The following will be discussed in this chapter: budget constraint, indifference curve, properties of indifference curve, optimal choices, income effect on consumer choice, price effect on consumer choice, income and substitution effect. | Review of the previous lecture A consumer’s budget constraint shows the possible combinations of different goods he can buy given his income and the prices of the goods. The slope of the budget constraint equals the relative price of the goods. The consumer’s indifference curves represent his preferences. Points on higher indifference curves are preferred to points on lower indifference curves. The slope of an indifference curve at any point is the consumer’s marginal rate of substitution. The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve. Lecture 6 The theory of consumer choice - II Instructor: Abbas Course code: ECO 400 Lecture Outline Optimal choices Income effect on consumer choice Price effect on consumer choice Income and substitution effect Optimization: what the consumer chooses Consumers want to get the combination of goods on the highest possible indifference curve. However, the consumer must also | Review of the previous lecture A consumer’s budget constraint shows the possible combinations of different goods he can buy given his income and the prices of the goods. The slope of the budget constraint equals the relative price of the goods. The consumer’s indifference curves represent his preferences. Points on higher indifference curves are preferred to points on lower indifference curves. The slope of an indifference curve at any point is the consumer’s marginal rate of substitution. The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve. Lecture 6 The theory of consumer choice - II Instructor: Abbas Course code: ECO 400 Lecture Outline Optimal choices Income effect on consumer choice Price effect on consumer choice Income and substitution effect Optimization: what the consumer chooses Consumers want to get the combination of goods on the highest possible indifference curve. However, the consumer must also end up on or below his budget constraint. The Consumer’s Optimal Choices Combining the indifference curve and the budget constraint determines the consumer’s optimal choice. Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent. The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price. At the consumer’s optimum, the consumer’s valuation of the two goods equals the market’s valuation. The Consumer’s Optimum The Consumer’s Optimum Income Affect the Consumer’s Choices How Changes in Income Affect the Consumer’s Choices An increase in income shifts the budget constraint outward. The consumer is able to choose a better combination of goods on a higher indifference curve. An Increase in Income Income Affect the Consumer’s Choices Normal versus Inferior Goods If a consumer buys more of a good when his or her income rises, the good is called a normal good. If a consumer buys
