The Theory of Consumer Choice

1. The Theory of Consumer Choice • Recall the principle that people face tradeoffs • Theory of consumer choice examines how consumers facing these tradeoffs make decisions and how they respond to changes in their environment (i.e., the decisions that are behind the demand curve) • We apply the theory to examine several household decisions: • Do all demand curves slope downward? • How do wages affect labor supply? • How do interest rate affect household savings? • Do poor people prefer to receive cash or in-kind transfers?

2. Consumer’s Choice: The Budget Constraint • People consume less than they desire because their spending is constrained by their income and the prices of the goods • The consumer’s budget constraint shows the various consumption bundles that the consumer can afford for a given income • The budget constraint shows the tradeoff between the chosen commodities • The slope of the budget constraint measures the rate at which the consumer can trade one good for another and is equal to the relative prices of the goods

3. Consumer’s Choice: Indifference Curves • Indifference curves represent the consumer’s preferences that make the consumer equally satisfied • Indifference curve show the consumption bundles that give the consumer the same level of satisfaction • The Marginal Rate of Substitution (MRS) is the rate at which a consumer is willing to trade one good for another and is given by the slope at any point on the indifference curve • A set of indifference curves gives a complete ranking of the consumer’s preferences

4. 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 concave or bowed inward • Extreme cases of indifference curves: • Perfect substitutes- two goods with straight line indifference curves • Perfect complements- two goods with right- angle indifference curves

5. Optimization: Consumer’s Optimal Choices • Using the consumer’s budget constraint and her set of indifference curves we arrive at her optimal choice • The optimal point is where the budget constraint is tangent to the highest indifference curve • Consumer chooses the consumption of the two goods so that MRS= relative prices • At the consumer’s optimum, the consumer’s valuation of the two goods equals the market valuation • Therefore, market prices of different goods reflect the value that consumers place on those goods.

6. Income Effect on Consumer’s Choices • An increase in consumer’s income leads to a parallel shift in the budget constraint to the right • If the goods are normal, the consumer buys more of both • If one of the goods is inferior, the consumer buys less of the inferior good • The consumer can reach a higher indifference curve due to the expanded budget constraint • The consumer moves from the initial optimum to the new optimum, which changes his purchases of both goods (whether normal or inferior good)

7. Price Effect on Consumer’s Choices • Changes in the relative prices of the goods leads to shift in the budget constraint • The slope of the budget constraint changes depending on the price change • The consumer moves from the initial optimum to the new optimum, which changes his purchases of both goods • The impact of a price change of a good on consumption can be broken down into two effects: • Income effect • Substitution effect

8. Income and Substitution Effects • Income effect- the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve • 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 MRS • If income and substitution effects act in the same direction, the consumer purchases more of the commodity • If income and substitution effects act in the opposite directions, the total effect on consumption of the good is ambiguous

9. Deriving the Demand Curve • A consumer’s demand curve is a summary of the optimal decisions that arise from the consumer’s budget constraint and indifference curves • A demand curve for any good reflects consumption decisions • The theory of consumer choice provides the theoretical foundation for the consumer’s demand curve and is used to study the determinants of household behavior

10. Applications: #1 and #2 • Do all demand curves slope downward? • Case of Giffen goods • Inferior goods for which the income effect dominates the substitution effect. • How do wages affect labor supply? • Labor supply curve slopes upward when substitution effect is greater than the income effect • Labor supply curve slopes backward when income effect is greater than the substitution effect

11. Application: #3 • How do interest rates affect household saving? • An increase in interest rate results in an increase in saving when young or • An increase in interest rate results in a decrease in saving when young

12. Application: #4 • Do the poor prefer to receive cash or in-kind transfers? • If the in-kind transfer is not binding, the recipient ends up with the same level of satisfaction under both policies. • If the in-kind transfer is binding (forces the recipient to consume more of the good than she would like to) on the consumer, then the recipient ends up on a lower indifference curve with the in-kind transfer. • Intersection of the budget line and the indifference curve implies that the consumer can move on to a higher indifference curve.