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Introduction Recall one of the Ten Principles from Chapter 1: People face tradeoffs. Buying more of one good leaves less income to buy other goods. Working more hours means more income and more consumption, but less leisure time. Reducing saving allows more consumption today but reduces future consumption. This chapter explores how consumers make choices like these. THE THEORY OF CONSUMER CHOICE 0 Household Choice in Output Markets Every household must make three basic decisions: 1. How much of each product, or output, to demand 2. How much labor to supply 3. How much to spend today and how much to save for the future 1 of 57 Household Choice in Output Markets The Determinants of Household Demand Several factors influence the quantity of a given good or service demanded by a single household: The price of the product The income available to the household The household’s amount of accumulated wealth The prices of other products available to the household The household’s tastes and preferences The household’s expectations about future income, wealth, and prices 2 of 57 Household Choice in Output Markets The Budget Constraint budget constraint The limits imposed on household choices by income, wealth, and product prices. TABLE 6.1 Possible Budget Choices of a Person Earning $1,000 Per Month After Taxes Option Monthly Rent Other Food Expenses Total Available ? A $ 400 $250 $350 $1,000 Yes B 600 200 200 1,000 Yes C 700 150 150 1,000 Yes D 1,000 100 100 1,200 No choice set or opportunity set The set of options that is defined and limited by a budget constraint. 3 of 57 Household Choice in Output Markets Preferences, Tastes, Trade-Offs, and Opportunity Cost FIGURE 6.1 Budget Constraint and Opportunity Set for Ann and Tom A budget constraint separates those combinations of goods and services that are available, given limited income, from those that are not. The available combinations make up the opportunity set. real income Set of opportunities to purchase real goods and services available to a household as determined by prices and money income. 4 of 57 HOUSEHOLD CHOICE IN OUTPUT MARKETS The Equation Of The Budget Constraint In general, the budget constraint can be written: PXX + PYY = I, where PX = the price of X, X = the quantity of X consumed, PY = the price of Y, Y = the quantity of Y consumed, and I = household income. 5 of 57 The Budget Constraint: What the Consumer Can Afford Example: Hurley divides his income between two goods: fish and mangos. A “consumption bundle” is a particular combination of the goods, e.g., 40 fish & 300 mangos. Budget constraint: the limit on the consumption bundles that a consumer can afford THE THEORY OF CONSUMER CHOICE 6 ACTIVE LEARNING 1 Budget Constraint Hurley’s income: $1200 Prices: PF = $4 per fish, PM = $1 per mango A. If Hurley spends all his income on fish, how many fish does he buy? B. If Hurley spends all his income on mangos, how many mangos does he buy? C. If Hurley buys 100 fish, how many mangos can he buy? D. Plot each of the bundles from parts A – C on a graph that measures fish on the horizontal axis and mangos on the vertical, connect the dots. 7 ACTIVE LEARNING Answers Quantity of Mangos A. $1200/$4 = 300 fish B. $1200/$1 = 1200 mangos C. 100 fish cost $400, $800 left buys 800 mangos 1 B D. Hurley’s budget constraint shows the bundles he can afford. C A Quantity of Fish The Slope of the Budget Constraint From C to D, Quantity of Mangos “rise” = –200 mangos “run” = +50 fish Slope = – 4 C D Hurley must give up 4 mangos to get one fish. THE THEORY OF CONSUMER CHOICE Quantity of Fish 9 The Slope of the Budget Constraint The slope of the budget constraint equals the rate at which Hurley can trade mangos for fish the opportunity cost of fish in terms of mangos the relative price of fish: price of fish $4 4 mangos per fish price of mangos $1 THE THEORY OF CONSUMER CHOICE 10 ACTIVE LEARNING 2 Budget constraint, continued. Show what happens to Hurley’s budget constraint if: A. His income falls to $800. B. The price of mangos rises to PM = $2 per mango 11 ACTIVE LEARNING Answers, part A Now, Hurley can buy Quantity of Mangos 2 A fall in income shifts the budget constraint down. $800/$4 = 200 fish or $800/$1 = 800 mangos or any combination in between. Quantity of Fish ACTIVE LEARNING Answers, part B Hurley can still buy 300 fish. Quantity of Mangos 2 An increase in the price of one good pivots the budget constraint inward. But now he can only buy $1200/$2 = 600 mangos. Notice: slope is smaller, relative price of fish is now only 2 mangos. Quantity of Fish Preferences: What the Consumer Wants Indifference curve: shows consumption bundles that give the consumer the same level of satisfaction Quantity of Mangos A, B, and all other bundles on I1 make Hurley equally