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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,Copyright2004 South-Western,5,The Theory of Consumer Choice,(Principles of Economics,Chapter 21),THE BUDGET CONSTRAINT:WHAT THE CONSUMER CAN AFFORD,The,budget constraint,depicts the limit on the consumption“bundles”that a consumer can afford.,People consume less than they desire because their spending is constrained,or limited,by their income.,The budget constraint shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods.,The Consumers Budget Constraint,THE BUDGET CONSTRAINT:WHAT THE CONSUMER CAN AFFORD,The Consumers Budget Constraint,Any point on the budget constraint line indicates the consumers combination or tradeoff between two goods.,For example,if the consumer buys no pizzas,he can afford 500 pints of Pepsi(point B).If he buys no Pepsi,he can afford 100 pizzas(point A).,Figure 1 The Consumers Budget Constraint,Quantity,of Pizza,Quantity,of Pepsi,0,Consumers,budget constraint,500,B,100,A,Copyright2004 South-Western,THE BUDGET CONSTRAINT:WHAT THE CONSUMER CAN AFFORD,The Consumers Budget Constraint,Alternately,the consumer can buy 50 pizzas and 250 pints of Pepsi.,Figure 1 The Consumers Budget Constraint,Quantity,of Pizza,Quantity,of Pepsi,0,Consumers,budget constraint,500,B,250,50,C,100,A,Copyright2004 South-Western,THE BUDGET CONSTRAINT:WHAT THE CONSUMER CAN AFFORD,The,slope,of the budget constraint line equals the relative price of the two goods,that is,the price of one good compared to the price of the other,.,It measures the rate at which the consumer can trade one good for the other.,PREFERENCES:WHAT THE CONSUMER WANTS,A consumers preference among consumption bundles may be illustrated with indifference curves.,An,indifference curve,is a curve that shows consumption bundles that give the consumer the same level of satisfaction,Figure 2 The Consumers Preferences,Quantity,of Pizza,Quantity,of Pepsi,0,Indifference,curve,I,1,I,2,C,B,A,D,Copyright2004 South-Western,Representing Preferences with Indifference Curves,The Consumers Preferences,The consumer is indifferent,or equally happy,with the combinations shown at points A,B,and C because they are all on the same curve.,The Marginal Rate of Substitution,The slope at any point on an indifference curve is the,marginal rate of substitution,.,It is the rate at which a consumer is willing to trade one good for another.,It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.,Figure 2 The Consumers Preferences,Quantity,of Pizza,Quantity,of Pepsi,0,Indifference,curve,I,1,I,2,1,MRS,C,B,A,D,Copyright2004 South-Western,Four 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 bowed inward.,Four Properties of Indifference Curves,Property 1:Higher indifference curves are preferred to lower ones.,Consumers usually prefer more of something to less of it.,Higher indifference curves represent larger quantities of goods than do lower indifference curves.,Figure 2 The Consumers Preferences,Quantity,of Pizza,Quantity,of Pepsi,0,Indifference,curve,I,1,I,2,C,B,A,D,Copyright2004 South-Western,Four Properties of Indifference Curves,Property 2:Indifference curves are downward sloping.,A consumer is willing to give up one good only if he or she gets more of the other good in order to remain equally happy.,If the quantity of one good is reduced,the quantity of the other good must increase.,For this reason,most indifference curves slope downward.,Figure 2 The Consumers Preferences,Quantity,of Pizza,Quantity,of Pepsi,0,Indifference,curve,I,1,Copyright2004 South-Western,Four Properties of Indifference Curves,Property 3:Indifference curves do not cross.,Points A and B should make the consumer equally happy.,Points B and C should make the consumer equally happy.,This implies that A and C would make the consumer equally happy.,But C has more of both goods compared to A.,Figure 3 The Impossibility of Intersecting Indifference Curves,Quantity,of Pizza,Quantity,of Pepsi,0,C,A,B,Copyright2004 South-Western,Four Properties of Indifference Curves,Property 4:Indifference curves are bowed inward.,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.,These differences in a consumers marginal substitution rates cause his or her indifference curve to bow inward.,Figure 4 Bowed Indifference Curves,Quantity,of Pizza,Quantity,of Pepsi,0,Indifference,curve,8,3,A,3,7,B,1,MRS,=6,1,MRS,=1,4,6,14,2,Copyright2004 South-Western,Two Extreme Examples of Indifference Curves,Perfect substitutes,Perfect complements,Two Extreme Examples of Indifference Curves,Perfect Substitutes,Two goods with straight-line indifference curves are perfect substitutes.,The marginal rate
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