When you walk into a store, you are confronted with thousands of varieties of goods that you might buy. Of course, because your financial resources are limited you cannot buy everything that you want. You therefore consider the prices of the various goods offered for sale and buy a bundle of goods that, given our resources best suits your needs and desires.
Marketing experts have developed a theory that describes how consumers make decisions about what to buy. As the demand increases for goods consumers are willing to pay for it. When the price of a good rises, consumers are willing to pay for fewer units, so the quantity demanded falls. The theory of consumer’s choice presented provides a more complete understanding of demand, just as the theory of the competitive firm in it provides a more complete understanding of supply.
The theory of consumer choice examines the trade-offs that people face in their role as consumers. When a consumer buys more of one good, he can afford less of other goods. When he spends more time enjoying leisure and less time working, he has lower income and can afford less consumption. When he spends more of his income in the present and saves less of it, he must accept a lower level of consumption in the future. The theory of consumer choice examines how consumers facing these trade-offs make decisions and how they respond to changes in their environment.
After developing the basic theory of consumer choice, we apply it to three questions about household decisions. In particular we ask:
*Do all demand curves slope downward?
* How do wages affect labour supply?
*How do interest rates affect household saving?
At first, these questions might seem unrelated. But as we will see, we can use the theory of consumer choice to address each of them.
Most people would like to increase the quantity or quality of the goods they consume – to take longer vacations, drive fancier cars, or eat at better restaurants. People consume less than they desire because their spending is constrained or limited, by their income. We begin our study of consumer choice by examining this link between income and spending.
To keep things simple, the decision facing a consumer who buys only two goods: Pepsi and pizza. Of course, real people buy thousands of different kinds of goods. Yet assuming there are only two goods greatly simplifies the problem without altering the basic insights about consumer choice.
Let us first consider how the consumer’s income constrains the amount he spends on Pepsi and pizza. Suppose that the consumer has an income of $1,000 per month and that he spends his entire income each month on Pepsi and pizza. The price of a pint of Pepsi is $2, and the price of a pizza is $10.
Some of the many combinations of Pepsi and pizza that the consumer can buy. If the consumer spends all his income on pizza, he can eat 100 pizzas during the month, but he would not be able to buy any Pepsi at all. Another possible consumption bundle; 90 pizzas and 50 pints of Pepsi. And so on. Each consumption bundle costs exactly say $1,000.
The consumption bundles that the consumer can choose, if we plot a graph, the vertical axis measures the number of pints of Pepsi, and the horizontal axis measures the number of pizzas. Three points are marked on this figure, At point A, the consumer buys no Pepsi and consumes 100 pizzas. At point B, the consumer buys no pizza and consumes 500 pints of Pepsi. At the point C, the consumer buys 50 pizzas and 250 pints of Pepsi. Point C, which is exactly at the middle of the line from A to B is the point at which the consumers spends an equal amount ($500) on Pepsi and pizza. These are only three of the many combinations of Pepsi and pizza that the consumer can choose. All the points on the line from A to B are possible. This line, called budget constraint shows the consumption bundles that the consumer can afford. In the case it shows the trade-offs between Pepsi and pizza that the consumer faces.
The slope of the budget constraint measures the rate at which the consumer can trade one good for the other. Recall that the slope between two points is calculated as the change in the vertical distance divided by the change in the horizontal distance (rise over run). From point A to point B, the vertical distance is 500 pints and the horizontal distance is 100 pizzas. Thus, the slope is 5 pints per pizza.
The budget constraint equals the relative price of the two goods – the price of one good compared to the price of the other. A pizza costs 5 times as much as a pint of Pepsi, so the opportunity cost of a pizza is 5 pints of Pepsi. The budget constraint’s slope of 5 reflects the trade-offs the market is offering the consumer: 1 pizza for 5 pints of Pepsi.
Our goal is to see how consumers make choices. The budget constraint is one piece of the analysis: It shows what combination of goods the consumer can afford given his income and the prices of the goods. The consumer’s choices, however, depend not only on his budget constraint but also on his preferences regarding the two goods.