Chapter 21: The Theory of Consumer Choice

Topics: Consumer theory, Supply and demand, Indifference curve Pages: 6 (1460 words) Published: March 24, 2013
Chapter 21: The theory of consumer choice

After developing the basic theory of consumer choice, we apply it to three questions about households decisions

1)Do all demand curves slope downward?
2)How do wages affect labour supply?
3)How do interest rates affect households saving?

The budget constraint: What the consumer can afford
-People consume less than they desire because their spending is constrained or limited by their income

Budget constraint: the limit on the consumption bundles that a consumer can afford -The slope of the budget constraint measures the rate at which the consumer can trade one good for the other

Preferences: What the consumer wants
-The budget constraint is one piece of the analysis: it shows what combination of goods the consumer can afford given his income and the prices of the goods -The consumers’ choice, however, depend not only on his budget constraint but also on his preferences regarding the two goods -The consumer’s preferences are the next piece of our analysis

Representing Preferences with Indifference Curves
Indifference curve: a curve that shows consumption bundles that give the consumer the same level of satisfaction

-The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other

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

-Because the indifference curve are not straight lines, the marginal rate of substitution is not the same at all points on a given indifference curve -The rate at which a consumer is willing to trade one good for the other depends on the amounts of the goods he is already consuming -The consumer is equally happy at all points on any given indifference curve, but he prefers some indifference curve to others -A consumer’s set of indifference curves gives a complete ranking of the consumer’s preferences -We can use the indifference curve to rank any two bundles of goods

Four properties of Indifference curves
Property 1: Higher indifference curves are preferred to lower ones. People usually prefer more of something to less of it. This preference of greater quantities is reflected in the indifference curves

Property 2: Indifference curves are downward sloping. The slope of an indifference curve reflects the rate at which the consumer is willing to substitute one good for the other, In most cases, the consumer like both goods. Therefore, if the quantity of one good is reduced, the quantity of the other good must increase in order for the consumer to be happy

Property 3: Indifference curves do not cross. Contradicts our assumption that the consumer always prefers more of both goods to less. Thus, indifference curves cannot cross. (Refer to example)

Property 4: Indifference curves are bowed inward. The slope of an indifference curve is marginal rate of substitution-the rate at which the consumer is willing to tradeoff one good for the other. The MRS usually depends on the amount of each good the consumer is currently consuming. People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little, the indifference curves are bowed inward

Two Extreme Examples of Indifference Curves
-The shape of an indifference curve tells us about the consumer’s willingness to trade one good for the other -When the goods are easy to sub. For each other, the indifference curve are less bowed; when the goods are hard to sub, the indifference curves are very bowed Perfect Substitute

-Because the marginal rate of substitution is constant, the indifference curves are straight lines - In this extreme case of straight indifference curve, we say that they two goods are perfect subs.

Perfect Complements
-The indifference curve, therefore are right angles
-In this extreme case of right-angle indifference curves, we say that the two...
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