Download Ch 8 possibilities, preferences, and choices I. Consumption

Ch 8 possibilities, preferences, and choices
I.
Consumption Possibilities
A. A household’s consumption choices
are constrained by its income and the
prices of the goods and services
available. The budget line describes
the limits to the household’s
consumption choices. Figure 8.1 shows
a consumer’s budget line.
1. Divisible goods can be bought in
any quantity desired (gasoline, for
example)
2. Indivisible goods must be bought
in whole units (movies, for
instance).
B. The Budget Equation
1.
We can describe the budget line
by using a budget equation, which
uses the fact that income equals
expenditure.
a) Calling the price of soda PS,
the quantity of soda QS, the
price of a movie PM, the
quantity of movies QM, and
income Y, we can write the
budget equation for Lisa who
consumes only soda and movies as:
PSQS + PMQM = Y,
which can be rearranged to:
QS = Y/PS – PM/PS  QM.
2.
A household’s real income is the household’s income expressed as a quantity of goods
the household can afford to buy. For example, the vertical intercept for the above budget
line, Y/PS, is the consumer’s real income in terms of soda.
3.
A relative price is the price of one good divided by the price of another good. The
magnitude of the slope of the budget line, PM/PS, is the relative price of a movie in terms
of soda. This relative price shows how many sodas must be foregone to see an additional
movie.
4.
The budget line slope is reflects the rate
at which one good can be substituted for
another good while keeping the level of
income unchanged. The budget line
changes if the relative price of a good
changes or shifts if the household’s
income changes.
a)
A fall in the price of the good on the
horizontal (vertical) axis increases
the total affordable quantity of that
good and decreases (increases) the
slope of the budget line. Figure 8.2a
shows the rotations of the budget line
after changes in the relative price of
movies.
b) An increase (decrease) in the
household income results in a
parallel shift of the budget line
rightward (leftward). The slope of
the budget line does not change
when the consumer’s income
changes. The effect of a decrease in
income is illustrated in Figure 8.2b.
II. Preferences and Indifference Curves
A. Figure 8.3 illustrates a consumer’s
indifference curve and indifference map,
which is based on the idea that people can sort
all possible combinations of goods into three
groups: preferred, not preferred and
indifferent.
1.
An indifference curve is a line that
shows those combinations of goods
among which a consumer is indifferent.
a)
The consumer prefers points above
the indifference curve to points on
the indifference curve. And the
consumer prefers points on the
indifference curve to points below
the indifference curve.
b) But the consumer is indifferent
among (hence its name) all the points
on an indifference curve.
2.
A single indifference curve is one of a
family of curves that form an indifference
map, which resemble the contour lines on
a topographical map. Figure 8.3b shows
three indifference curves from a
consumer’s family of indifference curves.
B. Marginal Rate of Substitution
1.
The marginal rate of substitution,
(MRS) measures the rate at which a
person will give up good y, (the good
measured on the y-axis) to get an
additional unit of good x (the good
measured on the x-axis) and at the same
time remain indifferent (remain on the
same indifference curve).
2.
The magnitude of the slope of the indifference curve measures the marginal rate of
substitution.
a)
If the indifference curve is relatively steep, the MRS is high.
b) If the indifference curve is relatively flat, the MRS is low.
3.
The diminishing marginal rate of
substitution is the tendency for the
marginal rate of substitution of good x for
good y to fall as more of good x is
consumed. Figure 8.4 shows the
diminishing MRS of movies for soda.
C. Degree of Substitutability
1. Figure 8.5a shows the indifference curves
for ordinary goods, which display
diminishing MRS.
2. Figure 8.5b shows the indifference curves
for perfect substitutes, which are straight
lines with a constant MRS.
3. Figure 8.5c shows the indifference curves
for perfect compliments, which are Lshaped.
III. Predicting Consumer Behavior
A. The consumer’s best affordable point,
illustrated in Figure 8.6, meets three
conditions:
1.
It is on the budget line.
2.
It is in the highest attainable indifference
curve.
3.
It has a marginal rate of substitution
between the two goods equal to the
relative price of the two goods.
B. A Change in Price
1.
The price effect shows how a change
in the price of a good affects the quantity
of that good demanded.
2.
