Download Consumer Choice

Consumer Choice
Unlimited Wants; Limited
Resources
Main Ideas
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The market demand is the outcome of
decisions made by individual consumers
about how to allocate income among
competing alternatives. For normal goods,
demand will slope down.
Labor supply is outcome of decisions made
by individuals about how to allocate time
among competing alternatives. Labor supply
may be backward bending.
Assumptions
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Consumer maximizes utility
Utility depends on the quantity
consumed of X and Y
More is better
Diminishing Marginal Utility
Consumer is a price taker.
Consumer income, I, is also
predetermined.
Utility
U(X, Y)
where X = units of Good X
Y = units o f Good Y
Choice is Constrained
I  PxX  PyY
where I = Consumer' s Income
Px = Price per unit of Good X
Py = Price per unit of Good Y
How Much X and How Much Y?
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Allocate Income Such That the Marginal
Benefit of an Additional Dollar Spent on
Good X Equals Its Marginal Cost.
Marginal Cost is the Foregone Benefit
of Spending Another Dollar on Y.
(Opportunity Cost)
Operate Within Budget
Optimal Consumption
MU x MU y

Px
Py
Geometry of Consumers Choice
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Budget Line
I  PxX  PyY
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Utility
– Indifference Curves
The Budget Line
Budget Line Describes Consumption Opportunities.
This bundle is unattainable
This bundle does not use all income
INTERCEPTS
Quantity of Y Consumer Can Purchase
If He Spends All of His Money on Y
=Income/Py
Quantity of X Consumer Can Purchase
If He Spends All of His Money on X
=Income/Px
Slope of Budget Line
 Px
Py
Changes in Income
An Increase in Income shifts
budget line out. Consumer
can buy more stuff
Changes in Prices
Decrease in Price of X allows
consumer to buy
more X with the
same income
Utility: Indifference Curve
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Describes bundles of X and Y that make
the consumer equally happy.
Each indifference curve represents a
level of happiness. The further away
from the origin, the greater the
happiness
Slope of indifference curve is the rate of
marginal substitution
Indifference Curves Describe Tastes of
Individual Consumer
More is better.
Consumer is happier at
A than at B
B
A
5,20
10,10
20,5
Willing to give up 3 Y
for every X here
Give up only 1/3 Y
for every X here
Consumer’s Optimal Bundle
A -- attainable, but
yields less happiness
than B
D -- attainable, but
more is better
C -- preferred to B, but
not available
A
B
D
C
Derivation of Demand
Individual Demand
P
2.5
5
10
Q
40
20
10
Impact of Price Change
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Budget set shrinks showing a decrease
in real purchasing power
Slope of budget line changes showing a
change in relative prices. As budget
line gets steeper, Good X is more
expensive relative to Good Y
Two Effects of Price Change
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Income Effect -- an increase in Price of
X reduces purchasing power. (Shrinks
budget set.) Consumer buys less of
normal goods.
Substitution Effect -- an Increase In
Price of X Means X is More Expensive
Relative to Y. (Change in slope)
Consumer substitutes away from X
towards Y.
Income and Substitution Effects
90
80
1. Price Increase shifts
budget from green to
light blue
70
60
2. Dk. blue budget line represents
income level that allows consumer
to return to old level of happiness
with new prices
50
40
U3
U4
Px=2.5, I=200
Px=5, I=200
Px=5, I New
30
20
X0-Xs - Substitution effect
10
0
Xs-Xn -Income effect
0
20
XN
Xs
40
60
X0
80
100