Transcript Krugman`s Chapter 11 PPT

WHAT YOU WILL LEARN IN THIS
CHAPTER
chapter:
11
>> Consumer Preferences and
Consumer Choice
Krugman/Wells
©2009  Worth Publishers
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WHAT YOU WILL LEARN IN THIS CHAPTER
 Why economists use indifference curves to illustrate a
person’s preferences
 The importance of the marginal rate of substitution,
the rate at which a consumer is just willing to
substitute one good for another
 An alternative way of finding a consumer’s optimal
consumption bundle using indifference curves and the
budget line
 How the shape of indifference curves helps determine
whether goods are substitutes or complements
 An in-depth understanding of income and substitution
effects
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Mapping the Utility Function

A utility function determines a consumer’s total utility
given his or her consumption bundle.

Using indifference curves, which represent a
consumer’s utility function, we will deepen our
understanding of the trade-off involved when
choosing the optimal consumption bundle and of
how the optimal consumption bundle itself changes
in response to changes in the prices of goods.
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Ingrid’s Utility Function
1,050 utils
All combinations of
rooms and restaurant
meals along this
contour line yield 450
utils.
900 utils
750 utils
600 utils
450 utils
B
A
300 utils
90
80
150 utils
70
Quantity of restaurants
60
0 utils
50
40
30
20
10
0
1
2
3
4
5
6
7
8
9
10
Quantity of
rooms
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Ingrid’s Utility Function

Ingrid is indifferent between A and B: because A and
B yield the same total utility level, Ingrid is equally
well off with either bundle. Hence, a contour line that
maps consumption bundles yielding the same
amount of total utility is known as an indifference
curve.
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An Indifference Curve
Quantity of restaurant meals
90
An indifference curve is a
contour line that shows all the
consumption bundles that
yield the same amount of total
utility for an individual.
80
450 utils
70
60
50
40
A
30
B
15
0
Indifference
curve,
1
2
3
4
5
6
7
8
9
10
Quantity of rooms
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An Indifference Curve Map
Quantity of
restaurant meals
Consumption
bundle
Quantity of
rooms
Quantity of
meals
Total utility
(utils)
90
A
3
30
450
80
B
6
15
450
C
5
10
391
D
4
45
519
70
391 utils
60
D
45
A
30
519 utils
B
15
10
0
450 utils
C
1
2
3
4
5
6
I3
I2
I1
7
8
9
10
Quantity of rooms
The entire utility function of an individual can be represented by an
indifference curve map, a collection of indifference curves in which each
curve corresponds to a different total utility level.
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FOR INQUIRING MINDS
Are Utils Useful?

The indifference curve map tells us all we need to know in
order to find a consumer’s optimal consumption bundle.

Economists say that bundle X is better than bundle Y. The
theory does not, however, require “cardinal” utility, which
actually assigns a specific number to the total utility yielded
by each bundle.

So why introduce the concept of utils at all? The answer is
that it is much easier to understand the basis of rational
choice by using the concept of measurable utility.
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Properties of Indifference Curves

All indifference curve maps share two general
properties:



indifference curves never cross
the farther out an indifference curve is from the origin, the
higher the level of total utility it indicates
In addition, indifference curves for most goods,
called ordinary goods, have two more properties:


they are downward sloping
are convex (bowed-in toward the origin) as a result of
diminishing marginal utility
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Properties of Indifference Curves
(a)Properties of All Indifference Curves
Quantity
of
restauran
t meals
Quantity
of
restauran
t meals
200 utils
200 utils
B
100 utils
A
A
I2
I2
100 utils
I1
I1
Quantity of rooms
Quantity of rooms
(b)Additional Properties of Indifference Curves for Ordinary Goods
Quantity
of
restauran
t meals
Quantity
of
restauran
t meals
W
A
X
Y
Steeper
slope
Z
I
Quantity of rooms
B
I
Flatter
slope
Quantity of rooms
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Indifference Curves and Consumer Choice

We will use indifference curve maps to find the
utility-maximizing consumption bundle of a
consumer given his/her budget constraint.

The optimal consumption bundle lies on the budget
line, and the marginal utility per dollar is the same
for every good in the bundle.

