Inthischapter,wewillstudyconsumerbehavior.Thegoaloftheconsumeristomaximizeutility/satisfaction/benefitfromconsumption.Theconstraintfacedbyconsumerishisbudget.Inthischapter,wewillunderstandhowarational

consumermakesoptimalconsumptionchoicesgivenhis/herbudgetconstraint.Theeffectsofchangesinhis/herincomeandrelativepricesonhisoptimalconsumption.Inthischapter,wewillalsoseethatthedemandcurvehasitsrootsinoptimalconsumerbehavior.Therefore:Wewillderivethedemandcurveusingourunderstandingofoptimalconsumerbehavior.Wewillalsoexplorethetheoreticalpossibilityofanupwardslopingdemandcurve!

ConsumptionPossibilitiesTheconsumer’sconsumptionchoicesareconstrainedbyhis/herincomeandthepricesofthegoodsandservicesavailable.Thebudgetlinedescribesthelimitstothehousehold’sconsumptionchoices.TheBudgetEquationWecandescribethebudgetlinebyusingabudgetequation.ThebudgetequationstatesthatExpenditure=IncomeCallthepriceofpopPP,thequantityofpopQP,thepriceofamoviePM,thequantityofmoviesQM,andincomeY.Lisa’sbudgetequationis:PPQP+PMQM=Y.ConsumptionPossibilitiesFigure9.1showsLisa’sbudgetline.Divisiblegoodscanbeboughtinanyquantityalongthebudgetline(gasoline,forexample).Indivisiblegoodsmustbeboughtinwholeunitsatthepointsmarked(movies,forexample).ConsumptionPossibilitiesThebudgetlineisaconstraintonLisa’schoices.Lisacanaffordanypointonherbudgetlineorinsideit.Lisacannotaffordanypointoutsideherbudgetline.ConsumptionPossibilitiesPPQP+PMQM=YDividebothsidesofthisequationbyPP,togive:QP+(PM/PP)QM=Y/PPThensubtract(PM/PP)QMfrombothsidesoftheequationtogive:QP=Y/PP–(PM/PP)QMY/PPisLisa’srealincomeintermsofpop.PM/PP

istherelativepriceofamovieintermsofpop.ConsumptionPossibilitiesAhousehold’srealincomeistheincomeexpressedasaquantityofgoodsthehouseholdcanaffordtobuy.Lisa’srealincomeintermsofpopisthepointonherbudgetlinewhereitmeetsthey-axis.Arelativepriceisthepriceofonegooddividedbythepriceofanothergood.Relativeprice

isthemagnitudeoftheslopeofthebudgetline.Therelativepriceofmovieintermsofpopshowshowmanycasesofpopmustbeforgonetoseeanadditionalmovie.ConsumptionPossibilitiesAChangeinPricesAriseinthepriceofthegoodonthex-axisdecreasestheaffordablequantityofthatgoodandincreasestheslopeofthebudgetline.Figure9.2(a)

showstherotationofabudgetlineafterachangeintherelativepriceofmovies.ConsumptionPossibilitiesAChangeinIncomeAchangeinmoneyincomebringsaparallelshiftofthebudgetline.Theslopeofthebudgetlinedoesn’tchangebecausetherelativepricedoesn’tchange.Figure9.2(b)showstheeffectofafallinincome.ConsumptionPossibilitiesPreferencesAhousehold’spreferencesdeterminethebenefitsorsatisfactionapersonreceivesconsumingagoodorservice.Thebenefitorsatisfactionfromconsumingagoodorserviceiscalledutility.TotalUtilityTotalutilityisthetotalbenefitapersongetsfromtheconsumptionofgoods.Generally,moreconsumptiongivesmoreutility.PreferencesandIndifferenceCurvesAnindifferencecurveisalinethatshowscombinationsofgoodsamongwhichaconsumerisindifferent.Figure9.3(a)illustratesaconsumer’sindifferencecurve.AtpointC,Lisasees

