Transcript Slide 1

POSSIBILITIES,
PREFERENCES, AND
CHOICES
8
CHAPTER
Objectives
After studying this chapter, you will able to
 Describe a household’s budget line and show how it
changes when prices or income changes
 Make a map of preferences by using indifference curves
and explain the principle of diminishing marginal rate of
substitution
 Predict the effects of changes in prices and income on
consumption choices
 Predict the effects of changes in wage rates on workleisure choices
Subterranean Movements
Like the continents floating on the earth’s mantle,
spending patterns change slowly over time, but as they
change, business empires rise and fall.
The model of consumer choice that we study in this
chapter explains such things as why we download music,
even if it costs the same as buying a CD, and why we
don’t (much) download audio books, even though they are
cheaper than audio tapes.
Consumption Possibilities
Household 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.
Consumption Possibilities
Figure 8.1 shows a
consumer’s budget line.
Divisible goods can be
bought in any quantity
desired along the budget
line (gasoline, for example)
Indivisible goods must be
bought in whole units at the
points marked on the
budget line (movies, for
example).
Consumption Possibilities
The Budget Equation
We can describe the budget line by using a budget
equation.
The budget equation states that
Expenditure = Income
Call the price of soda PS, the quantity of soda QS, the price
of a movie PM, the quantity of movies QM, and income Y.
Lisa’s budget equation is:
PSQS + PMQM = Y.
Consumption Possibilities
PSQS + PMQM = Y
Divide both sides of this equation by PS, to give:
QS + (PM/PS)QM = Y/PS
Then subtract (PM/PS)QM from both sides of the equation to
give:
QS = Y/PS – (PM/PS)QM
The term Y/PS is Lisa’s real income in terms of soda.
The term PM/PS is the relative price of a movie in terms of
soda.
Consumption Possibilities
A household’s real income is the income expressed as a
quantity of goods the household can afford to buy.
Lisa’s real income in terms of soda is the point on her
budget line where it meets the y-axis.
A relative price is the price of one good divided by the
price of another good.
It is the magnitude of the slope of the budget line
The relative price shows how many sodas must be
forgone to see an additional movie.
Consumption Possibilities
A fall in the price of the
good on the x-axis
increases the affordable
quantity of that good and
decreases the slope of the
budget line.
Figure 8.2(a) shows the
rotation of a budget line
after a change in the
relative price of movies.
Consumption Possibilities
An change in the
household’s income brings
a parallel shift of the
budget line.
The slope of the budget
line doesn’t change
because the relative price
doesn’t change.
Figure 8.2(b) shows the
effect of a fall in income.
Preferences and Indifference Curves
An indifference curve is a
line that shows
combinations of goods
among which a consumer
is indifferent.
Figure 8.3(a) illustrates a
consumer’s indifference
curve.
At point C, Lisa consumes
2 movies and 6 six-packs
a month.
Preferences and Indifference Curves
Lisa can sort all possible
combinations of goods into
three groups: preferred, not
preferred, and indifferent.
An indifference curve joins
all those points that Lisa
says are just as good as C.
G is such a point. Lisa is
indifferent between C and G.
Preferences and Indifference Curves
All the points above the
indifference curve are
preferred to the points on
the curve.
And all the points on the
indifference curve are
preferred to the points
below the curve.
Preferences and Indifference Curves
The indifference curve in
the figure is just one of
many curves that form an
indifference map.
Call the indifference curve
that we’ve just seen I1.
An indifference curve
below I1 is I0 . All the
points on I1 are preferred
to those on I0 .
Preferences and Indifference Curves
An indifference curve
above I1 is I2 . All the points
on I2 are preferred to those
on I1 .
For example, point J is
preferred to either point C
or point G.
Preferences and Indifference Curves
Marginal Rate of Substitution
The marginal rate of substitution, (MRS), measures the
rate at which a person is willing to 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).
The magnitude of the slope of the indifference curve
measures the marginal rate of substitution.
Preferences and Indifference Curves
If the indifference curve is relatively steep, the MRS is
high.
In this case, the person is willing to give up a large
quantity of y to get a bit more x.
If the indifference curve is relatively flat, the MRS is low.
In this case, the person is willing to give up a small
quantity of y to get more x.
Preferences and Indifference Curves
A diminishing marginal rate of substitution is the key
assumption of consumer theory.
A diminishing marginal rate of substitution is a general
tendency for a person to be willing to give up less of good
y to get one more unit of good x, and at the same time
remain indifferent, as the quantity of good x increases.
Preferences and Indifference Curves
Figure 8.4 shows the
diminishing MRS of
movies for soda.
At point C, Lisa is willing
to give up 2 six-packs to
see one more movie—her
MRS is 2.
At point G, Lisa is willing
to give up 1/2 a six-pack
to see one more movie—
her MRS is 1/2.
Preferences and Indifference Curves
Degree of Substitutability
The shape of the indifference curves reveals the degree
of substitutability between two goods.
Figure 8.5 shows the indifference curves for ordinary
goods, perfect substitutes, and perfect complements.
Predicting Consumer Behavior
The consumer’s best affordable point is:
 On the budget line
 On the highest attainable indifference curve
 Has a marginal rate of substitution between the two
goods equal to the relative price of the two goods
Predicting Consumer Behavior
Here, the best affordable
point is C.
