CONSUMER CHOICE THEORY

PUBLIC FINANCE AND THE PRICE SYSTEM

4TH EDITION
BROWNING, BROWNING

JOHNNY PATTA
KK PENGELOLAAN PEMBANGUNAN DAN PENGEMBANGAN KEBIJAKAN
SAPPK - ITB
2012
Outline
The Consumers Preferences

The Consumers Budget

The Consumer in Equilibrium

An Application
In this Chapter, you will learn...

A simple model of consumer behavior

that permits you to determine how consumer choices among

goods are affected by objective circumstances, such as prices,
incomes and subsidies
Learning Steps:
You will learn how to:

a. present a consumers tastes or subjective preferences

using indifference curves
b. present an objective conditions (eg. income) in a graph
c. treat consumers preference and objective conditions (eg.
income) jointly in a single model
d. examine several implications of the model
THE CONSUMERS PREFERENCES
The Consumers Preference

Consumers have different tastes or preference, which will

be reflected in their consumption decisions

The consumption of goods and services provides

satisfaction or utility to consumer

Consumer will arrange their personal consumption to

maximize their satisfaction
Assumptions
about the Consumers Preference Patterns

1. The consumer is able to rank different combinations or

bundles of goods in terms of desirability

2. The consumers preferences are transitive A > B, B > C,

A>C

3. The consumer always prefers more of a commodity to less

Indifference Curve
Consumer tastes can be
represented by
indifference curve

Indifference curve is a
locus of points indicating
different combinations of
goods that yield the
consumer the same level
of satisfaction
The Characteristics
of an Indifference Curve

1. Indifference curves are convex

2. Indifference curves that lie farther from the origin

represent higher levels of utility, or well being than do
those lying closer to the origin

3. Indifference curves cannot intersect an intersecting

indifference curves are inconsistent with our transitivity
assumptions
Intersecting Indifference Curves
This seems to imply that B
and C are equally
desirable
A and B yield the same
level of satisfaction to the
consumer
However B is more
preferable than C

A and C yield the same

level of satisfaction to the OUR TRANSITIVE
consumer ASSUMPTION IS
VIOLATED
The Consumers Budget
The Consumers Budget
When using indifference curves to explain and predict
consumer behavior, we must know more than the
consumers taste

Because higher indifference curves correspond to higher

levels of well being and a rational utility-maximizing
consumer will want to achieve the highest indifference
curve possible

However, the consumer is constrained by the level of

MONEY INCOME
The Budget Line
The Budget Line shows all
combinations of quantities
of X and Y that a consumer
can purchase per year

The slope at any point

shows how much of one
good must be given up to
get an additional unit of
the other
Budget Line:
Income and Price Changes

The position of the budget line depends on the size of the

budget
If the income increase, the budget line will be farther from
the origin and vice versa
A changes in the price of goods and services also affect the
budget line
The slope of any budget line indicates the price of one
good relative to that of the other
Income Changes
and the Budget Line

If the income
increase, the budget
line will be farther
from the origin and
vice versa
Price Changes
and the Budget Line

A changes in the price of

goods and services also affect
the budget line

The slope of any budget line

indicates the price of one
good relative to that of the
other
The Consumer in Equilibrium
The Consumer in Equilibrium
The budget line shows the combinations of goods from
which a consumer can choose
The indifference curves show how the consumer
subjectively ranks all combinations of goods
It is assumed that the consumer will choose the most
preferred combination of X and Y from among the
combinations attainable
An equilibrium will occur at a point, where the budget line
and the indifference curve are tangent
The Equilibrium of the Consumer
Equilibrium

In equilibrium, the marginal rate of substitution (MRS)

between X and Y for the consumer is equal to the price
ratio

The price ratio is the rate at which the consumer is

subjectively willing to substitute X for Y it is equal to
the rate at which market exchange can occur
BOX 1 :
MARGINAL RATE OF SUBSTITUTION

The Marginal Rate of Substitution of a good M (Meat) for another good T

(Tomato), (represented by MRS M,T ) is the maximum number of units of T a
consumer is willing to give up in return for getting one more unit of M.

This is the number that keeps the consumer just INDIFFERENT, between the
initial position and the proposed trade.