The first component of our approach is a new
concept, the marginal rate of substitution.
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The Changing Slope of an Indifference Curve
Quantity of
restaurant
meals
Quantity
of rooms
Quantity of
restaurant
meals
V
2
30
W
3
20
X
4
15
Y
5
12
Z
6
10
Ingrid trades 10
restaurant meals
V
30
Consumption
bundle
. . . for 1 room.
–10
Ingrid trades 2
restaurant meals
W
20
+1
X
15
Y
12
10
0
. . . for 1 room.
Z
–2
I
+1
2
3
4
5
6
Quantity of rooms
The terms of the trade-off between the reduced consumption of
restaurant meals for increased consumption of housing changes
as the consumer moves from V to W. Why?
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Two Opposing Effects on Total Utility

Moving down the indifference curve—reducing
restaurant meal consumption and increasing
housing consumption—will produce two opposing
effects on Ingrid’s total utility:



Lower restaurant meal consumption will reduce her total
utility,
but higher housing consumption will raise her total utility.
And since we are moving down the indifference
curve, these two effects must exactly cancel out.
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Two Opposing Effects on Total Utility

Hence, we can calculate the change in total utility
generated by a change in the consumption bundle
using the following equations:

Change in total utility arising from a change in
consumption of restaurant meals = MUM × ∆QM

Change in total utility arising from a change in
consumption of rooms = MUR × ∆QR
Along the indifference curve:
−MUM × ∆QM = MUR × ∆QR

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Marginal Rate of Substitution

The following equation would also hold along the
indifference curve:
−MUR / MUM = ∆QM /∆QR

Economists have a special name for the ratio of the
marginal utilities in the LHS of this equation and it is
called the marginal rate of substitution, MRS.
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Diminishing Marginal Rate of Substitution

The flattening of indifference curves as you slide
down them to the right—which reflects the same
logic as the principle of diminishing marginal utility—
is known as the principle of diminishing marginal
rate of substitution.

It says that an individual who consumes only a little
bit of good A and a lot of good B will be willing to
trade off a lot of B in return for one more unit of A;
an individual who already consumes a lot of A and
not much B will be less willing to make that tradeoff.
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Diminishing Marginal Rate of Substitution


The principle of diminishing marginal rate of
substitution states that the more of good R a
person consumes in proportion to good M, the less
M he or she is willing to substitute for another unit
of R.
Two goods, R and M, are ordinary goods in a
consumer’s utility function when (1) the consumer
requires additional units of R to compensate for
less M, and vice versa: and (2) the consumer
experiences a diminishing marginal rate of
substitution when substituting one good in place of
another.
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The Optimal Consumption Bundle
Quantity of
restaurant
meals
Optimal
consumption
bundle
80
B
70
60
50
I
A
40
30
3
I
2
20
C
I
1
10
BL
0
2
4
6
8
10
12
14
16
Quantity of rooms
The tangency condition between the indifference curve and the budget line
holds when the indifference curve and the budget line just touch. This condition
determines the optimal consumption bundle when the indifference curves have
the typical convex shape.
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The Slope of the Budget Line

The relative price of good R in terms of good M is
equal to PR /PM, the rate at which R trades for M in
the market.

The relative price rule says that at the optimal
consumption bundle, the marginal rate of
substitution between two goods is equal to their
relative price.
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Prices and the Marginal Rate of Substitution




At the optimal consumption point, the slope of the
indifference curve is just equal to the slope of the
budget line:
 Slope of indifference curve = −MUR /MUM
 Slope of budget line = − (N/PM)/(N/PR) = − PR /PM
Putting these two equations together, we arrive at
the relative price rule.
At the optimal consumption bundle:
 −MUR /MUM = − PR /PM
Optimal consumption rule: MUR / PR= MUM /PM
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Understanding the Relative Price Rule
At the optimal consumption bundle:
Quantity of
restaurant
meals
−MUR /MUM = − PR /PM
80
B
70
At the optimal
consumption
bundle, MRS is
equal to the
relative price.
60
50
A
40
30
I
2
20
C
10
I
1
BL
0
2
4
6
8
10
12
14
16
Quantity of rooms
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Preferences and Choices

When we say that two consumers have different
preferences, we mean that they have different utility
functions.

This, in turn, means that they will have indifference
curve maps with different shapes.

