THEORY OF CONSUMER CHOICE

The contents are;
The budget constraint- what the consumer can afford.

Preferences- what the consumer wants

Optimization- what the consumer chooses

Three applications

Summary/conclusion

1. THEORY OF CONSUMER CHOICE

2. TOPICS OF DISCUSSION The budget constraint- what the consumer can afford. Preferences- what the consumer wants Optimization- what the consumer chooses Three applications Summary/conclusion

3. 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 constraint, 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.

4. THE CONSUMER'S BUDGET CONSTRAINT Any point on the budget constraint line indicates the consumer's combination or trade off between two goods. For example, if the consumer buys no pizzas, he can afford 500 points of P epsi (point B). I f he buys no Pepsi, he can afford 100 pizzas (point A)

5. Alternately, the consumer can buy 50 pizzas and 250 points of Pepsi. 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.

6. PREFERENCES: WHAT THE CONSUMER WANTS A consumer’s 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

7. REPRESENTING PREFERENCE WITH INDIFFERENCE CURVES The consumers preferences- the consumer is indifferent, equally happy with the points shown at A, B and C because they are all on the same curve The Marginal Rate of Substitution (MRS): the slope at any point on an indifference curve is called the MRS. the rate at which a consumer is willing to trade one good for another In this example; the MRS measures how much Pepsi is enough for the consumer to be compensated for a one unit reduction in pizza that he or she will be consuming

8. FOUR PROPERTIES OF INDIFFERENCE CURVES Property 1: Higher indifference curves are preferred to lower ones Property 2: Indifference curves are downward sloping Property 3: Indifference curves do not cross Property 4: Indifference curves are bowed inwards

9. TWO EXTREME EXAMPLES OF INDIFFERENCE CURVES Perfect substitutes Perfect complements

10. OPTIMIZATION: WHAT THE CONSUMER CHOOSES Consumers want to get the best combination on the highest possible indifference curve But has to end up either on or below his or her budget restraint Combining the indifference curve and the consumer’s budget constraint determines the consumer’s optimal choice This consumer optimum point occurs at the point where the highest indifference curve and the budget constraint are tangent

11. HOW CHANGES IN INCOME AFFECT CONSUMER CHOICES An increase in income will definitely shift the budget constraint outward, this means the consumer is now able to purchase a better combination of goods on the higher indifference curve Normal vs. inferior goods- if a consumer buys more of a good due to a rise in income, it is a normal good. However if he buys less of it, it is an inferior good.

12. INCOME AND SUBSTITUTION EFFECTS A price change has two effects on consumption Income effect Substitution effect

13. THREE APPLICATIONS Do all demand curves slope downwards? – sometimes, they can slope upward. This happens when an individual/ consumer buys more of a good when its price rises Giffen goods- a good that violates the laws of demand price increase = increase in demand The income effect dominates the substitution effect They have demand curves that slope upward

14. HOW DO WAGES AFFECT LABOR SUPPLY? If the substitution affect is dominant over the income affect, he or she has to work more If the income affect is dominant over the substitution affect, he or she works less

15. HOW DO INTEREST RATES AFFECT HOUSEHOLD SAVING? If the substitution affect of a higher interest rate is greater than the income affect, households save more If the income affect of a higher interest rate is greater than the substitution affect, households save less

16. Thus, an increase in the interest rate could either encourage or discourage saving

17. SUMMARY A consumer’s budget constraints shows the possible combination of different goods he can buy given his income and the prices of the goods The slope of the budget constraints equals the relative price of the goods The consumer’s indifference curves represent his preferences Points on higher indifference curves are given more preference to points on lower indifference curves

18. CONT. The slope of an indifference curve at any point is the marginal rate of substitution The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve When the price of the good falls, the impact on the consumer’s choices can be broken down into an income affect and a substitution affect The income affect is the change in consumption that arises because a lower price makes the consumer better off The income affect is reflected by the movement from a lower to a higher indifference curve

19. CONT. The substitution affect is the change in consumption that arises because a price change encourages greater consumption of the good that becomes relatively cheaper The substitution effect is reflected by a movement along an indifference curve to a point with a different slope The theory of consumer can potentially slope upward How wages affect labor supply How interest rates affect household saving

20. THANK YOU