435
W
hen you walk into a store, you are confronted with thousands of goods that
you might buy. Because your financial resources are limited, however, you
cannot buy everything that you want. You therefore consider the prices of
the various goods offered for sale and buy a bundle of goods that, given your
resources, best suits your needs and desires.
In this chapter, we develop a theory that describes how consumers make deci-
sions about what to buy. Thus far in this book, we have summarized consumers’
decisions with the demand curve. As we have seen, the demand curve for a good
reflects consumers’ willingness to pay for it. When the price of a good rises,
consumers are willing to pay for fewer units, so the quantity demanded
falls. We now look more deeply at the decisions that lie behind the demand
curve. The theory of consumer choice presented in this chapter provides a
more complete understanding of demand, just as the theory of the competi-
tive firm in Chapter 14 provides a more complete understanding of supply.
Chapter
21
The
Theory of
Consumer
Choice
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436 PART VII
tOpICS
FOr FUrther StUDY
One of the
Ten Principles of Economics discussed in Chapter 1 is that people face
trade-offs. The theory of consumer choice examines the trade-offs that people face
in their role as consumers. When a consumer buys more of one good, she can
afford less of other goods. When she spends more time enjoying leisure and less
time working, she has lower income and can afford less consumption. When she
spends more of her income in the present and saves less of it, she must accept a
lower level of consumption in the future. The theory of consumer choice exam-
ines how consumers facing these trade-offs make decisions and how they respond
to changes in their environment.
After developing the basic theory of consumer choice, we apply it to three
questions about household decisions. In particular, we ask:
• Do all demand curves slope downward?
• How do wages affect labor supply?
• How do interest rates affect household saving?
At first, these questions might seem unrelated. But as we will see, we can use the
theory of consumer choice to address each of them.
21-1
the Budget Constraint: What the Consumer Can afford
Most people would like to increase the quantity or quality of the goods they con-
sume—to take longer vacations, drive fancier cars, or eat at better restaurants.
People consume less than they desire because their spending is
constrained, or
limited, by their income. We begin our study of consumer choice by examining
this link between income and spending.
To keep things simple, we examine the decision facing a consumer who buys
only two goods: pizza and Pepsi. Of course, real people buy thousands of dif-
ferent kinds of goods. Assuming there are only two goods greatly simplifies the
problem without altering the basic insights about consumer choice.
We first consider how the consumer’s income constrains the amount she
spends on pizza and Pepsi. Suppose the consumer has an income of $1,000 per
month and she spends her entire income on pizza and Pepsi. The price of a pizza
is $10, and the price of a liter of Pepsi is $2.
The table in Figure 1 shows some of the many combinations of pizza and Pepsi
that the consumer can buy. The first row in the table shows that if the consumer
spends all her income on pizza, she can eat 100 pizzas during the month, but she
would not be able to buy any Pepsi at all. The second row shows another possible
consumption bundle: 90 pizzas and 50 liters of Pepsi. And so on. Each consump-
tion bundle in the table costs exactly $1,000.
The graph in Figure 1 illustrates the consumption bundles that the consumer
can choose. The vertical axis measures the number of liters of Pepsi, and the
horizontal axis measures the number of pizzas. Three points are marked on this
figure. At point A, the consumer buys no Pepsi and consumes 100 pizzas. At point
B, the consumer buys no pizza and consumes 500 liters of Pepsi. At point C, the
consumer buys 50 pizzas and 250 liters of Pepsi. Point C, which is exactly at the
middle of the line from A to B, is the point at which the consumer spends an equal
amount ($500) on pizza and Pepsi. These are only three of the many combinations
of pizza and Pepsi that the consumer can choose. All the points on the line from A
to B are possible. This line, called the
budget constraint, shows the consumption