The theory of consumer choice
demand curve tells us how much consumers would pay for a given amount of a good
based on preferences and budget constraint
What can we say about how preferences and the budget constraint affect demand?
The Budget Constraint - what consumers can afford
Most people can’t afford everything they’d like - their income constrains their spending
We can illustrate this budget constraint with a graph:
Facts about the Budget Constraint
Graph illustrates feasible bundles of goods
Endpoints = amount one could afford if ONLY one good were purchased
Slope = rate at which goods can be traded for each other
Slope = relative price of the goods
What happens if prices change?
The slope of the budget constraint equals the ratio of prices of the two goods
when one of the prices changes, the ratio of prices changes, and the slope of the budget constraint changes
Example
The Indifference Curve - what consumers want
Preferences also affect consumer demand - indifference curves illustrate preferences
show us the set of bundles that make the consumer equally well off
the consumer is indifferent between bundles on a given curve
example:
Facts about Indifference Curves
Slope gives us rate at which consumer is willing to trade one good for another (marginal rate of substitution)
the slope is negative because...
Slope depends on the amount of each good the consumer has
since more is better, curves to the northeast are preferred
More Facts about Indifference Curves
Indifference curves do not cross
why not?
- Indifference curves are convex (bowed inward)
Special Indifference Curves
Perfect substitutes
ex: nickels and dimes; white onions and yellow onions
graph:
ex: right shoes and left shoes; VCRs and videotapes
graph:
Consumer Choice
Budget constraint = what consumer can afford
Indifference curve = what consumer wants
Put them together, and we can see how much of each good the consumer buys
example:
Characteristics of the Optimal Choice
Consumer is on highest indifference curve that is affordable
slope of indifference curve equals slope of budget constraint
MRS=ratio of relative prices
consumer is willing to trade one good for another at the same rate as she can trade one good for another
How do changes in income affect the consumer’s choice?
Higher income shifts the budget constraint to the northeast but doesn’t change its slope
consumer can reach a higher indifference curve, and is therefore better off
NB: consumer may buy more of both goods, or more of one good and less of another
normal good - higher income, more bought
inferior good - higher income, less bought
How do changes in prices affect the consumer’s choice?
Graph:
Two effects
lower price means more can be bought (real income is higher when prices are lower)
lower price makes consumers switch (substitute) to the cheaper good
The income and substitution effects
Lower prices always make the consumer substitute toward the cheaper good
substitution effect always positive
- Higher (real) income may makes the consumer buy more or less
income effect may be positive or negative
- Can’t always tell whether more is purchased when price falls
Deriving the demand curve
We can use indifference curves and the budget constraint to determine how much consumers will be at various prices - but this is what the demand curve tells us
example: