Theory of Consumer Choice
Theory
of Consumer Choice - Consumers face trade-offs in their purchase decisions since their income is limited and choices are numerous. In order to make
choices, consumers must combine budget constraints (what they can afford), and preferences
(what they would like to consume).
A budget constraint means what a consumer can purchase is
constrained by income. The slope of the budget constraint measures the rate at
which one consumer can trade off one good for another, and the relative prices
of the two goods. Budget constraints are determined by both the income of the
consumers, and the relative prices.
If a consumer equally
prefers two product bundles, then the consumer is indifferent between the two
bundles. The consumer will get the same level of satisfaction (utility) from
either bundle. Graphically speaking, this is known as the indifference curve.
This curve shows that all bundles are equally preferred, or have the same
utility or same level of satisfaction. The slope of the indifference curve is the
rate at which a consumer is willing to trade one good for another, which is
also known as the marginal rate of substitution (MRS).
Properties of Indifference Curves
1. Higher indifference curves are preferred to lower
ones since more is preferred to less (non-satiation).
2. Indifference curves are downward sloping. If the
quantity of one goods is reduced, then you must have more of the other good to
compensate for the loss.
3. Indifference curves do not cross (intersect), since
this would imply a contradiction.
4. Indifference curves are bowed inward (in most cases).
The slope of indifference curves represents the MRS (rate at which consumers are
willing to substitute one good for the other). People are usually willing to
trade away more of one good when they have a lot of it, and less willing to trade away goods which are in scarce supply. This
implies that MRS must increase as we get less of a good.
Nota bene that two
extreme examples exist. Perfect substitutes have straight-line indifference
curves. As we get more of the good, we trade off with the substitute at a
constant rate because we are indifferent between them (i.e. Coke and Pepsi).
Perfect complements have right-angled indifference curves. If goods can only be
used together, there is no satisfaction in having more of A without additional
amounts of B (i.e. left and right shoe). In general, the better substitutes
goods are, the straighter the indifference curve.
Consumers' Optimal Choice
We must combine what a
consumer can obtain (budget constraint) and the preferences (indifference
curve). The optimum is the highest point on the indifference curve that is
still within the budget constraint. This will usually occur where the
indifference curve is tangent to budget constraints. At the optimum point, MRS =
relative prices of goods since MRS = slope of the indifference curve, and relative
price = slope of the budget constraint. The marginal rate of substitution is the
rate at which consumers are willing to trade-off and is equal to the rate at which
they can trade.
Changes in income will
undoubtedly affect the optimal choice. The budget constraint will shift
parallel to the original - upwards for an increase in income, and downwards for
a decrease in income. The new equilibrium for a higher income will be on a
higher indifference curve, and since income is higher, more of both products
could be consumed. For normal goods, as income increases, more of the goodwill
be preferred. For inferior goods, as income increases, less of the goodwill be
chosen.
Changes in Prices
A change in price will
change the slope of the curve. A fall in price will rotate the budget
constraint outwards, and an increase in price will rotate the budget constraint
inwards. Thus a change in price will change both the relative prices of the two
products and also the amount that can be bought, ceteris paribus (income).
Changes in price have two effects:
1. Substitution Effect
o arises from the tendency to buy less of goods which
are more expensive
o can be measured by keeping satisfaction constant (stay
on same indifference curve and finding where MRS = new relative prices
2. Income Effect
o arises from the change in price effect on the total amount
that can be purchased
o change in consumption when we shift to a new
indifference curve as a result of the price change
“Theory of Consumer Choice” (aspropendo.org)
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