happy – he is indifferent between them. One of Hurley’s indifference curves B A I1 Quantity of Fish THE THEORY OF CONSUMER CHOICE 14 Four Properties of Indifference Curves 1. Indifference curves are downwardsloping. Quantity of Mangos If the quantity of fish is reduced, the quantity of mangos must be increased to keep Hurley equally happy. THE THEORY OF CONSUMER CHOICE One of Hurley’s indifference curves B A I1 Quantity of Fish 15 Four Properties of Indifference Curves 2. Higher indifference curves are preferred to lower ones. A few of Hurley’s indifference curves Quantity of Mangos Hurley prefers every bundle on I2 (like C) to every bundle on I1 (like A). He prefers every bundle on I1 (like A) to every bundle on I0 (like D). THE THEORY OF CONSUMER CHOICE C D I2 A I1 I0 Quantity of Fish 16 Four Properties of Indifference Curves 3. Indifference curves cannot cross. Hurley’s indifference curves Quantity of Mangos Suppose they did. Hurley should prefer B to C, since B has more of both goods. Yet, Hurley is indifferent between B and C: He likes C as much as A (both are on I4). He likes A as much as B (both are on I1). THE THEORY OF CONSUMER CHOICE B C A I1 I4 Quantity of Fish 17 Four Properties of Indifference Curves 4. Indifference curves are bowed inward. Quantity of Mangos Hurley is willing to give up more mangos for a fish if he has few fish (A) than if he has many (B). A 6 1 2 B 1 I1 Quantity of Fish THE THEORY OF CONSUMER CHOICE 18 The Marginal Rate of Substitution Quantity Marginal rate of of Mangos substitution (MRS): the rate at which a consumer is willing to trade one good for another. Hurley’s MRS is the amount of mangos he would substitute for another fish. MRS falls as you move down along an indifference curve. THE THEORY OF CONSUMER CHOICE MRS = slope of indifference curve A MRS = 6 1 MRS = 2 B 1 I1 Quantity of Fish 19 One Extreme Case: Perfect Substitutes Perfect substitutes: two goods with straight-line indifference curves, constant MRS Example: nickels & dimes Consumer is always willing to trade two nickels for one dime. THE THEORY OF CONSUMER CHOICE 20 Another Extreme Case: Perfect Complements Perfect complements: two goods with right-angle indifference curves Example: Left shoes, right shoes {7 left shoes, 5 right shoes} is just as good as {5 left shoes, 5 right shoes} THE THEORY OF CONSUMER CHOICE 21 Less Extreme Cases: Close Substitutes and Close Complements Quantity of Pepsi Indifference curves for close substitutes are not very bowed Quantity of Coke Quantity of hot dog buns Indifference curves for close complements are very bowed Quantity of hot dogs Optimization: What the Consumer Chooses A is the optimum: the point on the budget constraint that touches the highest possible indifference curve. Quantity of Mangos The optimum is the bundle Hurley most prefers out of all the bundles he can afford. 1200 Hurley prefers B to A, but he cannot afford B. Hurley can afford C and D, but A is on a higher indifference curve. THE THEORY OF CONSUMER CHOICE B A 600 C D 150 300 Quantity of Fish 23 Optimization: What the Consumer Chooses At the optimum, slope of the indifference curve equals slope of the budget constraint: Quantity of Mangos 1200 MRS = PF/PM marginal value of fish (in terms of mangos) Consumer optimization is another example of “thinking at the margin.” price of fish (in terms of mangos) THE THEORY OF CONSUMER CHOICE 600 A 150 300 Quantity of Fish 24 The Effects of an Increase in Income Quantity of Mangos An increase in income shifts the budget constraint outward. If both goods are “normal,” Hurley buys more of each. B A Quantity of Fish THE THEORY OF CONSUMER CHOICE 25 Income and Substitution Effects The Income Effect Price changes affect households in two ways. First, if we assume that households confine their choices to products that improve their well-being, then a decline in the price of any product, ceteris paribus, will make the household unequivocally better off. In other words, if a household continues to buy the same amount of every good and service after the price decrease, it will have income left over. That extra income may be spent on the product whose price has declined, hereafter called good X, or on other products. The change in consumption of X due to this improvement in wellbeing is called the income effect of a price change. 26 of 57 Income and Substitution Effects The Substitution Effect When the price of a product falls, that product also becomes relatively cheaper. That is, it becomes more attractive relative to potential substitutes. A fall in the price of product X might cause a household to shift its purchasing pattern away from substitutes toward X. This shift is called the substitution effect of a price change. Everything works in the opposite direction when a price rises, ceteris paribus. When the price of a product rises, that item becomes more expensive relative to potential substitutes and the household is likely to substitute other goods for it. 27 of 57 Income and Substitution Effects FIGURE 6.4 Diminishing Marginal Utility and Downward-Sloping Demand For normal goods, the income and substitution effects work in the same direction. Higher prices lead to a lower quantity demanded, and lower prices lead to a higher quantity demanded. 