Lisa can afford to consume
more soda and fewer
movies at point F.
And she can afford to
consume more movies and
less soda at point H.
But she is indifferent
between F, I, and H and
she clearly prefers C to I.
Predicting Consumer Behavior
At point F, Lisa’s MRS is
greater than the relative
price.
At point H, Lisa’s MRS is
less than the relative price..
At point C, Lisa’s MRS is
equal to the relative price.
Predicting …
A Change in Price
The effect of a change in the
price of a good on the quantity of
the good consumed is called the
price effect.
Figure 8.7 illustrates the price
effect and shows how the
consumer’s demand curve is
generated.
Initially, the price of a movie is $6
and Lisa consumes at point C in
part (a) and at point A in part (b).
Predicting …
The price of a movie then falls
to $3.
The budget line rotates
outward.
Lisa’s best affordable point is
now J in part (a).
In part (b), Lisa moves to point
B, which is a movement along
her demand curve for movies.
Predicting …
A Change in Income
The effect of a change in
income on the quantity of a
good consumed is called the
income effect.
Figure 8.8 illustrates the effect
of a decrease in Lisa’s income.
Initially, Lisa consumes at point
J in part (a) and at point B on
demand curve D0 in part (b).
Predicting …
Lisa’s income decreases and
her budget line shifts leftward
in part (a).
Her new best affordable point
is K in part (a).
Her demand for movies
decreases, shown by a leftward
shift of her demand curve for
movies in part (b).
Predicting Consumer Behavior
When a good is a normal good, the quantity consumed
changes in the same direction as the change in income.
For Lisa, movies are a normal good.
When a good is an inferior good, the quantity consumed
changes in the opposite direction to the change in income.
Predicting Consumer Behavior
Substitution Effect and Income Effect
For a normal good, a fall in price always increases the
quantity consumed.
We can prove this assertion by dividing the price effect in
two parts:
 Substitution effect
 Income effect
Predicting Consumer Behavior
The substitution effect is
the effect of a change in
price on the quantity
bought when the
consumer remains
indifferent between the
original situation and the
new situation.
Predicting Consumer Behavior
Initially, Lisa has an
income of $30, the price of
a movie is $6, and she
consumes at point C.
The price of a movie falls
from $6 to $3 and her
budget line rotates
outward.
Lisa’s best affordable point
is then J.
Predicting Consumer Behavior
We’re going to break the
move from C to J into two
parts.
The first part is the
substitution effect and the
second is the income
effect.
Predicting Consumer Behavior
To isolate the substitution
effect, we give Lisa a
hypothetical pay cut.
Lisa is now back on her
original indifference curve
but with a lower price of
movies and her best
affordable point is K.
The move from C to K is
the substitution effect.
Predicting Consumer Behavior
The direction of the
substitution effect never
varies: a fall in price brings
an increase in the quantity
bought.
The substitution effect is
the first reason why the
demand curve slopes
downward.
Predicting Consumer Behavior
To isolate the income
effect, we reverse the
hypothetical pay cut and
restore Lisa’s income to its
original level (its actual
level).
Lisa is now back on
indifference curve I2 and her
best affordable point is J.
The move from K to J is
the income effect.
Predicting Consumer Behavior
For Lisa, movies are a normal
good.
When her income increases,
she sees more movies—the
income effect is positive.
For a normal good, the
income effect reinforces the
substitution effect and is the
second reason why the
demand curve slopes
downward.
Predicting Consumer Behavior
For an inferior good, when
income increases, the quantity
bought decreases.
For an inferior good, the
income effect works against
the substitution effect.
So long as the substitution
effect dominates, the demand
curve still slopes downward.
Predicting Consumer Behavior
If the negative income effect is
stronger than the substitution
effect, a lower price for inferior
goods brings a decrease in
the quantity demanded—the
demand curve slopes upward!
This case has not been found
in any real-world market.
Work-Leisure Choices
Labor Supply
Indifference curves can be
used to study the
allocation of time between
work and leisure.
The two “goods” are
leisure and income, which
represent all other goods.
Work-Leisure Choices
The Labor Supply Curve
By changing the wage rate,
we can find a person’s labor
supply curve.
A higher wage rate makes
leisure relatively more
expensive (higher
opportunity cost to not
working) and has a
substitution effect toward
less leisure (toward more
work).
Work-Leisure Choices
A higher wage also has a
positive income effect on
leisure.
If the income effect is weaker
than the substitution effect,
the quantity of work hours
increases with the wage rate.
The move from A to B when
the wage rate rises from $5
to $10 illustrates this case.
Work-Leisure Choices
But if the income effect is
stronger than the substitution
effect, the quantity of work
hours decreases with the
wage rate.
The move from B to C when
the wage rate increases from
$10 to $15 an hour illustrates
this case.
Work-Leisure Choices
The move from A to B when
the wage rate increases from
$5 to $10 means that the
labor supply curve slopes
upward over this range.
The move from B to C when
the wage rate increases from
$10 to $15 means that the
labor supply curve bends
backward above a certain
wage rate.
Work-Leisure Choices
Historical evidence shows
that the average workweek
has declined over the
centuries, implying that
people have preferred to
seek greater leisure
despite its higher
opportunity cost.
POSSIBILITIES,
PREFERENCES, AND
CHOICES
THE END
8
CHAPTER