Rational Choice Theory
Rational Choice Theory
Rational Choice Theory
THEORY
- Dr. Aashita Dawer
Preferences
Let’s see how an indifference curve looks for two goods – Pizza and Pepsi –
graphically.
Figure 2 The Consumer’s Preferences
Quantity of
Pepsi
B D
I2
Indifference
A
curve, I1
0 Quantity of
Pizza
B D
MRS I2
1
Indifference
A
curve, I1
0 Quantity
of Pizza
The Consumer’s Preferences: MRS
Five Properties of Indifference Curves
B D
I2
Indifference
A
curve, I1
0 Quantity
The Consumer’s Preferences of Pizza
Properties of Indifference Curves
A consumer is willing to give up one economic good only if he or she gets more
of the other economic good in order to remain equally happy.
If the quantity of one good is reduced, the quantity of the other good must
increase if ICs are downward sloping.
For this reason, most indifference curves slope downward.
Quantity
of Pepsi
Indifference
curve, I1
0 Quantity
The Consumer’s Preferences of Pizza
Properties of Indifference Curves
0 Quantity
of Pizza
The Consumer’s Preferences
Properties of Indifference Curves
People are usually more willing to trade away goods that they have in
abundance and less willing to trade away goods of which they have little.
These differences in a consumer’s marginal substitution rates cause his or her
indifference curve for economic goods to bow inward.
Quantity
of Pepsi
14
MRS = 6
A
8
1
4 B
MRS = 1
3
1
Indifference
curve
0 2 3 6 7 Quantity
• To describe
preferences for all
D combinations of goods,
B A we have a set of
U3 indifference curves –
an indifference map.
Indifference Map
THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD
The budget constraint depicts the limit on the consumption “bundles” that
a consumer can afford.
People consume less than they desire because their spending is constrained, or
limited, by their income.
Indicates all combinations of two commodities for which total money spent
equals total income.
We assume only 2 goods are consumed, so we do not consider savings.
The Consumer’s Budget
Constraint
THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD
Let’s draw a consumer’s budget constraint on a graph.
Any point on the budget constraint line indicates the consumer’s combination or
trade-off between two goods.
For example, if the consumer buys no pizzas, he can afford 500 pints of Pepsi
(point B). If he buys no Pepsi, he can afford 100 pizzas (point A).
Figure 1 The Consumer’s Budget Constraint
Quantity of Pepsi
B
500
Consumer’s
budget constraint
A
0 Quantity of Pizza
Constraint
Quantity of Pepsi
B
500
Alternately, the
consumer can buy
50 pizzas and 250
pints of Pepsi in the
same budget.
C (point C)
250
Consumer’s
budget constraint
A
0 Quantity of Pizza
50 100
The Consumer’s Budget
Constraint
THE BUDGET CONSTRAINT:
WHAT THE CONSUMER CAN AFFORD
The slope of the budget constraint line equals the relative price of the two
goods, that is, the price of one good compared to the price of the other.
Therefore, it measures the rate at which the consumer can trade one good
for the other.
Let’s take another example. Let this consumer use her income on two
goods - food and clothing.
The Budget Line
PF F PC C I
Different choices of food and clothing can be calculated that
use all income.
These choices when graphed give us the budget line.
Example: Assume income of $80/week, PF = $1; PC = $2
40
A decrease in
income shifts
20 L3
the budget line L1 L2
inward Food
(I = $40) (I = $80) (I = $160)
(units per week)
0 40 80 120 160
If the two goods increase in price, but the ratio of the two prices is
unchanged, the slope will not change.
However, the budget line will shift inward parallel to the original
budget line.
If the two goods decrease in price, but the ratio of the two prices is
unchanged, the slope will not change.
However, the budget line will shift outward parallel to the original
budget line.
Clothing
(units
per week)
A decrease in the
price of food to
$.50 changes
the slope of the
40 budget line and
An increase in the L2 rotates it outward.
price of food to
$2.00 changes L1
the slope of the L3
budget line and
rotates it inward.
(PF = 1) (PF = 1/2)
(PF = 2) Food
40 80 120 160 (units per week)
If the price of one good increases, the budget line shifts inward,
pivoting from the other good’s intercept.
If the price of food increases and you buy only food (x-intercept),
then you can’t buy as much food. The x-intercept shifts in.
If you buy only clothing (y-intercept), you can buy the same
amount. No change in y-intercept.
If the price of one good decreases, the budget line shifts outward,
pivoting from the other good’s intercept.
If the price of food decreases and you buy only food (x-intercept),
then you can buy more food. The x-intercept shifts out.
If you buy only clothing (y-intercept), you can buy the same
amount. No change in y-intercept.
Given budget constraints, how do consumers choose what to buy i.e. what
do they do about their preferences?
20 C
U3
U1
B
0 20 40 80 Food (units per week)
Consumer Choice
Consumer Choice
PF
Further, the slope of the budget line is: Slope
PC
-10C
20
+10F U1
0 20 40 80 Food
Consumer Choice
Consumer Choice
$10,000
These consumers
want performance
worth $7000 and styling
worth $3000
$3,000
Consumer Choice
Styling
Consumer Choice
$10,000
$7,000
These consumers
want styling worth
$7000 and
performance worth
$3000
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.
Quantity
of Clothing
New budget constraint
New optimum
3. . . . and
Clothing
consumption. Initial
optimum I2
Initial
budget
I1
constraint
An Increase
0 in Income Quantity
of Food
2. . . . raising Food consumption . . .
How Changes in Income Affect the
Consumer’s Choices
Initial
budget I1 I2
constraint
An Inferior
0 Good Quantity
of Food
2. . . . Food consumption rises, making Food a normal good . . .
How Changes in Prices Affect Consumer’s
Choices
New optimum
B 1. A fall in the price of Clothing rotates
500
the budget constraint outward . . .
3. . . . and
raising Clothing Initial optimum
consumption.
Initial I2
budget I1
constraint A
0 100 Quantity
of Food
2. . . . reducing Food consumption . . .
A Change in Price
Deriving the Demand Curve
B A
750 $2
I2
B
1
A
250 Demand
I1