Chapter 6

PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
Consumer Choice
CHAPTER
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The Budget Constraint
• Budget constraint
–Different combinations of goods
–A consumer can afford with a limited
budget
–At given prices
• Budget line
–Graphical representation of a budget
constraint
• Maximum affordable quantity of one good, for
given amounts of another good
2
© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as

• Max
–Total entertainment budget = $100 per
month
–Price of a movie = $10
–Price of a concert = $20
• Relative price
–Price of one good relative to the price of
another
3

Figure
4
1

Figure
5
1
Number of Concerts per Month
Number of
Movies per
Month
8
1 2
With $100 per month, Max can afford
10 movies and no concerts, . . .
6
4
2
3 4
10
5
A
B
C
D
E
F
H
G
8 movies and 1 concert or any other
combination on the budget line.
Points below the line are
also affordable.
But not points above the line.

• If
–Py: price of the good on the vertical axis
–Px: price of the good on the horizontal axis
• Then, Px/Py is
–The relative price of good X
–The opportunity cost of one more unit of
good X
–The absolute value of the slope of the
consumer’s budget line
6

Changes in the Budget Line
• Changes in income
–An increase in income will shift the budget
line upward (and rightward)
–A decrease in income will shift the budget
line downward (and leftward)
–These shifts are parallel
• Changes in income do not affect the budget
line’s slope
7

• Changes in price
–The budget line rotates
–The slope of the budget line changes
–One of the intercepts of the budget line
changes
8

Figure
9
2
Number of
Concerts per Month
Number of
movies per
month
(a)
5
10
10
20
1. An increase in
income shifts the
budget line
rightward, with no
change in slope.
Number of
Concerts per Month
Number of
movies per
month
(b)
5
10
20
2. A decrease in
the price of movies
rotates the budget
line upward . . .
Number of
Concerts per Month
Number of
movies per
month
(c)
5
10
10
3. While a
decrease in the
price of concerts
rotates it rightward

Preferences
• Rational preferences satisfy two
conditions:
1. Any two alternatives can be compared,
and one is preferred or else the two are
valued equally
2. The comparisons are logically consistent
or transitive
• More is better
–Always choose a point on the budget line,
rather than a point below it
10

The Marginal Utility Approach
• Utility
–Quantitative measure of pleasure/
satisfaction obtained from consuming
goods and services
• Marginal utility
–Change in total utility
–From consuming an additional unit of a
good or service
11

Figure
Total and Marginal Utility
12
3

Figure
Total and Marginal Utility
13
3
Ice cream cones per week
Utils
10
20
30
40
50
60
70
1 2 3 4 5 6
Ice cream cones per week
Utils
10
20
30
1 2 3 4 5 6
Total Utility
Marginal Utility
1. The change in total
utility from one more ice
cream cone . . .
2. Is called the marginal utility of
an additional cone.
3. Marginal utility
falls as more cones
are consumed.

• Law of diminishing marginal utility
–As consumption of a good or service
increases, marginal utility decreases
• Marginal utility
–Can be zero
• Assumption
–Marginal utility for every good is positive
–‘More is better’
14

• Utility maximization
–Consumer will choose the point on the
budget line
–Where marginal utility per dollar is the
same for both goods: MUx/Px = MUy/Py
–There is no further gain from reallocating
expenditures in either direction
15

Table
Total and Marginal Utility of Concerts and Movies
16
1

Figure
Consumer Decision Making
17
4

Figure
The budget line shows the maximum number of movies Max could attend for each number of concerts
he attends. He would never choose an interior point like G because there are affordable points—on
the line—that make him better off. Max will choose the point on the budget line at which the marginal
utilities per dollar spent on movies and concerts are equal. From the table, this occurs at point D.
18
4
Number of
Movies
per Month
8
1 2
6
4
2
3 4
10
5
A
D
F
G
B
C
E
40, 20c m
c m
MU MU
P P
 
30, 30c m
c m
MU MU
P P
 
20, 45c m
c m
MU MU
P P
 

• A rise in income
–With no change in prices
–A new quantity demanded for each good
–Individual preferences (marginal utility)
• Normal good – quantity demanded increases
• Inferior good – quantity demanded decreases
19

Figure
Effects of an Increase in Income
20
5

Figure
Effects of an Increase in Income
21
5
Number of
Movies per
Month
8
1 2
1. When Max's income rises to $200,
his budget line shifts outward.
6
4
2
3 4
A
B
C
D
E
F
10
5 6 7 8 9
14
16
18
12
20
10
G
H
J
K
L
2. If his preferences are as given
in the table, he'll choose point K.