28 of 57 The Effects of a Price Change Initially, Quantity of Mangos PF = $4 PM = $1 PF falls to $2 budget constraint rotates outward, Hurley buys more fish and fewer mangos. 1200 initial optimum new optimum 600 500 150 300 600 350 THE THEORY OF CONSUMER CHOICE Quantity of Fish 29 The Income and Substitution Effects A fall in the price of fish has two effects on Hurley’s optimal consumption of both goods. Income effect A fall in PF boosts the purchasing power of Hurley’s income, allows him to buy more mangos and more fish. Substitution effect A fall in PF makes mangos more expensive relative to fish, causes Hurley to buy fewer mangos & more fish. Notice: The net effect on mangos is ambiguous. THE THEORY OF CONSUMER CHOICE 30 The Income and Substitution Effects Initial optimum at A. Quantity of Mangos In this example, the net effect on mangos is negative. PF falls. Substitution effect: from A to B, buy more fish and fewer mangos. Income effect: from B to C, buy more of both goods. THE THEORY OF CONSUMER CHOICE A C B Quantity of Fish 31 Application 1: Giffen Goods Do all goods obey the Law of Demand? Suppose the goods are potatoes and meat, and potatoes are an inferior good. If price of potatoes rises, substitution effect: buy less potatoes income effect: buy more potatoes If income effect > substitution effect, then potatoes are a Giffen good, a good for which an increase in price raises the quantity demanded. THE THEORY OF CONSUMER CHOICE 32 Application 1: Giffen Goods THE THEORY OF CONSUMER CHOICE 33 The Basis of Choice: Utility utility The satisfaction, or reward, a product yields relative to its alternatives. The basis of choice. Diminishing Marginal Utility marginal utility (MU) The additional satisfaction gained by the consumption or use of one more unit of something. total utility The total amount of satisfaction obtained from consumption of a good or service. law of diminishing marginal utility The more of any one good consumed in a given period, the less satisfaction (utility) generated by consuming each additional (marginal) unit of the same good. 34 of 57 The Basis of Choice: Utility FIGURE 6.3 Graphs of Frank’s Total and Marginal Utility Marginal utility is the additional utility gained by consuming one additional unit of a commodity—in this case, trips to the club. When marginal utility is zero, total utility stops rising. TABLE 6.2 Total Utility and Marginal Utility of Trips to the Club Per Week Trips to Club Total Utility Marginal Utility 1 12 12 2 22 10 3 28 6 4 32 4 5 34 2 6 34 0 35 of 57 The Basis of Choice: Utility Allocating Income To Maximize Utility TABLE 6.3 Allocation of Fixed Expenditure per Week Between Two Alternatives (5) Marginal Utility per Dollar (MU/P) 4.0 (1) Trips to Club per Week 1 (2) Total Utility 12 (3) Marginal Utility (MU) 12 2 22 10 3.00 3.3 3 28 6 3.00 2.0 4 32 4 3.00 1.3 5 6 34 34 2 0 3.00 3.00 0.7 0 (1) Basketball Games per Week (2) Total Utility (3) Marginal Utility (MU) (4) Price (P) $3.00 (4) Price (P) (5) Marginal Utility per Dollar (MU/P) 1 2 21 33 21 12 $6.00 6.00 3.5 2.0 3 4 42 48 9 6 6.00 6.00 1.5 1.0 5 51 3 6.00 .5 6 51 0 6.00 0 36 of 57 The Basis of Choice: Utility The Utility-Maximizing Rule In general, utility-maximizing consumers spread out their expenditures until the following condition holds: utility-maximizing rule: MU X MU Y for all goods PX PY utility-maximizing rule Equating the ratio of the marginal utility of a good to its price for all goods. diamond/water paradox A paradox stating that (1) the things with the greatest value in use frequently have little or no value in exchange and (2) the things with the greatest value in exchange frequently have little or no value in use. 37 of 57 The Basis of Choice: Utility Diminishing Marginal Utility and Downward-Sloping Demand FIGURE 6.4 Diminishing Marginal Utility and Downward-Sloping Demand At a price of $40, the utility gained from even the first Thai meal is not worth the price. However, a lower price of $25 lures Ann and Tom into the Thai restaurant 5 times a month. (The utility from the sixth meal is not worth $25.) If the price is $15, Ann and Tom will eat Thai meals 10 times a month— until the marginal utility of a Thai meal drops below the utility they could gain from spending $15 on other goods. At 25 meals a month, they cannot tolerate the thought of another Thai meal even if it is free. 38 of 57