W hen you walk into a store, you are confronted with thousands of goods that
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Explain how an increase in the wage can potentially decrease the amount that a person wants to work. 65875_ch21_ptg01_433-460.indd 456 15/10/13 11:53 AM Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. CHAPTER 21 the theOrY OF CONSUMer ChOICe 457 The best way to view the theory of consumer choice is as a metaphor for how consumers make decisions. No consumer (except an occasional economist) goes through the explicit optimization envisioned in the theory. Yet consumers are aware that their choices are constrained by their financial resources. And given those constraints, they do the best they can to achieve the highest level of satisfac- tion. The theory of consumer choice tries to describe this implicit, psychological process in a way that permits explicit, economic analysis. Just as the proof of the pudding is in the eating, the test of a theory is in its applications. In the last section of this chapter, we applied the theory of consumer choice to three practical issues about the economy. If you take more advanced courses in economics, you will see that this theory provides the framework for much additional analysis. • A consumer’s budget constraint shows the possible combinations of different goods she can buy given her income and the prices of the goods. The slope of the budget constraint equals the relative price of the goods. • The consumer’s indifference curves represent her preferences. An indifference curve shows the various bundles of goods that make the consumer equally happy. Points on higher indifference curves are pre- ferred to points on lower indifference curves. The slope of an indifference curve at any point is the consumer’s marginal rate of substitution—the rate at which the consumer is willing to trade one good for the other. • The consumer optimizes by choosing the point on her budget constraint that lies on the highest indifference curve. At this point, the slope of the indifference curve (the marginal rate of substitution between the goods) equals the slope of the budget constraint (the relative price of the goods), and the consumer’s valuation of the two goods (measured by the marginal rate of substitution) equals the market’s valuation (measured by the relative price). • When the price of a good falls, the impact on the con- sumer’s choices can be broken down into an income effect and a substitution effect. The income effect is the change in consumption that arises because a lower price makes the consumer better off. The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper. The income effect is reflected in the movement from a lower to a higher indifference curve, whereas the substitution effect is reflected by a movement along an indifference curve to a point with a different slope. • The theory of consumer choice can be applied in many situations. It explains why demand curves can poten- tially slope upward, why higher wages could either increase or decrease the quantity of labor supplied, and why higher interest rates could either increase or decrease saving. Summary budget constraint, p. 436 indifference curve, p. 438 marginal rate of substitution, p. 438 perfect substitutes, p. 441 perfect complements, p. 441 normal good, p. 444 inferior good, p. 444 income effect, p. 446 substitution effect, p. 446 Giffen good, p. 449 Key Concepts 1. A consumer has income of $3,000. Wine costs $3 per glass, and cheese costs $6 per pound. Draw the con- sumer’s budget constraint with wine on the vertical axis. What is the slope of this budget constraint? 2. Draw a consumer’s indifference curves for wine and cheese. Describe and explain four properties of these indifference curves. Questions for Review 65875_ch21_ptg01_433-460.indd 457 15/10/13 11:53 AM Copyright 201 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. |