Figure
Normal and Inferior Goods
22
6
Number of
Movies per
Month
8
1 2
6
4
2
3 4 6 7 8 9
14
16
18
12
5 10
20
10
If income rises and concerts are
inferior, Max moves to a point like K″
(fewer concerts).
A
B
C
D
E
F
K”
K
K’
If income rises and movies are
inferior, Max moves to a point like
K′ (fewer movies).

• Change in prices
–Decrease in the price of one good
• Other things constant
• Rotates the budget line rightward
• Individual demand curve
–Quantity of a good a consumer demands
at each different price
23

Figure
Deriving the Demand Curve
24
7

Figure
Deriving the Demand Curve
25
7
Number of Concerts per month
Price per
Concert
$5
$10
$20
3 5 8
Number of Concerts
per month
Number of
Movies per
Month
4
5
6
10
3 5 108 20
1. When the price of concerts is $20,
point D is best for Max.
T
D
R 3. And if the price drops to $5,
he chooses point T.
4. The demand curve shows the
quantity Max chooses at each price
T
D
R
2. If the price falls to $10, Max's
budget line rotates rightward,
and he chooses point R.

Income and Substitution Effects
• Substitution effect
–As the price of a good falls, the consumer
substitutes that good in place of other
goods whose prices have not changed
–Arises from a change in the relative price
of a good
–It moves quantity demanded in the
opposite direction to the price change
26

• Income effect
–As the price of a good decreases, the
consumer’s purchasing power increases
• Causing a change in quantity demanded for
the good
–Arises from a change in purchasing power
over both goods
27

• Normal goods
–Substitution and income effects work
together
–Quantity demanded - moves in the
opposite direction of the price
–Always obey the law of demand
28

• Inferior goods
–Substitution and income effects work
against each other
–Substitution effect virtually always
dominates
–Virtually always obey the law of demand
29

Figure
30
8

Consumers in Markets
• Market demand curve
–Horizontally summing the individual
demand curves of every consumer in the
market
–Obeys the law of demand
–Downward sloping
31

Figure
The individual demand curves show how much bottled water will be demanded by Jerry,
George, and Elaine at different prices. As the price falls, each demands more.
From Individual to Market Demand (a)
32
9
Number of Bottles
per Week
Price
Jerry$4
3
2
1
8 124
C
Number of Bottles
per Week
Price
George$4
3
2
1
9 126
C’
Number of Bottles
per Week
Price
Elaine$4
3
2
1
2010
C”

Figure
The market demand curve in panel (b) is obtained by adding up the total quantity demanded by
all market participants at different prices.
From Individual to Market Demand (b)
33
9
Number of Bottles per Week
Price
1
4410
2
$4
3
3 27
A
B
C
D
E
Market Demand Curve

Consumer Theory in Perspective
• Extensions of the model
–Incorporate choices among many goods
–Recognize saving and borrowing
–Incorporate uncertainty and imperfect
information
–Behavioral economics
34

• Behavioral economics
–Subfield of economics
–Decision-making patterns that deviate from
those predicted by traditional consumer
theory
• Salience of a particular outcome
–The extent to which it “jumps out at them”
35

• Preference for defaults
–People tend to stick to the default choice
• Decision-making environment
–Environment in which a decision is made -
can exert a strong and surprising influence
• Self-binding
–To a narrower set of choices - long-run
good
36

• Behavioral economics and policy
–Financial incentive for firms to make
“automatic contribution” by employees the
default choice
–People with gambling problems -
voluntarily put themselves on a list that
bans them from any casino
–Industry-wide “vanilla” versions of
mortgages, student loans, credit card
agreements
37

• Behavioral economics and traditional
theory
–Traditional economic theory: assumes that
consumers have rational preferences
–Behavioral economics: analyzes decisions
that violate rational preferences
38

Improving Education
• Model of consumer choice
–Student’s time allocation problem
–Only two activities: studying economics
and studying French
–Each of these activities costs time
–Students “buy” points on their exams with
hours spent studying
39

