Chapter Outline

Rational consumer choice theory begins with a budget constraint or opportunity set.
1. The slope of the constraint shows the relative price ratio of the two goods under consideration. This is the rate at which the two goods can be exchanged in the marketplace.
2. The location of the budget constraint shows the amount of income that is available.
3. One good can be used as a composite good that represents income spent on all goods other than X.
Consumer preference patterns are the next building block of consumer theory.
1. Consumer preference orderings must be complete, transitive, and more must be preferred to less.
2. These qualities lead to indifference curves that are negatively sloped, nonintersecting, and continuous.
3. The slope of the indifference curves shows the rate at which the consumer would like to exchange one good for the other. This is called the marginal rate of substitution.
4. A diminishing marginal rate of substitution is common and results in an indifference curve that is convex to the origin.
5. Perfect substitutes have straight-line indifference curves and perfect complements have L-shaped curves.
Maximizing a consumer's utility requires that the marginal rate of substitution equal the price ratio of the goods.
Where the marginal rate of substitution cannot equal the price ratio, a corner solution exists and all income is spent on one good.
Applications of this theory include an analysis of the subsidized housing example in the text and an explanation of gift giving.
(Chapter 3 Appendix) A utility function analysis will result in the same conclusions that the indifference curve process has set forth.

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