Theory of Consumer Choice

7/24/2019 Theory of Consumer Choice

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A presentation on Theoryof consumer choice.

Sidharth Yadav

Roll no. 531

Section I


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IntroductionThe theory of consumer choice eamines the

trade!o"s that people face in their role asconsumers. It eamines ho# consumers facin$these trade!o"s ma%e decisions and ho# theyrespond to chan$es in their environment.

Three &asic 'uestions concernin$ householddecisions are (

)o all demand curves slope do#n#ard*

+o# do #a$es a"ect la&or supply*

+o# do interest rates a"ect household savin$*


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,ud$et -onstraint /hat the

consumer can a"ord*0eople consume less than they desire &ecause

their spendin$ is constrained or limited &y theirincome. /e &e$in the study of consumer choice

&y eaminin$ the lin% &et#een income andspendin$.

,ud$et constraint is the limit on the consumption&undles that a consumer can a"ord. /hen

represented $raphically it is called a &ud$et line.

1. ,ud$et line of aconsumer consumin$ 2


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0references /hat the consumer #ants*

The &ud$et constraint in the previous slidesho#s the trade o" that the consumer faces&et#een $ood 4Y.

,ut the consumers choices depend not only onthe constraints and also his preferences.

A consumers preferences lets him choose

amon$st di"erent &undles of the same $ood.A curve #hich sho#s the &undles #hichprovide e'ual satisfaction to the consumer iscalled an indi"erence curve. )i"erent

indi"erence curves depict di"erent levels of


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Indi"erence -urve

2. I- sho#in$ &undles A,6 of$oods 4Y.

0roperties of an I-

+i$her I-s represent hi$her satisfaction.I-s are al#ays do#n#ard slopin$.2 I-s never intersect.I-s are al#ays conve.


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7ptimi8ation /hat the consumerchooses*

9. :i$ure sho#in$ di"erent I-s alon$ #ith the &ud$et line of aconsumer consumin$ 2 $oods 4Y. ,- is the &ud$et line.


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/ith reference to the previous slide

The consumer chooses the point on his &ud$etconstraint that lies on the hi$hest I-. At this pointslope of the I- ; slope of the &ud$et line.

+ere the hi$hest I- that the consumer can reach isI-3. The consumer prefers I-9 and I-5 &ut theconsumer cannot a"ord any &undle on these I-s asthey are a&ove the &ud$et line.

,y contrast I-1 and I-2 are a"orda&le &ut theconsumer #ould not prefer them as they o"er a lo#erlevel of satisfaction as compared to I-3.Therefore the optimum point of consumption for thisconsumer is the point of tan$ency A6 of I-3 and

&ud$et line ,-.


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-han$e in 0rices.The impact of chan$e in the price of a $ood

on its consumption can &e decomposed intot#o e"ects!

1. Income e"ect

2. Su&stitution


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Income


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Su&stitution


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0rice


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The Three Applications)o all demand curves slope

do#n#ard*

+o# do #a$es a"ect la&or supply*

+o# do interest rates a"ecthousehold savin$*


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)o all demand curves slope do#n#ard*

As a matter of economic theory demand curvescan sometimes slope up#ards also. In thiscase the consumers violate the la# ofdemand.

This happens in case of a $i"en $ood.


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+o# do #a$es a"ect la&or supply*0eople spend some of their time enBoyin$

leisure and some of it #or%in$ so they cana"ord to &uy $oods. The essence of the time!

allocation pro&lem is the trade!o" &et#eenleisure and consumption.

The #or%!leisure decision sho#s a persons

&ud$et constraint for decidin$ ho# much to#or% his I-s for consumption and leisure andhis optimum.


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An increase in the #a$es (0anel A

C. In panel A a hi$her #a$e induces the person to enBoy lessleisure and #or% more so the la&or supply curve slopes up#ard.


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An increase in the #a$es (0anel ,

D. In panel , a hi$her #a$e induces the person to enBoy moreleisure and #or% less so the la&or supply curve slopes &ac%#ard.


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0anel A vs. ,In panel A #hen #a$es rise leisure &ecomes more

costly relative to consumption and this encoura$es himto su&stitute a#ay from leisure and to#ards

consumption. Ea&or supply curve slopes up#ard.In panel , #hen #a$es rise he moves to a hi$her I-.

As lon$ as consumption and leisure are &oth normal$oods he tends to #ant to use this increase in #ell!&ein$ to enBoy &oth hi$her consumption and $reater

leisure. Ea&or supply curve slopes &ac%#ard.If the su&stitution e"ect is $reater than income e"ect

he #or%s more. If income e"ect is $reater thansu&stitution he #or%s less. The la&or supply curvetherefore could &e either up#ard or &ac%#ard slopin$.


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+o# do interest rates a"ect

household savin$*An important decision that every person facesis ho# much income to consume today andho# much to save for the future.

1F. This G$ure sho#s the&ud$et constraint for aperson decidin$ ho#

much to consume in thet#o periods of his lifethe I-s representin$ hispreferences and theoptimum.


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/hen the interest rate increases

11. In &oth panels an increase in the interest rate shifts the&ud$et constraint out#ard. In the panel on the left consumption#hen youn$ falls. The result is an increase in savin$ #hen youn$.In the panel on the ri$ht consumption in &oth period rises resultis decrease in savin$ #hen youn$.


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Than% YouH

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Theory of Consumer Choice