Improving Education
• Student’s time allocation problem
–Opportunity cost of scoring better in
French
• Scoring lower in economics
–Slope of budget line = -PF/PE = -2
• Each additional point in French: sacrifice 2
points in economics
40

Improving Education
• New computer-assisted technique in
French class
–Learn more French with the same study
time or to study less and learn the same
amount
–A decrease in the price of French points
–Budget line rotates outward
41

Figure
Panel (a) shows combinations of French and economics test scores that can be obtained for a
given amount of study time. The slope of −2 indicates that each additional point in French
requires a sacrifice of 2 points in economics. The student chooses point C. Panel (b) shows
that computer-assisted French instruction causes the budget line to rotate outward; French
points are now less expensive. The student might move to point D, attaining a higher French
score. Or she might choose F, using all of the time freed up in French to study economics. Or
she might choose an intermediate point, such as E.
Time Allocation
42
10
French score
Economics
score
90
70
80
75 80
(a)
C
French score
Economics
score
90
70
80
9075 80
(b)
C
D
E
F

The Indifference Curve Approach
• Assumptions
–Rational preferences: an individual can
compare any two options and decide
which is best
• Makes choices that are logically consistent
–An individual prefers more of every good to
less
• Consumer - choose to be on budget line,
rather than below it
43

An Indifference Curve
• An indifference curve
–All combinations of two goods that make
the consumer equally well off
–Slopes downward
• Marginal rate of substitution, MRSy,x
–Of good y for good x along any segment of
an indifference curve
–Is the maximum rate at which a consumer
would willingly trade units of y for units of x
44

Figure
45
A.1
Number of Movies
per Month
6
3
4
11
20
1 2 3 4 5
If Max gets another concert . . .
G
H
J
K
L
+1
+1
+1
+1
-9
-5
-2
-1
He could give up 9 movies
and be just as satisfied.

• MRS at any point on the indifference
curve
–The (absolute value of) the slope of the
curve at that point
–Maximum rate at which a consumer would
willingly trade good y for a tiny bit more of
good x
46

The Indifference Map
• Indifference map
–A set of indifference curves that describe
one persons’ preferences
–Any point on a higher indifference curve is
preferred to any point on a lower one
47

Figure
An Indifference Map
48
A.2
Number of Movies
per Month
6
11
20
1 2 3
1.Max prefers any point on
this indifference curve…G
H
J
2.to any point on this one.R
S
3.And any point on this
curve is preferred to any
point on the other two.

• Optimal combination of goods
–The point on the budget line where an
indifference curve is tangent to the budget
line
–That combination on the budget line for
which MRSy,x = Px/Py
49

Figure
Consumer Decision Making with Indifference Curves
50
A.3
Number of Movies
per Month
Number of Concerts
per Month
6
10
1 2 3 4 5
8
4
2
2. But point D (also affordable) is
preferred because it is on a higher
indifference curve.
A
B
D
E
1. Points B
and E are
affordable . . .

What Happens When Things Change?
• A rise in income
–With no change in prices
–Leads to a new quantity demanded for
each good
–Quantity demanded increases (normal
good)
–Quantity demanded decreases (inferior
good)
–Depends on the individual’s preferences
• Indifference map
51

Figure
An Increase in Income
52
A.4
Number of
Movies
per Month
8
4
3 65 10
20
10
1. When Max's income rises to $200, his
budget line shifts outward.
2. With the preferences represented
by these indifference curves, he'll
choose point H.
D
H
3. In this case, both
movies and concerts are
normal goods for Max.

Figure
Number of
Movies
per Month
2
4
3 95 10
20
10
8
6
An Increase in Income
53
A.4
D
H’
4. But if Max instead had
these indifference curves, he
would choose point H’ . . .
5. Concerts would be
normal for Max, but
movies would be inferior.

What Happens When Things Change?
• Changes in price
–Budget line rotates
–Quantity demanded changes
–Downward sloping demand curve
54

Figure
Deriving the Demand Curve with Indifference Curves
55
A.5
Number of
Movies
per Month
5
4
3 85 10
10
6
20
D
K
J
1. When the price of concerts is
$20, MRSm,c = Pc /Pm at Point D.
2. But when the price of
concerts falls to $10, this
condition is satisfied at point J.
Price per
concert
$5
3 85
$20
$10
D
K
J
3. The demand curve shows the
quantity of concerts Max chooses
at each price for concerts.

Chapter 6

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