Transcript Chapter 21 The Theory of Consumer Choice

Chapter 21 The Theory of Consumer Choice
Outline of Topics
• T1 The budget constraint: What the consumer
can afford
• T2 Preference: What the consumer wants
• T3 Optimization: What the consumer chooses
• T4 Four Applications
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T1, The budget constraint: What the consumer can afford
• Budget constraint: the limit on the consumption bundles
that a consumer can afford
• People consume less than they desire because their spending
is constrained, or limited, by their income.
• See Table 21-1 and Figure 21-1 on page 469
– All the points on the line from A to B are possible. This
line, called budget constraint, shows the consumption
bundles that the consumer can afford.
– It also shows the tradeoff between two goods that the
consumer faces. The slope of the budget constraint
measures the rate at which the consumer can trade one
good for the other.
– The slope of the budget constraint equals the relative
price of the two goods-the price of one good compared
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with the price of the other.
T2 Preference: What the consumer wants
• Indifference curve: a curve that shows the consumption
bundles that give the consumer the same level of
satisfaction
• If the two bundles suit his tastes equally well, we say that
the consumer is indifferent between the two bundles.
• The consumer is equally happy at all points on any given
indifference curve, but he prefers some indifference curves
to others. Because he prefers more consumption to less,
higher indifference curves are preferred to lower ones.
• See Figure 21-2 on page 471
• The slope at any point on an indifference curve equals the
rate at which the consumer is willing to substitute one good
for the other. This rate is called the marginal rate of
substitution (MRS).
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– MRS: the rate at which a consumer is willing to trade
one good for another.
• Four Properties of Indifference Curves
– Property 1: Higher indifference curves are preferred to
lower ones.
– Property 2: Indifference curves are downward sloping.
– Property 3: Indifference curves do not cross.
• See Figure 21-3
– Property 4: Indifference curves are bowed inward.
• See Figure 21-4
• The bowed shape of the indifference curve reflects the
consumer’s greater willingness to give up a good that
he already has in large quantity
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• Two extreme examples of Indifference Curves
– Perfect Substitute: Two goods with straight-line
indifference curves; eg, nickels and dimes
– Perfect complements: Two goods with right-angle
indifference curves; eg, left shoes and right shoes.
– See Figure 21-5 on page 474
T3 Optimization: What the consumer chooses
The consumer’s optimal choices: The consumer chooses the
point on his budget constraint that lies on the highest
indifference curve.
• We say that the indifference curve is tangent to the budget
constraint.
• At this point,called the optimum, the marginal rate of
substitution equals the relative price of the two goods. 5
• Thus, the consumer chooses consumption of the two goods
so that the marginal rate of substitution equals the relative
price.
• See Figure 21-6 on page 476
How changes in income affect the consumer’s choices:
When the consumer’s income raises, the budget constraint
shifts out.
– If both goods are normal goods, the consumer responds
to the increase in income by buying more of both of
them.
• See Figure 21-7 on page 477
– If an increase in income induces the consumer to buy
more of Good 1 but less of Good 2, then economists call
Good 2, an inferior good.
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• See Figure 21-8 on page 478
How changes in prices affect the consumer’s choices
• When the price of Pepsi falls, the consumer’s budget
constraint shifts outward and changes slope. The consumer
moves from the initial optimum to the new optimum, which
changes his purchases of both Pepsi and pizza.
• See Figure 21-9 on page 479.
Income and Substitution Effects
• The impact of a change in the price of a good on
consumption can be decomposed into two effects: an
income effect and a substitution effect.
– Income effect: the change in consumption that results
when a price change moves the consumer to a higher or
lower indifference curve
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– Substitution effect: the change in consumption that
results when a price change moves the consumer along a
given indifference curve to a point with a new marginal
rate of substitution
– Now consider the end result of these two effects. In our
example, we assume that Pepsi is cheaper and pizza is
still the same price. See Figure 21-10 on page 480.
• The consumer certainly buys more Pepsi, because the
income and substitution effects both act to raise
purchases of Pepsi.
• But it is ambiguous whether the consumer buys more
pizza because the income and substitution effects work
in opposite directions.
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– See Table 21-2 on page 480 for conclusion & also page
481 regarding to two steps of change, A-B & B-C.
Deriving the demand curve
• Recall that a demand curve shows the quantity demanded of
a good for any given price. We can view a consumer’s
demand curve as a summary of the optimal decision that
arise from his or her budget constraint and indifference
curves.
• See Figure 21-11 on page 482.
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T4 Four Applications
1, Do all demand curves slope downward?
• Demand curves can sometimes slope upward. In other
words, consumers can sometimes violate the law of demand
and buy more of a good when the price rises.
• Giffen good: a good for which an increase in the price raises
the quantity demanded
• See Figure 21-12. Notice that a rise in the price of potatoes
has led the consumer to buy a larger quantity of potatoes.
The reason is that potatoes here are a strongly inferior good.
When the price of potatoes rises, the consumer is poorer.
The income effect makes the consumer want to buy less
meat and more potatoes.
• But, Giffen goods are very rare.
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2, How do wages affect labour supply?
• See Figure 21-13 on page 484 for the Work-Leisure
Decision.
• Now consider what happens when the wage increases. See
Figure 21-14 on page 485.
• Two possible outcomes:
– labour supply curve has an upward slope: Agent responds
to the higher wage by working harder and enjoying less
leisure.
– labour supply curve has a backward slope: Agent
responds to the higher wage by enjoying more leisure.
• Why would a person respond to a higher wage by working
less? Because of income and substitution effects of a higher
wage.
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– SE: When the wage rises, leisure becomes more costly
relative to consumption, and this encourage the agent to
substitute consumption for leisure.
– In other words, the SE induces the agent to work harder
in response to higher wages.
– IE: When the wage rises, the agent moves to a higher
indifference curve. She is now better off than she was. As
long as consumption and leisure are both normal goods,
she tends to use this increase in well-being to enjoy
higher consumption and greater leisure.
– In other words, the IE induces the agent to work less,
which tends to make the labour supply curve slope
backward.
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3, How do interest rates affect household saving?
• See Figure 21-15 on page 488, the consumption-saving
decision
• Now, consider what happens when the interest rate
increases. See Figure 21-16 on page 489.
• Two possible outcomes because of different preferences:
– However, in both cases, the budget constraint shifts
outward and becomes steeper. Besides, consumption
when old rises in both cases.
– In panel (a), Rohan responds to the higher interest rate by
consuming less when young.
– In panel (b), Rohan responds by consuming more when
young.
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4, Do the poor prefer to receive cash or in-kind transfers?
• The government wants to help Paula because of her low
income. The government can either give Paula $1000 worth
of food or simply give her $1000 in cash. What does the
theory of consumer choice have to say about the comparison
between these two policy options?
• See Figure 21-17 on page 490.
• The theory of consumer choice teaches a simple lesson
about cash vs. in-kind transfers.
• If an in-kind transfer of a good forces the recipient to
consume more of the good than he or she would on his or
her own, then the recipient prefers the cash transfer.
• If an in-kind transfer of a good does not forces the recipient
to consume more of the good than he or she would on his or
her own, then the cash and in-kind transfer have exactly the
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same effect on the consumption and welfare of the recipient.