As the price of the good on the x-axis
decreases (increases), the budget line
rotates around the y-axis intercept
quantity and becomes flatter (steeper).
a)
Figure 8.7a shows how a fall in the
price of a movie leads the consumer
to substitute movies for sodas. The
change in the relative prices allows
the consumer to reach a higher
indifference curve by substituting
away from the relatively more
expensive good and toward the
relatively inexpensive good.
b) The new consumption bundle at
point J satisfies all three properties
of the best affordable point: it is on
the new budget line, it is on the
highest attainable indifference
curve, and the MRS equals the slope
of new budget line.
3.
Figure 8.7b shows how the consumer’s
demand curve can be derived from the
budget line and indifference curves. The
demand curve is downward sloping, in
accord with the law of demand.
C. A Change in Income
1.
The income effect is the effect of a
change in income on the quantity of a
good consumed.
2.
As the consumer’s income increases, the budget line shifts outward from the origin. The
set of affordable combinations of goods increases, which enables the consumer to reach a
higher indifference curves.
3.
As the consumer’s income decreases,
the budget line shifts inward toward the
origin. The set of affordable
combinations of goods decreases, which
enables the consumer to reach only
lower indifference curves. Figure 8.8a
shows how a decrease in a consumer’s
income forces the consumer to a lower
indifference curve and decreases the
demand for movies.
4.
The relative price of the goods has not
changed, so the slope of the budget line
remains constant. The new consumption
bundle satisfies the three properties of
the best affordable point: it is on the
new budget line, it is on the highest
attainable indifference curve, and the
MRS equals the slope of the new budget
line.
5.
When a good is a normal good, the
quantity of the good consumed will
decrease (increase) as income decreases
(increases). Figure 8.8a shows that the
quantity of the good consumed has
decreased without a change in the
relative price of the good, which
indicates that the demand curve for that
good shifted leftward when income
decreased. Figure 8.8b shows how the
decrease in the consumer’s income
shifts the demand curve for movies
leftward.
6.
When a good is an inferior good, the
quantity of the good consumed will increase (decrease) as income decreases (increases).
Because the quantity of the good consumed increases when income falls without a
change in the relative price of the good, the demand curve for the good shifts rightward
as income decreases.
D. Substitution Effect and Income Effect
1.
For a normal good, a fall in the price of the good always increases the quantity
consumed. We can prove this proposition by breaking the price effect in two different
parts:
a)
The substitution effect is the
effect of a change in price on the
quantity bought when the consumer
(hypothetically) remains indifferent
between the original situation and
the new situation. To analyze this
effect, the consumer moves along
the same indifference curve until the
MRS equals the slope of the new
budget line reflecting the change in
price. In Figure 8.9b, the
substitution effect is the movement
from point C to point K. This effect
always leads to an increase in the
quantity of the good whose relative
price has fallen.
b) The income effect is the effect of a
change in income at the new relative
price. This effect shifts the budget
line outward (with no change in its
slope) from the consumption
reached by the substitution effect to
the highest affordable indifference
curve attainable on the new budget
line reflecting the price change. In
Figure 8.9b, the income effect is the
movement from point K to point J.
For a normal good, the quantity of
the good consumed increases when
income increases.
2.
Because both the substitution effect and
income effect lead to an increase in the
quantity of the good consumed, a fall in
price always increases the quantity consumed for a normal good. As a result, the demand
curve for a normal good is always downward sloping.
3. For an inferior good, a fall (rise) in price might not always increase (decrease) the
quantity consumed.
a)
In this case the income effect is negative and counteracts the substitution effect.
b) If the negative income effect is stronger than the substitution effect, then a lower
(higher) price for an inferior good does not lead to an increase (decrease) in the
quantity of that good demanded.
c)
The demand curve in this case will have a positive slope. But such a case has not
been found in any market for real world goods or services.
IV. Work-Leisure Choices
A. Labor Supply
1.
Indifference curves can be used to study the allocation of time between work and leisure.
2.
The two goods are leisure and income. “Income” represents all other goods.
B. The Labor Supply Curve
1.
By changing the wage rate, we can find a person’s labor supply curve.
2.
A higher wage rate makes leisure relatively more expensive because the opportunity cost
of not working increases. As a result, a higher wage rate creates a substitution effect
away from leisure and toward more work.
3.
A higher wage rate also has a positive income effect. Leisure is a normal good, so the
income effect leads to increased consumption of leisure, which means less work.
a)
If the income effect is weaker than the substitution effect, the quantity of work hours
increases when the wage rate rises.
b) If the income effect is stronger than the substitution effect, then the quantity of work
hours could decrease when the wage rate rises.