Possibilities, Preferences, and Choices: Consumer Theory in Microeconomics

Possibilities, Preferences, and Choices

Introduction

This chapter explores how consumers make choices given their limited resources. It introduces the concepts of the budget line, indifference curves, and the effects of changes in prices and income on consumption decisions. These tools are fundamental for understanding consumer behavior in microeconomics.

Consumption Possibilities

Budget Constraints

• Household consumption choices are limited by income and the prices of available goods and services.

• The budget line represents the combinations of goods a household can afford.

Example: Lisa's Budget

• Lisa has $40 to spend. The price of a movie is $8, and the price of a case of cola is $4.

• Possible combinations of movies and cola she can buy are shown below:

Consumption Possibility	Movies (per month)	Cola (cases per month)
A	0	10
B	1	8
C	2	6
D	3	4
E	4	2
F	5	0

• Lisa can afford any combination on or inside the budget line (A to F).

• Points outside the budget line are unaffordable.

The Budget Equation

• The budget line can be described by the equation:

$P_C Q_C + P_M Q_M = Y$

• Where $P_C$ = price of cola, $Q_C$ = quantity of cola, $P_M$ = price of movies, $Q_M$ = quantity of movies, $Y$ = income.

• Rearranging the equation gives:

$Q_C = \frac{Y}{P_C} - \left(\frac{P_M}{P_C}\right) Q_M$

• $\frac{Y}{P_C}$ is real income in terms of cola.

• $\frac{P_M}{P_C}$ is the relative price of a movie in terms of cola.

Effects of Changes in Prices and Income

• Change in Price: An increase in the price of a good on the x-axis (e.g., movies) decreases the affordable quantity and makes the budget line steeper (rotates inward).

• Change in Income: An increase in income shifts the budget line outward in a parallel fashion; the slope does not change because relative prices remain constant.

Preferences and Indifference Curves

Indifference Curves

• An indifference curve shows combinations of goods among which a consumer is indifferent (derives the same satisfaction).

• All points on an indifference curve are equally preferred; points above are more preferred, and points below are less preferred.

Preference Map

• A preference map is a collection of indifference curves, each representing different levels of utility.

• Higher indifference curves represent higher levels of satisfaction.

Marginal Rate of Substitution (MRS)

• The marginal rate of substitution (MRS) is the rate at which a consumer is willing to give up one good (y) to get an additional unit of another good (x), remaining on the same indifference curve.

• The MRS is measured by the slope of the indifference curve at any point.

• If the curve is steep, MRS is high (willing to give up a lot of y for x); if flat, MRS is low.

Diminishing Marginal Rate of Substitution

• A key assumption in consumer theory is the diminishing marginal rate of substitution: as a consumer has more of good x, they are willing to give up less of good y for additional units of x.

• This results in indifference curves being convex to the origin.

• Example: At point C, Lisa is willing to give up 2 cases of cola for one more movie (MRS = 2). At point G, she is willing to give up only 1/2 case of cola for one more movie (MRS = 1/2).

Degree of Substitutability

• The shape of indifference curves indicates the degree of substitutability between goods:

  • Ordinary goods: Convex indifference curves (diminishing MRS).

  • Perfect substitutes: Straight-line indifference curves (constant MRS).

  • Perfect complements: Right-angle indifference curves (goods consumed in fixed proportions).

Predicting Consumer Choices

Best Affordable Choice

• The best affordable choice is the point on the budget line that lies on the highest attainable indifference curve.

• At this point, the MRS between the two goods equals the relative price:

$MRS = \frac{P_M}{P_C}$

• If MRS > relative price, the consumer should consume more of good x; if MRS < relative price, more of good y.

Effects of Changes in Price and Income

• Price Effect: The change in quantity consumed of a good when its price changes, holding income constant.

• Income Effect: The change in quantity consumed of a good when income changes, holding prices constant.

Substitution Effect and Income Effect

Decomposing the Price Effect

• When the price of a good falls, the total effect (price effect) can be separated into:

  • Substitution Effect: The change in consumption when the consumer moves along the same indifference curve due to a change in relative prices.

  • Income Effect: The change in consumption due to the increased real income (purchasing power) from the price change.

Example: Lisa's Movie Consumption

• Initial situation: Income = $40, price of a movie = $8, best affordable point = C.

• Price of a movie falls to $4; budget line rotates outward, new best affordable point = J.

• The movement from C to J is the price effect.

• To isolate the substitution effect, Lisa is given a hypothetical pay cut to keep her on the original indifference curve but with the new price; her best affordable point is K (move from C to K).

• To isolate the income effect, Lisa's income is restored to its actual level, moving her from K to J.

Normal and Inferior Goods

• For a normal good, both substitution and income effects increase quantity demanded when price falls.

• For an inferior good, the income effect is negative (reduces quantity demanded as income rises), but as long as the substitution effect dominates, the demand curve still slopes downward.

• If the negative income effect outweighs the substitution effect (rare in reality), the demand curve could slope upward (Giffen good).

Summary Table: Effects of Price and Income Changes

Effect	Definition	Direction for Normal Good	Direction for Inferior Good
Substitution Effect	Change in quantity demanded due to change in relative price, holding utility constant	Increases quantity demanded when price falls	Increases quantity demanded when price falls
Income Effect	Change in quantity demanded due to change in real income	Increases quantity demanded when price falls	Decreases quantity demanded when price falls
Total Price Effect	Sum of substitution and income effects	Increases quantity demanded when price falls	Usually increases, but could decrease if income effect dominates

Key Takeaways

• Consumers maximize satisfaction by choosing the best affordable combination of goods, where the budget line is tangent to the highest indifference curve.

• Changes in prices and income shift the budget line and alter consumption choices.

• The substitution effect and income effect explain how and why demand curves slope downward for most goods.