2moviesanddrinks6casesofpopamonth.PreferencesandIndifferenceCurvesPreferencesandIndifferenceCurvesLisacansortallpossiblecombinationsofgoodsintothreegroups:preferred,notpreferred,andjustasgoodaspointC.AnindifferencecurvejoinsallthosepointsthatLisasaysarejustasgoodasC.Gissuchapoint.LisaisindifferentbetweenpointCandpointG.Allthepointsontheindifferencecurvearepreferredtoallthepointsbelowtheindifferencecurve.Andallthepointsabovetheindifferencecurvearepreferredtoallthepointsontheindifferencecurve.PreferencesandIndifferenceCurvesApreferencemapisaseriesofindifferencecurves.Calltheindifferencecurvethatwe’vejustseenI1.I0isanindifferencecurvebelowI1.LisaprefersanypointonI1toanypointonI0.PreferencesandIndifferenceCurvesI2isanindifferencecurveaboveI1.LisaprefersanypointonI2toanypointonI1.Forexample,LisapreferspointJtoeitherpointCorpointG.PreferencesandIndifferenceCurvesMarginalRateofSubstitutionThemarginalrateofsubstitution,(MRS)measurestherateatwhichapersoniswillingtogiveupgoodytogetanadditionalunitofgoodxwhileatthesametimeremainindifferent(remainonthesameindifferencecurve).Themagnitudeoftheslopeoftheindifferencecurvemeasuresthemarginalrateofsubstitution.PreferencesandIndifferenceCurvesIftheindifferencecurveisrelativelysteep,theMRSis high. Inthiscase,thepersoniswillingtogiveupalarge quantityofytogetabitmorex.Iftheindifferencecurveisrelativelyflat,theMRSislow. Inthiscase,thepersoniswillingtogiveupasmall quantityofytogetmorex.PreferencesandIndifferenceCurvesAdiminishingmarginalrateofsubstitutionisthekeyassumptionofconsumertheory.Adiminishingmarginalrateofsubstitutionisageneraltendencyforapersontobewillingtogiveuplessofgoodytogetonemoreunitofgoodx,whileatthesametimeremainindifferentasthequantityofgoodxincreases.PreferencesandIndifferenceCurvesFigure9.4showsthediminishingMRSofmoviesforpop.AtpointC,Lisaiswillingtogiveup2casesofpoptoseeonemoremovie—herMRSis2.AtpointG,Lisaiswillingtogiveup1/2caseofpoptoseeonemoremovie—herMRSis1/2.PreferencesandIndifferenceCurvesDegreeofSubstitutabilityTheshapeoftheindifferencecurvesrevealsthedegreeofsubstitutabilitybetweentwogoods.Figure9.5showstheindifferencecurvesforordinarygoods,perfectssubstitutes,andperfectcomplements.PreferencesandIndifferenceCurvesHere,thebestaffordablepointisC.LisacanaffordtoconsumemorepopandseefewermoviesatpointF.AndshecanaffordtoseemoremoviesandconsumelesspopatpointH.ButsheisindifferentbetweenF,I,andHandsheprefersCtoI.PredictingOptimalConsumerChoicesPredictingConsumerChoicesBest/OptimalAffordableChoiceTheconsumer’sbestaffordablechoiceisOnthebudgetlineOnthehighestattainableindifferencecurveHasamarginalrateofsubstitutionbetweenthetwogoodsequaltotherelativepriceofthetwogoodsAtpointF,Lisa’sMRSisgreaterthantherelativeprice.AtpointH,Lisa’sMRSislessthantherelativeprice.AtpointC,Lisa’sMRSisequaltotherelativeprice.PredictingConsumerChoicesPredicting…AChangeinPriceTheeffectofachangeinthepriceofagoodonthequantityofthegoodconsumediscalledthepriceeffect.Figure9.7illustratesthepriceeffectandshowshowtheconsumer’sdemandcurveisgenerated.Initially,thepriceofamovieis$8andLisaconsumesatpointCinpart(a)andatpointAinpart(b).Thepriceofamoviethenfallsto$4.Thebudgetlinerotatesoutward.Lisa’sbestaffordablepointisnowJinpart(a).Inpart(b),LisamovestopointB,whichisamovementalongherdemandcurveformovies.Predicting…AChangeinIncomeTheeffectofachangeinincomeonthequantityofagoodconsumediscalledtheincomeeffect.Figure9.8illustratestheeffectofadecreaseinLisa’sincome.Initially,LisaconsumesatpointJinpart(a)andatpointBondemandcurveD0inpart(b).Predicting…Lisa’sincomedecreasesandherbudgetlineshiftsleftwardinpart(a).HernewbestaffordablepointisKinpart(a).Herdemandformoviesdecreases,shownbyaleftwardshiftofherdemandcurveformoviesinpart(b).Predicting…PredictingConsumerChoicesSubstitutionEffectandIncomeEffectForanormalgood,afallinpricealwaysincreasesthequantityconsumed.Wecanprovethisassertionbydividingthepriceeffectintwoparts:SubstitutioneffectIncomeeffectInitially,Lisahasanincomeof$40,thepriceofamovieis$8,andsheconsumesatpointC.Lisa’sbestaffordablepointisnowJ.ThemovefrompointCtopointJisthepriceeffect.Thepriceofamoviefallsfrom$8to$4andherbudgetlinerotatesoutward.PredictingConsumerChoicesWe’regoingtobreakthemovefrompointCtopointJintotwoparts.Thefirstpartisthesubstitutioneffectandthesecondistheincomeeffect.PredictingConsumerChoicesSubstitutionEffectThesubstitutioneffectistheeffectofachangeinpriceonthequantityboughtwhentheconsumerremainsonthesameindifferentcurve.PredictingConsumerChoicesToisolatethesubstitutioneffect,wegiveLisaahypotheticalpaycut.LisaisnowbackonheroriginalindifferencecurvebutwithalowerpriceofmoviesandherbestaffordablepointisK.ThemovefromCtoKisthesubstitutioneffect.PredictingConsumerChoicesThedirectionofthesubstitutioneffectnevervaries:Whentherelativepricefalls,theconsumeralwayssubstitutesmoreofthatgoodforothergoods.Thesubstitutioneffectisthefirstreasonwhythedemandcurveslopesdownward.PredictingConsumerChoicesIncomeEffectToisolatetheincome