1. The document discusses the theory of consumer choice and how it addresses questions about demand curves, labor supply, and household saving. 2. It explains the budget constraint and indifference curves, which represent the combinations of goods a consumer can afford and their preferences. 3. The consumer's optimal choice occurs where the highest indifference curve is tangent to the budget constraint, equaling the marginal rate of substitution to the relative price.

1. 7 TOPICS FOR FURTHER STUDY

2. Session 14 The Theory of Consumer Choice

6. The Consumer’s Budget Constraint

8. Figure 1 The Consumer’s Budget Constraint Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western Consumer’s budget constraint 500 B 100 A

10. Figure 1 The Consumer’s Budget Constraint Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western Consumer’s budget constraint 500 B 250 50 C 100 A

14. Figure 2 The Consumer’s Preferences Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western Indifference curve, I 1 I 2 C B A D

16. Figure 2 The Consumer’s Preferences Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western Indifference curve, I 1 I 2 1 MRS C B A D

19. Figure 2 The Consumer’s Preferences Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western Indifference curve, I 1 I 2 C B A D

21. Figure 2 The Consumer’s Preferences Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western Indifference curve, I 1

23. Figure 3 The Impossibility of Intersecting Indifference Curves Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western C A B

25. Figure 4 Bowed Indifference Curves Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western Indifference curve 8 3 A 3 7 B 1 MRS = 6 1 MRS = 1 4 6 14 2

28. Figure 5 Perfect Substitutes and Perfect Complements Dimes 0 Nickels (a) Perfect Substitutes Copyright©2004 South-Western I 1 I 2 I 3 3 6 2 4 1 2

30. Figure 5 Perfect Substitutes and Perfect Complements Right Shoes 0 Left Shoes (b) Perfect Complements Copyright©2004 South-Western I 1 I 2 7 7 5 5

35. Figure 6 The Consumer’s Optimum Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western Budget constraint I 1 I 2 I 3 Optimum A B

37. Figure 7 An Increase in Income Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western New budget constraint I 1 I 2 2. . . . raising pizza consumption . . . 3. . . . and Pepsi consumption. Initial budget constraint 1. An increase in income shifts the budget constraint outward . . . Initial optimum New optimum

39. Figure 8 An Inferior Good Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western Initial budget constraint New budget constraint I 1 I 2 1. When an increase in income shifts the budget constraint outward . . . 3. . . . but Pepsi consumption falls, making Pepsi an inferior good. 2. . . . pizza consumption rises, making pizza a normal good . . . Initial optimum New optimum

41. Figure 9 A Change in Price Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western 1,000 D 500 B 100 A I 1 I 2 Initial optimum New budget constraint Initial budget constraint 1. A fall in the price of Pepsi rotates the budget constraint outward . . . 3. . . . and raising Pepsi consumption. 2. . . . reducing pizza consumption . . . New optimum

45. Figure 10 Income and Substitution Effects Quantity of Pizza Quantity of Pepsi 0 Copyright©2004 South-Western I 1 I 2 A Initial optimum New budget constraint Initial budget constraint Substitution effect Substitution effect Income effect Income effect B C New optimum

46. Table 1 Income and Substitution Effects When the Price of Pepsi Falls Copyright©2004 South-Western

48. Figure 11 Deriving the Demand Curve Quantity of Pizza 0 (a) The Consumer ’ s Optimum Quantity of Pepsi 0 Price of Pepsi (b) The Demand Curve for Pepsi Quantity of Pepsi Copyright©2004 South-Western Demand 250 $2 A 750 1 B I 1 I 2 New budget constraint Initial budget constraint 750 B 250 A

50. Figure 12 A Giffen Good Quantity of Meat Quantity of Potatoes 0 Copyright©2004 South-Western I 2 I 1 Initial budget constraint New budget constraint D A B 2. . . . which increases potato consumption if potatoes are a Giffen good. Optimum with low price of potatoes Optimum with high price of potatoes E C 1. An increase in the price of potatoes rotates the budget constraint inward . . .

52. Figure 13 The Work-Leisure Decision Hours of Leisure 0 Consumption Copyright©2004 South-Western $5,000 100 I 3 I 2 I 1 Optimum 2,000 60

53. Figure 14 An Increase in the Wage Hours of Leisure 0 Consumption (a) For a person with these preferences . . . Hours of Labor Supplied 0 Wage . . . the labor supply curve slopes upward. Copyright©2004 South-Western I 1 I 2 BC 2 BC 1 2. . . . hours of leisure decrease . . . 3. . . . and hours of labor increase. 1. When the wage rises . . . Labor supply

54. Figure 14 An Increase in the Wage Hours of Leisure 0 Consumption (b) For a person with these preferences . . . Hours of Labor Supplied 0 Wage . . . the labor supply curve slopes backward. Copyright©2004 South-Western I 1 I 2 BC 2 BC 1 1. When the wage rises . . . 2. . . . hours of leisure increase . . . 3. . . . and hours of labor decrease. Labor supply

56. Figure 15 The Consumption-Saving Decision Consumption when Young 0 Consumption when Old Copyright©2004 South-Western $110,000 100,000 I 3 I 2 I 1 Budget constraint 55,000 $50,000 Optimum

57. Figure 16 An Increase in the Interest Rate 0 (a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving Consumption when Old 0 Consumption when Old Consumption when Young Consumption when Young Copyright©2004 South-Western I 1 I 2 BC 1 BC 2 I 1 I 2 BC 1 BC 2 1. A higher interest rate rotates the budget constraint outward . . . 1. A higher interest rate rotates the budget constraint outward . . . 2. . . . resulting in lower consumption when young and, thus, higher saving. 2. . . . resulting in higher consumption when young and, thus, lower saving.