Fomally, the MRS M,T is defined as the negative of the slope of the
indifference curve. And since the slope is itself negative, the MRS is positive.
BOX 2 :
DIMINISHING MARGINAL RATE OF SUBSTITUTION

The MRS is is diminishing: along an indifference curve, meaning that the more
meat a consumer has, the fewer tomatoes she/he will be willing to give up for
still another pound of meat.

At point C, a bundle with a relatively

large quantity of tomatoes relative
to meat, the individual is willing to
give up TC tomatoes to get one
extra unit of meat M.

But at point B, having fewer tomatoes

and more meat, the individual will not
give up as many tomatoes as before to
get yet another unit of meat M. This
time the individual will only give up TB.
Consumer Equilibrium
An Alternative Representation

When the
consumer is in
equilibrium, the
market price of
good is a measure
of the marginal
value of the good to
the consumer
Changes in Income
A line connecting the consumer equilibrium yields the
income consumption curve

The Income Consumption Curve identifies the various

quantities of X that will be consumed at different income
levels

If the curve is upward sloping to the right, X will be

considered a normal goods

Normal goods as income rises, when prices are

unchanged, the consumption of X increases
Changes in Income (2)

In contrast to normal goods, there are inferior goods

A good is an inferior good if the quantity consumed falls

when income rises

In this case, the income consumption curve slopes

backward to the left
Income Changes & Consumption Choices
the case of Normal Goods

upward sloping to the right

Income Changes & Consumption Choices
the case of Inferior Goods

backward sloping to the left

Changes in Prices
Recall that a variation in price is reflected by a change in
the slope of the budget line

If the price of X falls, the budget line will become flatter,

rotating to the right

If the price rises, the budget line will become steeper,

rotating toward the origin
Derivation of the

Consumers Demand Curve

Substitution and Income Effects
of Price Changes

When the price of a good changes (eg. the price of beef falls
by half), the consumer is affected in two distinct ways

1. The income effect

2. The substitution effect
The Income Effects

The income effects stems from the fact that the consumer
is better off as a result of the price change because his or
her budget now increase

The consumer can buy the same amount of beef as before

and still have more income left over to spend on other
goods and services
 The price change raises the consumers real income

With a higher real income, the consumer can now afford to

purchase more of all goods (including beef)

So, when the price of beef decreases, the consumer, as a

result of income effect, will expand his or her purchases of
beef if it is a normal good
The Substitution Effects
The substitution effects result from the consumers
decision to substitute the now cheaper good for other good

Illustration:
People tend to buy other type of meat and poultry rather than beef,
since the price of other meat and poultry is cheaper than beef
Then the price of beef falls by half (nearly equal to the price of other
meat and poultry and probably in some cases cheaper)
To the consumer, beef (because of its lower prices) has become a more
attractive buy
Therefore, the consumer will choose to purchase more beef relative to
other types of meat and poultry
(Underlying Assumption: people prefer beef than other type of meat and poultry with equal price)
The Price Changes
The decrease in the price of beef has caused the consumers
purchases of beef to increase for two independent reasons:

1. The income effect makes the consumer better off by

increasing real income

2. The substitution effect leads the consumer to

substitute the cheaper good for the now relatively
more expensive ones
Income and Substitution Effects
of a Price Reduction
AN APPLICATION
An Application
THE CASE:
Individual labor supply decisions associated with changes in
wage rates

Assumes that workers can vary the amount of time they

work
The more hours are worked, the less leisure time will be
available
The more leisure consumed, the less time will be available
to spend at work
Income-Leisure Choice
of the Worker

The workers wage

rate is reflected in
the slope of budget
line

The flatter the budget line

the lower the wage rate

The steeper the budget line

the higher the wage rate
Effect of Wage Changes
on Labor Supply

An increase in the wage rate has two effects on labor supply

decision:

The income effect: the higher wage rate raises the workers
income for any amount of the work effort supplied. Thus, it
encourages the increase consumption of leisure (reduced
work effort)

The substitution effect: on the other hand, encourages

greater work effort
Effect of Wage Changes
on Labor Supply

The income effect The substitution effect

If the wage rate changes, the budget line will rotate around the horizontal intercept
Lesson learned...
The income and the substitution effects work in opposing
directions
It is impossible to predict whether a person will work more,
less, or the same amount in response to changes in wage
rate
The response of labor supply to changes in wages rates is of
particular interest to us in public finance, because many
taxes fall on labor income and consequently affect labor
supply decisions
THANK YOU
email: jpatta@pl.itb.ac.id