And those different maps will translate into different
consumption choices, even among consumers with
the same income who face the same prices.
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Differences in Preferences
(a) Ingrid’s Preference and Her Optimal Consumption Bundle
Quantity of
restaurant
meals
Ingrid’s
Ingrid and Lars have different
80
optimal
70
preferences. They choose
consumption
60
bundle
different consumption
50
I3
40
bundles.
30
I2
Both of them have an income
20
I1
10
BL
of $2,400 and face prices of
0
2
4
6
8
10 12 14 16
Quantity of rooms $30 per meal and $150 per
(b) Lars’s Preference and His Optimal Consumption Bundleroom.
Quantity of
While Ingrid’s consumption
Lars’s
restaurant
optimal
meals
choice is 8 rooms and 40
80
consumption
bundle
70
restaurant meals, Lars
60
I3
consumes fewer rooms and
50
40
I2
more restaurant meals even
30
I1
though he has the same
20
10
budget line.
BL
0
2
4
6
8
10 12 14 16
Quantity of rooms
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►ECONOMICS IN ACTION
Rats and Rational Choice



The theory of consumer choice does not bear much
resemblance to the way most of us think about our consumption
decisions. The purpose of the theory to help economists think
systematically about how a rational consumer would behave.
The practical consumers actually behave rationally.
Economists have conducted experiments in which rats are
presented with a “budget constraint”—a limited number of times
per hour they can push either of two levers. One of the levers
yields small cups of water; the other yields pellets of food. After
the rats’ choices have been observed, the budget constraint is
changed by varying the number of lever pushes required to get
each good. Sure enough, the rats satisfy the rule for rational
choice.
If rats are rational, can people be far behind?
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A Test for Rationality
Quantity of Y
B
A
C
BL
1
BL
2
Quantity of X
A consumer has the budget line BL1 and chooses the bundle A. If that
consumer is now given a new budget line—BL2, it would be irrational to choose
a bundle such as B; the consumer could have afforded that bundle before but
chose A instead. A rational consumer would always at least stay at A or choose
a new bundle that was not affordable before, such as C. It’s difficult to test
people in this way—but it works for rats!
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Using Indifference Curves: Substitutes and Complements

What determines whether two goods are substitutes
or complements?

It depends on the shape of a consumer’s
indifference curves.

This relationship can be illustrated with two extreme
cases: the cases of perfect substitutes and perfect
complements.
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Perfect Substitutes
Quantity of
peanut
butter
cookies
12
10
8
6
4
2
0
2
I1
I2
4
6
8
10
12
Quantity of chocolate chip cookies
Two goods are perfect substitutes if the marginal rate of
substitution of one good in place of the other good is constant,
regardless of how much of each an individual consumes.
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Consumer Choice Between Perfect Substitutes
(a) Cokie Buys Only Peanut Butter Cookies
Quantity of
peanut
butter
cookies
12
(b) Cokie Buys Only Chocolate Chip Cookies
Quantity of
peanut
butter
cookies 12 I 2
A
10 I 1
10
8
8
6
6
4
4
2
0
BL
2
4
6
I1
I2
8
10 12
Quantity of
chocolate chip
cookies
BL
2
0
2
4
6
B
8
10 12
Quantity of
chocolate chip
cookies
When two goods are perfect substitutes, small price changes can
lead to large changes in the consumption bundle.
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Perfect Complements
Quantity
of milk
(glasses)
A
5
B
C
I
4
I
3
I
2
3
2
I
1
BL
1
0
4
1
2
3
4
5
Quantity of cookies
Two goods are perfect complements when a consumer
wants to consume the goods in the same ratio regardless of
their relative price.
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►ECONOMICS IN ACTION
Publicity or Piracy?





When the practice of audio file-sharing took off in the late
1990s, a controversy erupted at the same time.
Musicians argued that the widespread sharing of audio files was
a modern version of theft.
On the other hand, there were those who argued that instead of
serving as a substitute for buying the CD, file-sharing actually
acted as a compliment. After hearing one or two tracks from a
CD via file sharing, a listener was more likely to go out and buy
the CD. They argued that file-sharing acted like free publicity.
However, the music industry was right because once most
people had downloaded the songs they wanted, they did not
purchase the CD.
So file sharing and CD purchases are substitutes not
compliments.
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Prices, Income, and Demand

How would our consumption choice change if either
the prices of goods or our income change?

