CENGAGE

Learning

Principles of
economics
6th Edition

N. Gregory Mankiw
 CHAPTER - 21

Principles of
MICROeconomics
(HSS – 1021)

The Theory of
Consumer Choice
N. Gregory Mankiw
10/16/2019 10:03 PM 1
In this chapter,
look for the answers to these questions:

 How do consumers represent their preferences?

 What are the properties of indifference curves?
 What is Marginal Rate of Substitution (MRS)
between two commodities?

2
 Introduction
 Recall one of the Ten Principles from Chapter 1:
People face tradeoffs.
 Buying more of one good leaves
less income to buy other goods.
 Working more hours means more income and
more consumption, but less leisure time.
 Reducing saving allows more consumption today
but reduces future consumption.
 This chapter explores how consumers make
choices like these.

3
 What Consumer Wants
 Example: Mango Fish Point
Ramesh divides his income
30 6 A
between two goods: B
24 7
fish and mangos. 20 8 C
14 10 D
 A “consumption bundle” is a 10 13 E
particular combination of the 8 15 F
goods, e.g., 20 fish & 6 6 20 G
mangos or 25 fish and 10 30
28
26
mangos. 24 J
22

 The consumer prefers D to

20
18
16

all combinations in the 14

12
D
10

yellow box (say K), while all 8

6
K IC
those in the pink box (say J) 4
2
0
are preferred to D. 0 2 4 6 8 10 12 14 16 18 20 22
4
 What Consumer Wants
 But Ramesh can able to reveal
Mango Fish Commodity
different consumption bundles of Bundle
two commodities that gives the
consumer the same level of 30 6 A
satisfaction. 24 7 B
20 8 C
 Ramesh is indifferent between 14 10 D
commodity bundle A (6 fish and 10 13 E
30 mangos) and commodity 8 15 F
bundle B (10 fish and 13 6 20 G
mangos) because these two
commodity bundles give
Ramesh the same level of
satisfaction.
5
 Preferences: What the Consumer Wants

Indifference curve: Quantity One of Ramesh’s

shows consumption of Mangos indifference curves
bundles that give the
consumer the same
level of satisfaction
B
A, B, and all other
bundles on I1 make A
Ramesh equally happy
I1
– he is indifferent
between them.
Quantity
of Fish
6
 Constructing an indifference curve
30 A
28
Mango Fish Point
26 Mango Fish Point
24 B 30 6 a
30 6 A
24 7 b
22 24 7 B
20 8 c
20 C 20 8 C
14 10 d
14 10 D
18 10 13 e
Mango

10 13 E
8 15 f
16 8 15 F
D 6 20 g
14 6 20 G
12
E
10 F
8 G
6
4 IC
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Fish
 Four Properties of Indifference Curves
1. Indifference Quantity One of Ramesh’s
curves slope of Mango indifference curves
downward from
left to right.

If the quantity of
fish is reduced, B

the quantity of
A
mangos must be
I1
increased to keep
Ramesh equally
happy. Quantity
of Fish
8
 Four Properties of Indifference Curves
1. Indifference
If indifference
curves slope Quantity
of Mangos I1 curve is vertical
downward from
left to right.
If the indifference curve is
vertical straight line as shown in
the diagram, the consumer will B
consume more amount of
mango at point B than in point A A
and receives more satisfaction .
But, According to definition of IC,
Point ‘A’ and ‘B’ gives same level Quantity
of satisfaction. Therefore, IC of Fish
cannot be a vertical straight line. 9
 Four Properties of Indifference Curves
1. Indifference
If indifference
curves slope Quantity
of Mangos curve is
downward from horizontal
left to right.
If the indifference curve is
horizontal straight line as shown
in the diagram, the consumer
will consume more amount of
fish at point B than in point A A B I1
and receives more satisfaction .
But, According to definition of IC,
Point ‘A’ and ‘B’ gives same level
of satisfaction. Therefore, IC Quantity
of Fish
cannot be a horizontal straight
line. 10
 Four Properties of Indifference Curves
1. Indifference
If indifference
curves slope Quantity
of Mangos curve is up-ward
downward from sloping
left to right.
If the indifference curve is upward I1
sloping as shown in the diagram,
the consumer will consume more
amount of both fish and mango at B
point B than in point A and receives
more satisfaction . A
But, According to definition of IC,
Point ‘A’ and ‘B’ gives same level of
satisfaction. Therefore, IC cannot Quantity
of Fish
be upward sloping.
11
 Four Properties of Indifference Curves
2. Higher indifference
Quantity A few of Ramesh’s
curves are preferred
of Mangos indifference curves
to lower ones.
Ramesh prefers every bundle
on I2 (like C) to every bundle
on I1 (like A) because at ‘C’,
he consumes more of fish C
D
and mango which gives more A I2
level of satisfaction. I1
Similarly, he prefers every I0
bundle on I1 (like A) to every
Quantity
bundle on I0 (like D). of Fish
12
 Four Properties of Indifference Curves
3. Indifference curves Quantity Ramesh’s
cannot intersect of Mangos indifference curves
each other.
Suppose they did.
Ramesh is indifferent between ‘B’ and ‘A’,
since they are on I1.
Similarly, he is indifferent between ‘C’ and B
‘A’, since they are on I4.
C A
So, using the mathematical principle of
transitivity, one conclude, ‘B’ and ‘C’ give I1 I4
same level of satisfaction.
But, ‘B’ contain more of fish and mango and
thus give more level of satisfaction.
Quantity
These two situation cannot occur at the of Fish
same time.
Therefore, indifference curves cannot intersect each other 13
 Four Properties of Indifference Curves

