CHAPTER - 21

Introduction to
MICROeconomics
(HSS – 2023)

The Theory of
Consumer Choice
Lecture No: 8, 9, 10

N. Gregory Mankiw
Copyright © 2004 South-Western/Thomson Learning
 THE THEORY OF CONSUMER CHOICE

• WHAT THE CONSUMER CAN AFFORD?

• WHAT THE CONSUMER WANTS?

• WHAT THE CONSUMER CHOOSES?

Copyright © 2004 South-Western/Thomson Learning

 THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD ?

Budget Constraint
A budget constraint identifies all possible consumption
bundles a consumer can afford over some period of time,
with a given income and prices of the commodities.
Thus,
Cost of the Consumption Bundle

Income of the Consumer
 WHAT THE CONSUMER CAN AFFORD ?
Budget Constraint
Assume, a consumption bundle containing x1 units of
commodity 1, and x2 units of commodity 2.

Commodity prices are p1, and p2.

Income of the consumer is ‘m’

p1x1 + p2x2  m

When is a bundle (x1,x2) affordable at prices p1,p2

???
WHAT THE CONSUMER CAN AFFORD ?

Affordable ???
INCOME OF THE CONSUMER RS 60/-

3 60 80 100 120
ICE
CREAM 2 40 60 80 100
(X2)
@ 1 20 40 60 80
Rs 20
per
Unit
0 0 20 40 60
0 1 2 3
CHOCOLATE (X1) @ Rs 20/unit
 WHAT THE CONSUMER CAN AFFORD ?

x2 Budget Line is
p1x1 + p2x2 = m

A
O
x1
 Budget Constraint for two Commodities

Budget Line is
x2 p1x1 + p2x2 = m.
m /p2 B
Not affordable
Just affordable
Budget Line:
Affordable The set of bundles
that cost exactly m;
A p1x1 + p2x2 = m
O
m /p1 x1
Budget Constraint vs. Budget Line
 Slope of the Budget Line
x2 B Slope (B→A) = -(m/p2)/(m/p1) = -p1/p2

m/p2
Downward slopping Budget Line
The opportunity cost of
consuming one extra unit of
commodity x1 is p1/p2
-p1/p2 sacrifice of consumption of
commodity x2.
A
O
m/p1 x1
Any point on the budget constraint line (BA) indicates the
consumer’s combination or tradeoff between two goods.
 Slope of the Budget Line
x2 B Slope (B→A) = -(m/p2)/(m/p1) = -p1/p2

m /p2 The slope of the budget

line equals the relative
price of the two goods,
that is, the price of one
good compared to the

ΔX2 price of the other.

It measures the rate at
which the consumer can
-p1/p2 trade one good for the
other.

ΔX1 A
O
m /p1 x1
Any point on the budget line (BA) indicates the consumer’s
combination or tradeoff between two goods.
HOW THE BUDGET LINE CHANGES ?

INCREASING INCOME
(From Rs 60/- to Rs 80/-)

INCOME OF THE CONSUMER RS 80/-

4 80 100 120 140 160

ICE
CREAM 3 60 80 100 120 140
(X2) 2 40 60 80 100 120
@
Rs 20 1 20 40 60 80 100
per
Unit 0 0 20 40 60 80
0 1 2 3 4
CHOCOLATE (X1) @ Rs 20/unit
 HOW THE BUDGET LINE CHANGES ?
Higher income gives more choice
x2 New affordable
consumption
B’
choices
B
INCREASING INCOME
(From Rs 60/- to Rs 80/-)

New
Original Budget line
budget line A’B’
AB

O
A A’ x1
HOW THE BUDGET LINE CHANGES ?

DECREASE IN INCOME
(From Rs 60/- to Rs 40/-)

INCOME OF THE CONSUMER RS 40/-

3 60 80 100 120
ICE
CREAM 2 40 60 80 100
(X2)
@ 1 20 40 60 80
Rs 20
per
0 0 20 40 60
Unit
0 1 2 3
CHOCOLATE (X1) @ Rs 20/unit
 HOW THE BUDGET LINE CHANGES ?
Lower income gives less choice
x2 B Consumption
Original bundles that are
budget line
no longer
B”
affordable.

DECREASE IN INCOME
(From Rs 60/- to Rs 40/-)

New
budget line

O
A” A x1
 HOW THE BUDGET LINE CHANGES ?

Price of x1 decreases
From Rs 20/- to Rs 10/-

INCOME OF THE CONSUMER RS 60/-

3 60 70 80 90 100 110 120

ICE
CREAM 2 40 50 60 70 80 90 100
(X2)
@ 1 20 30 40 50 60 70 80
Rs 20
per
0 0 10 20 30 40 50 60
Unit
0 1 2 3 4 5 6
CHOCOLATE (X1) @ Rs 10/unit
 HOW THE BUDGET LINE CHANGES ?

x2 B
New affordable choices

Price of x1 decreases
From Rs 20/- to Rs 10/-
Original
budget line New
budget line

O
A A’ x1
 HOW THE BUDGET LINE CHANGES ?
Analyse the following cases
Case-1 Case-2

x2 B’ x2 B’
New
budget line
New
B budget line

Original
Original budget line
budget line

O x1 O x1
A A’ A
 The Consumer’s Budget Constraint
An Example:

Given,
Price of Pepsi per unit = $ 2
Price of Pizza per unuit = $ 10
REVISITING UTILITY
REVISITING UTILITY
CONSUMER BEHAVIOUR : ORDINAL ANALYSIS
 CONSUMER PREFERENCES
What the Consumer Wants ?
CONSUMER PREFERENCES
 CONSUMER PREFERENCES (MONOTONIC)
Preferences are Monotonic (more is better) if a basket with
more of at least one good and no less of any good is
preferred to the original basket.
o ‘B’ & ‘C’ preferred
over ‘A’
o ‘B’ & ‘C’ provide
the same
satisfaction
o ‘A’ preferred over
‘D’ & ‘E’
o ‘F’ is preferred over
‘A’, ‘B’, ‘C’, ‘D’, ‘E’

O
REPRESENTING PREFERENCES WITH INDIFFERENCE CURVE

O
 SLOPE OF THE INDIFFERENCE CURVE
(MARGINAL RATE OF SUBSTITUTION – MRSx1x2)

The slope at any point on an indifference curve is the marginal rate of

substitution (MRS). MRS is the rate at which a consumer is willing to trade
one good for another. Thus, it is the additional amount of one good that a
consumer requires as compensation to give up one unit of the other good.
 PROPERTIES OF INDIFFERENCE CURVE (IC)
1. Higher indifference curves are preferred to lower ones

O
 PROPERTIES OF INDIFFERENCE CURVE (IC)
2. Indifference curves are downward-sloping

O
 PROPERTIES OF INDIFFERENCE CURVE (IC)
3. Indifference curves don’t cross

O
 PROPERTIES OF INDIFFERENCE CURVE (IC)
4. Indifference curves are bowed-inward

Bowed-inward
Indifference Curves
Indifference curves are usually bowed
inward. This shape implies
that the marginal rate of substitution
(MRS) depends on the quantity of the
two goods the consumer is consuming.
At point A, the consumer has little pizza
and much Pepsi, so she requires a lot of
extra Pepsi to induce her to give up one
of the pizzas: The marginal rate of
IC substitution is 6 liters of Pepsi per pizza.
At point B, the consumer has much pizza
and little Pepsi, so she requires only a
little extra Pepsi to induce her to give up
one of the pizzas: The marginal rate of
substitution is 1 liter of Pepsi per pizza.
 Consumer’s Optimal Choice
WHAT THE CONSUMER CHOOSES ?
• Consumers want to get the combination of two goods on the
highest possible indifference curve.
• Combining the indifference curve and the budget line determines
the consumer’s optimal choice.
• Consumer optimum occurs at the point where the highest
indifference curve touches the budget line (the point of tangency).
• The consumer chooses consumption of the two goods so that the
slope of the budget line and slope of the indifference curve must
be equal (marginal rate of substitution equals the relative price)

Slope of IC = Slope of BL
=> MRSx1x2 = P1/P2
 Consumer’s Optimal Choice
WHAT THE CONSUMER CHOOSES ?

O
Impact of change in income on the
Consumer’s Optimal Choice

➢ An increase in income shifts the

budget line outward.

➢ As the relative price of the two

goods has not changed, the slope of
the new budget line (-Px/Py) is the
same as that of the initial budget
line.

➢ Thus, an increase in income leads

to a parallel shift in the budget line
outward.

➢ The expanded budget line allows

the consumer to choose a better
combination of X1 and X2, which is
on a higher indifference curve.
 Impact of change in price on the
Consumer’s Optimal Choice

➢ A decrease in the price of a

commodity expands the consumer’s
buying opportunities.
➢ A fall in the price of X1 shifts the
budget line outward (from BL to
BL’) with a decreasing slope.
➢ As the price of X1 has fallen while
the price of X2 and the consumer’s
income remains unchanged, the
consumer moves from the initial
optimum (E) to the new optimum
(E’).
➢ As commodity X1 is cheaper in
comparison to X2, thus,
consumption of X1 increases, and
O
X2 falls.
 Summing-up …
▪ Budget constraint identifies all possible consumption
bundles a consumer can afford over some period of time,
i.e.,
p1x1 + p2x2  m
▪ Budget Line represents the set of bundles that cost exactly
m;
p1x1 + p2x2 = m
▪ Increases in income shift the budget line outward in
a parallel manner, thereby improving choice.
▪ Decreases in income shift the budget line inward in a
parallel manner, thereby reducing choice.
▪ Reducing the price of one commodity shifts the
budget line outward. No old choice is lost and new choices
are added, so reducing one price cannot make the consumer
worse off.
 Summing-up
▪ Preferences means Consumer’s Like or Dislike towards goods and
services
▪ The collection of goods that an individual consumes over a given period is
known as Consumption bundle/basket.
▪ Preferences are transitive if a consumer who prefers basket ‘A’ to
basket ‘B’, and basket ‘B’ to basket ‘C’ also prefers basket ‘A’ to basket ‘C’
▪ Preferences are Monotonic (more is better) if a basket with more of
at least one good and no less of any good is preferred to the original basket.
▪ Indifference curve shows different consumption bundles that give the
consumer the same level of satisfaction
▪ Indifference Map is a collection of indifference curves that provides
different level of satisfaction to the same consumer.
▪ Indifference curves always slope downward, convex to the origin,
never intersect each other, and higher one always provides
higher level of satisfaction.
▪ The optimal commodity bundle the consumer chooses is
characterized by the condition that the slope of the IC must be equal
to slope of the BL
 Next … … …

The Market Forces of

Supply & Demand