First, let’s see the effects of a price increase
illustrated in the following figure.

Then, we will consider the impact of a change in
income.
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PITFALLS
“Other Things Equal,” Revisited
 One of the biggest sources of confusion and error in
economics—both in the classroom and in the real
world—is failure to keep in mind the principle that all
economic relationships are defined “other things
equal.”

The law of demand, which says that increasing the
price of a good reduces the quantity demanded, is only
an “other things equal” proposition; a higher price
results in a lower quantity demanded, holding other
prices and income constant.
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Effects of a Price Increase on the Budget Line
Quantity of
restaurant
meals
80
New BL:
price of rooms
= $600
An increase in the
relative price of
rooms rotates the
budget line inward.
70
60
Original BL:
price of rooms =
$150
50
40
30
20
10
BL
0
2
4
BL
2
6
8
10
12
14
1
16
Quantity of rooms
An increase in the price
of rooms, holding the
price of restaurant
meals constant,
increases the relative
price of rooms in terms
of restaurant meals. As
a result, Ingrid’s original
budget line, BL1, rotates
inward to BL2.
Her maximum possible
purchase of restaurant
meals is unchanged, but
her maximum possible
purchase of rooms is
reduced.
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Responding to a Price Increase
Quantity of
restaurant
meals
New optimal
consumption
bundle
80
70
3. … and
increases
restaurant
meal
consumption.
60
Original
optimal
consumption
bundle
C
50
A
40
I
2
30
Ingrid responds to the
higher relative price of
rooms by choosing a
new consumption bundle
with fewer rooms and
more restaurant meals.
Her new bundle, C,
contains 1 room instead
of 8 and 60 restaurant
meals instead of 40.
20
10
0
1 2
BL
2
4
6
I
1
8
10
12
14
BL
1
16
Quantity of rooms
2. … reduces
housing
consumption
…
1.An increase in the
relative price of rooms
rotates the budget line…
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Effect of a Change in Income on the Budget Line
Quantity of
restaurant
meals
100
80
A fall in income results
in a parallel inward shift
of the budget line.
A rise in income results in
a parallel outward shift of
the budget line.
40
BL
BL
0
8
2
BL
3
1
16
20
Quantity of rooms
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Income and Consumption: Normal Goods
Quantity of
restaurant
meals
At a monthly income of $1,200,
$2,400,
Ingrid
she
chooses
chooses
bundle
bundle
B,A,
consisting of 4
8 rooms and 20
40
restaurant meals. Since
When
relative consumption
Ingrid’s
price remainsof both
unchanged,meals
restaurant
a fall and
in income
rooms
shiftswhen
falls
her budget
her income
line inward
falls, to
BL2. goods are normal goods.
both
Optimal consumption
bundle income at of
$1,200
80
Optimal consumption
bundle at income of
$2,400
70
60
50
3. … and a
fall in
consumption
of restaurant
meals
A
40
I
2
30
B
20
10
0
2
4
6
BL
2
8
10
2. … resulting
in a fall in
consumption
of rooms…
12
I
1
BL
1
14 16
Quantity of rooms
1. A fall in
income shifts
the budget
line inward,
…
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Income and Consumption: An Inferior Good
Quantity of
restaurant
meals
Optimal consumption bundle
at income of $2,400
D
Optimal
consumption
bundle at
income of
$1,200
I
2
3...and a fall
in
consumption
of restaurant
meals
E
BL
2
I
1
BL
1
When Ingrid’s income falls
from $2,400 to $1,200, her
optimal consumption
bundle changes from D to
E. Her consumption of
second-hand furniture
increases, implying that
second-hand furniture is
an inferior good. In
contrast, her consumption
of restaurant meals falls,
implying that restaurant
meals are a normal good.
Quantity of second-hand furniture
2. … resulting in a
rise in consumption
of second-hand
furniture
1. A fall in
income shifts the
budget line
inward, …
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Income and Substitution Effects

The change in a consumer’s optimal consumption
bundle caused by a change in price can be
decomposed into two effects: the substitution effect,
due to the change in relative price, and the income
effect, due to the change in purchasing power.

