Chapter 21: The Theory of Consumer Choice

• There are many factors that contribute to the theory of consumer choice.

• People face trade-offs while making decisions.

• There are three questions while making household decisions:

  • Do all demand curves slope downward?

  • How do wages affect labor supply?

  • How do interest rates affect household savings?

Chapter 21.1: The Budget Constraint: What a Consumer Can Afford

• Constrained: to be limited (in this context, by income)

• 21.1a: Representing Consumption Opportunities in a Graph

  • Budget constraint: the limit on the consumption bundles a consumers can afford

  • This slope measures the rate where the consumer can buy or trade one good for the other.

    • EX: 4 pens, 3 pens 1 pencil, 2 pens 2 pencils, 1 pen 3 pencils, or 4 pencils

  • Relative Price: the price of one good compared to another

    • EX: Hardcover books cost more than soft-covered books.

• 21.1b: Shifts in the Budget Constraint

  • The budget constraint includes the consumer’s income and the prices of the two goods.

  • If income or prices change, the constraint shifts. An increase in income causes a parallel shift. An expansion in consumer’s opportunities causes a rotational shift.

Chapter 21.2: Preferences: What a Consumer Wants

• 21.2a: Representing Preferences with Indifference Curves

  • Indifference curve: a curve that shows consumption bundles that give the consumer the same level of satisfaction

  • Consumers will choose products and services that give them more satisfaction.

  • Marginal rate of substitution; the rate at which a consumer is willing to trade one good for another

  • The marginal rate of substitution depends on the amount of prior instruments

  • Higher indifference curves are preferred to lowers indifference curves.

• 21.2b: Four Properties of Indifference Curves

  • Higher indifference curves are preferred to lower ones

  • Indifference curves slope downward

  • Indifference curves do not cross

  • Indifference curves are bowed inward

• 21.2c: Two Extreme Examples of Indifference Curves

  • When goods are hard to substitute, indifference curves are very bowed.

  • Perfect substitutes: two goods with straight-line indifference curves

  • Perfect complements: two goods with right-angle indifference curves

Chapter 21.3: Optimization: What a Consumer Chooses

• 21.3a: The Consumer’s Optimal Choices

  • Optimum: where the indifference curve and the budget constraint touches

  • The optimum is the choice that will bring the most utility

  • The indifference curve is tangent to the budget constraint at the optimum.

  • The consumer chooses the quantities of the two goods so that the marginal rate of substitution equals the relative price.

  • Market prices of different goods reflect how much consumers value that good.

• 21.3b: How Changes in Income Affect the Consumer’s Choices

  • Normal good: a good for which an increase in income raises the quantity demanded

  • Inferior good: a good for which an increase in income reduces the quantity demanded

• 21.3c: How Changes in Prices Affect the Consumer’s Choices

  • When the price of a good falls, the consumer budget constraint shifts outward and changes slope.

  • When it increases, it shifts inwards and changes slope.

• 21.3d: 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 marginal rate of substitution

  • The income effect is the change in consumption that results from the movement to a new indifference curve. The substitution effect is the change in consumption that results from moving to a new point on the same indifference curve with a different marginal rate of substitution.

• 21.3e: Deriving the Demand Curve

  • The demand curve reflects consumption decisions.

  • A consumer’s demand curve is a summary of the optimums and decisions they can make.

Chapter 21.4: Three Applications

• 21.4a: Do All Demand Curves Slope Downward?

  • Law of demand: when a price of a good rises, people buy less of it

  • Giffen goods: a good that violates the law of demand. These are inferior goods where the income effect dominates the substitution effect

• 21.4b: How Do Wages Affect Labor Supply?

  • The time-allocation problem is a trade-off between leisure and consumption.

  • The chosen combination of consumption and leisure is called the optimum.

• 21.4c: How Do Interest Rates Affect Household Saving?

  • If the substitution effect of a higher interest rate is greater than the income effect, savings increase.

  • If the substitution effect of a higher interest rate is greater than the substitution effect, savings decrease.