Some Notes on Consumer Choice – Chapter 10

You should remember the material we learned in Chapter 3 about the law of demand. You remember the downward-sloping individual and market demand curves. It is the law of diminishing marginal utility that is basis concept on which the law of demand is based. There are two effects that explain the down sloping nature of the demand curve: the substitution effect and the income effect.

The Substitution Effect: This represents the change in quantity consumed as the consumer substitutes the relatively cheaper good for the more expensive good. For example, as the price of gasoline rose from $1.50 to $2.00, the marginal utility per dollar of a gallon of gasoline fell. Consumers could increase their utility by purchasing fewer gallons. In another example, if the price of computer peripherals falls, the marginal utility per dollar has risen and consumers will buy more. Again, consumers can increase their utility by buying more computer accessories.
The substitution effect is dominant when items purchased are a small portion of the consumer’s total budget.

The Income Effect: This represents the change in purchasing power of a consumer due to the higher price of a good. For example, college tuition has risen steadily over the past 10 years. The result is that tuition payments take a bigger portion of a consumer’s income, and consumers have less purchasing power for other goods. In contrast, sometimes the income effect is negligible such as if the price of newspapers were to rise; there is less of an impact on consumer incomes.

Some things to keep in mind

• All income is spent.
You may ask why a consumer cannot choose a consumption bundle within the budget constraint. The reason is because we assume that the consumer maximizes utility but receives zero utility from saving money, so all income is spent.

• The “right”