The substitution effect refers to the substitution of
the good that is now relatively cheaper for the good
that is now relatively more expensive, holding the
utility level constant. It is represented by movement
along the original indifference curve.
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Income and Substitution Effects



When a price change alters a consumer’s
purchasing power, the resulting change in
consumption is the income effect. It is represented
by a movement to a new indifference curve, keeping
the relative price unchanged.
For normal goods, the income and substitution
effects work in the same direction; so their demand
curves always slope downward.
Although these effects work in opposite directions
for inferior goods, their demand curves usually slope
downward as well because the substitution effect is
typically stronger than the income effect. The
exception is the case of a Giffen good.
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Income and Substitution Effects
Quantity of
restaurant meals
Hypothetical
optimal
consumption
bundle
180
160
140
B
120
New optimal
consumption
bundle
100
Original
optimal
consumption
bundle
80
60
A
C
40
I
BL
20
BL
0
1
2
4
S
I
2
6
2
8
1
10
BL
12
14
1
16
Quantity of rooms
Income effect
Substitution effect
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►ECONOMICS IN ACTION
How Much Housing?

To illustrate the substitution effect, an example was given
where an individual moves form Cincinnati to San Jose,
gaining higher income but facing a higher price of housing.
Also, the cost of living in San Jose is about twice that in
Cincinnati. So, on average, families live about as well in the
two metropolitan areas.

But they don’t live the same way because the relative prices
are different. Houses are typically smaller in San Jose, with
fewer rooms and fewer square feet. Most noticeably, the
great majority of new homes in the Cincinnati area are
single-family houses on big lots; in San Jose, people are
much more likely to live in townhouses or apartments.
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SUMMARY
1. Preferences can be represented by an indifference curve
map, a series of indifference curves. Each curve shows
all the consumption bundles that yield a given level of total
utility. Indifference curves never cross, and greater
distance from the origin indicates higher total utility levels.
The indifference curves of ordinary goods slope downward
and are convex in shape.
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SUMMARY
2. The marginal rate of substitution, or MRS, of R in place
of M—the rate at which a consumer is willing to substitute
more R for less M—is equal to MUR/MUM and is also
equal to minus the slope of the indifference curve when R
is on the horizontal axis and M is on the vertical axis.
Convex indifference curves get flatter as you move to the
right along the horizontal axis and steeper as you move
upward along the vertical axis because of diminishing
marginal utility: a consumer requires more and more units
of R to substitute for a forgone unit of M as the amount of
R consumed rises relative to the amount of M consumed.
3. Most goods are ordinary goods, goods for which a
consumer requires additional units of some other good as
compensation for giving up some of the good and for
which there is diminishing marginal rate of substitution.
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SUMMARY
4. A consumer maximizes utility by moving to the highest
indifference curve his or her budget constraint allows.
Using the tangency condition, the consumer chooses the
bundle at which the indifference curve just touches the
budget line. At this point, the relative price of R in terms of
M, PR/PM (which is equal to minus the slope of the budget
line when R is on the horizontal axis and M is on the
vertical axis) is equal to the marginal rate of substitution of
R in place of M, MUR/MUM (which is equal to minus the
slope of the indifference curve). This gives us the relative
price rule: at the optimal consumption bundle, the relative
price is equal to the marginal rate of substitution.
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SUMMARY
5. When the marginal rate of substitution is constant, two
goods are perfect substitutes and indifference curves are
straight lines: there is only one relative price at which the
consumer is willing to purchase both goods. When a
consumer wants to consume the two goods in the same
ratio, regardless of the relative price, the goods are
perfect complements. In this case, the indifference
curves form right angles and the marginal rate of
substitution is undefined.
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SUMMARY
6. The effect of a change in price on consumer choice can be
decomposed into the substitution effect and the income
effect. The substitution effect is shown by a movement
along the original indifference curve in response to the
change in relative price, as the consumer substitutes more
of the relatively cheaper good in place of the relatively
more expensive good. The income effect is shown by a
change to a new indifference curve, reflecting the fact that
a change in a good’s price alters the purchasing power of
a given level of income.
7. The income and substitution effects work in the same
direction for normal goods, ensuring that demand curves
slope downward.
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The End of Chapter 11
Coming attraction:
Chapter 12:
Behind the Supply Curve:
Inputs and Costs
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