pepsi New budget constraint

1. When an increase in income shifts the

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

Initial
budget I1 I2
constraint
0 Quantity
of Pizza
2. . . . pizza consumption rises, making pizza a normal good . . .
Income and Substitution Effects
A price change has two effects on consumption.
An income effect
A substitution effect
Income and Substitution Effects
The Income Effect
The income effect is the change in consumption that
results when a price change moves the consumer to a
higher or lower indifference curve.
“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 pizza and
more Pepsi.” (This is the income effect.)
Income and Substitution Effects
The Substitution Effect
The substitution effect is the change in consumption
that results when a price change moves the consumer
along an indifference curve to a point with a different
marginal rate of substitution.
“Now that the price of Pepsi has fallen, I get more pints
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.)