Quantity
4. Indifference of Mangos
curves are bowed
inward or convex
A
to the origin.
6
Ramesh is willing to
give up more mangos 1
for a fish if he has few B
2
fish (A) than if he has 1 I1
many (B).
Quantity
of Fish
14
 The Marginal Rate of Substitution

Marginal rate of Quantity MRS = slope of

substitution (MRS): of Mangos indifference curve
the rate at which a consumer
is willing to trade one good for A MRSFM
another. = ∆M / ∆F
∆M=6 =6
Ramesh’s MRS is the
∆F=1 MRSFM
amount of mangos he
= ∆M / ∆F
would substitute for B
∆M=2 =2
another fish. I1
∆F=1
MRS falls as you move
down along an Quantity
indifference curve. of Fish
15
 The Marginal Rate of Substitution
 Suppose a consumer is MRS XY = ∆Y / ∆X
consuming two commodities = MUX / MUY
∆Y
X and Y and at point A (X, Y)
 Consider a change in this
bundle (∆X, ∆Y), i.e. a move ∆X
from Point A to Point B
(X + ∆X, Y−∆Y) such that the
consumer is kept at the
same indifference curve - i.e.
at the same utility level.

 To be kept at the same utility level we must have that

the increase in utility resulting from the increase of good
X is exactly offset by the decrease of utility resulting
from the decrease in good Y.
16
 The Marginal Rate of Substitution
MRS XY = ∆Y / ∆X = MUX / MUY
∆Y

∆X

MOVE CHANGE IN UTILITY

A to C (MUY)(∆Y) (Decrease in utility due decrease in Y)
C to B (MUX)(∆X) (Increase in utility due decrease in Y)
TOTAL A to B (MUY)(∆Y) + (MUX)(∆X) = 0 because the Consumer
is in the same Indifference Curve I2 17
 The Marginal Rate of Substitution
Y
Assume the utility function is U = XY = 25
∆Uy = ∆Y * MUy = 12.5 At point A consumer consumes 10 Y and 2.5 X
and at B, 5Y and 5X.
10 A
∆Y= -5
∆Ux = Therefore, to consume additional 2.5 X
B ∆Y * MUy the consumer is sacrificing 5 units of Y.
5 =12.5
∆X= C Therefore, the loss
2.5 2.5
of utility due to
D
1
U = XY = 25 less consumption
of Y is ∆Y * MUy
O X = 5 * 2.5 = 12.5
2.5 5 10 25

Similarly, the gain in utility due to more consumption of X is ∆X

* MUx = 2.5 * 5 = 12.5. Therefore, the total utility remains 25
18
 The Marginal Rate of Substitution
MRS XY = ∆Y / ∆X
∆Y = MUX / MUY
Movement from
∆X point A to B
Consuming more
of X by sacrificing
consumption of Y

Now we have -(MUY)(∆Y) + (MUX)(∆X) = 0

 (MUY)(∆Y) = (MUX)(∆X)
 ∆Y / ∆X = MUX / MUY
 MRSXY = MUX / MUY
19
 The Marginal Rate of Substitution
MRS YX = ∆X / ∆Y
∆Y = MUY / MUX
Movement from
∆X point B to A
Consuming more
of Y by sacrificing
consumption of X

Now we have -(MUY)(∆Y) + (MUX)(∆X) = 0

 (MUY)(∆Y) = (MUX)(∆X)
 ∆Y / ∆X = MUX / MUY
 MRSXY = MUX / MUY
20
 One Extreme Case: Perfect Substitutes
Orange Juice

Substitute: One commodity is used

in place of other, i.e., Tea & Coffee
Perfect substitutes: two
goods with straight-line
indifference curves,
constant MRS
Example: orange juice and
apple juice
Consumer is always willing
to trade two glasses of
Apple Juice orange juice against one
glass of apple juice. 21
One Extreme Case: Perfect Substitutes
Let U = Ax + By
where: A,B are positive
constants

Properties:
MUx = A
MUy = B
MRSx,y = A
B
(constant MRS)

22
Another Extreme Case: Perfect Complements
Complement: One commodity is used
along with the other, i.e., Pen & ink

Perfect complements:
two goods with right-angle
indifference curves
U = min {Ax, By}
Where, A & B are
positive constants
Example: Left shoes,
right shoes
{5 left shoes, 7 right
shoes}
is just as good as
{5 left shoes, 5 right
shoes} 23