Transcript Session15-TheoryofConsumerBehaviour

Economic Analysis
for Business
Session XV: Theory of Consumer
Choice (Chapter 21)
Instructor
Sandeep Basnyat
9841892281
[email protected]
ACTIVE LEARNING
1:
Budget constraint
The consumer’s income: $1000
Prices: $10 per pizza, $2 per pint of Pepsi
A. If the consumer spends all his income on pizza, how
many pizzas does he buy?
B. If the consumer spends all his income on Pepsi, how
many pints of Pepsi does he buy?
C. If the consumer spends $400 on pizza,
how many pizzas and Pepsis does he buy?
D. Plot each of the bundles from parts A-C on a diagram
that measures the quantity of pizza on the horizontal
axis and quantity of Pepsi on the vertical axis, then
connect the dots.
2
ACTIVE LEARNING
Answers
A. $1000/$10
= 100 pizzas
B. $1000/$2
= 500 Pepsis
C. $400/$10
= 40 pizzas
$600/$2
= 300 Pepsis
1:
D. The budget constraint
shows the various
combinations of goods
the consumer can afford
given his or her income
and the prices of the
two goods.
Pepsis
B
500
400
C
300
200
100
A
0
0
20 40 60 80 100 Pizzas
3
The Slope of the Budget Constraint
From C to D,
Pepsis
“rise” = –100
Pepsis
500
“run” = +20 pizzas 400
Slope = –5
C
300
Consumer must
200
give up 5 Pepsis to
get another pizza. 100
D
0
0
20 40 60 80 100 Pizzas
CHAPTER 21 THE THEORY
OF CONSUMER CHOICE
The Slope of the Budget Constraint
 The slope of the budget constraint equals
◦ the rate at which the consumer
can trade Pepsi for pizza: the opportunity cost
of pizza in terms of Pepsi
◦ the relative price of pizza: price of one good
compared to the other
price of pizza
$10

 5 Pepsis per pizza
price of Pepsi
$2
CHAPTER 21 THE THEORY
OF CONSUMER CHOICE
ACTIVE LEARNING
Exercise
What happens to
the budget
constraint if:
A. Income falls to
$800
2:
Pepsis
500
400
300
200
100
0
0
20 40 60 80 100 Pizzas
6
ACTIVE LEARNING
Answers
Consumer
can buy
$800/$10
= 80 pizzas
or $800/$2
= 400 Pepsis
or any
combination
in between.
2A:
A fall in income
shifts the budget
constraint inward.
Pepsis
500
400
300
200
100
0
0
20 40 60 80 100 Pizzas
7
ACTIVE LEARNING
Exercise
What happens to
the budget
constraint if:
B. The price of
Pepsi rises to
$4/pint.
2:
Pepsis
500
400
300
200
100
0
0
20 40 60 80 100 Pizzas
8
ACTIVE LEARNING
Answers
Consumer
can still buy
100 pizzas.
But now,
can only buy
$1000/$4
= 250 Pepsis.
2B:
Pepsis
500
An increase in the price
of one good pivots the
budget constraint inward.
400
300
200
Notice: slope is
100
smaller, relative price
of pizza now only 2.5 0
Pepsis.
0
20 40 60 80 100 Pizzas
9
PREFERENCES: WHAT THE CONSUMER
WANT
The consumer’s preferences allow him to
choose among different bundles of the same
goods he wants, for example Pepsi and Pizza,
that best suits his tastes.
 If the two bundles suit his tastes equally well,
the consumer is indifferent between two
bundles.
 A graphical representation of the bundles of
consumption that make the consumer equally
happy is called the indifference curve.

The Consumer’s Preferences
Quantity
of Pepsi
An indifference curve is a curve that
shows consumption bundles that give
the consumer the same level of
satisfaction, such as in points A, B or C
C
B
A
0
If the consumption of pizza is reduced,
consumption of Pepsi must increase to
keep him equally happy.
Indifference
curve, I1
Quantity
of Pizza
The Consumer’s Preferences-MRS
The slope at any point on an indifference curve is the
Marginal Rate of Substitution MRS
Quantity
of Pepsi
• MRS is the rate at which a consumer is
willing to trade one good for another.
• It is the amount of one good that a
consumer requires as compensation to
give up one unit of the other good.
C
200
B
MRS
100
5
A
0
30
50
MRS tells how much Pepsi the consumer requires to be
compensated for a one unit increase in pizza consumption
Indifference
curve, I1
Quantity
of Pizza
Higher and Lower Indifference Curves: Indifference Map
Higher indifference
curves represent higher
level of satisfaction
Quantity
of Pepsi
C
E
B
MRS
D
I2
5
A
0
Indifference
curve, I1
Quantity
of Pizza
Four Properties of Indifference Curves
Higher indifference curves are preferred
to lower ones.
 Indifference curves are downward sloping.
 Indifference curves do not cross.
 Indifference curves are bowed inward.

Four Properties of Indifference Curves

Property 1: Higher indifference curves are
preferred to lower ones.
◦ Consumers usually prefer more of something
to less of it.
◦ Higher indifference curves represent larger
quantities of goods than do lower indifference
curves.
The Consumer’s Preferences
Quantity
of Pepsi
C
B
D
I2
A
0
Indifference
curve, I1
Quantity
of Pizza
Four Properties of Indifference Curves

Property 2: Indifference curves are
downward sloping.
◦ A consumer is willing to give up one good
only if he or she gets more of the other good
in order to remain equally happy.
◦ If the quantity of one good is reduced, the
quantity of the other good must increase.
◦ For this reason, most indifference curves
slope downward.
The Consumer’s Preferences
Quantity
of Pepsi
Indifference
curve, I1
0
Quantity
of Pizza
Four Properties of Indifference Curves

Property 3: Indifference curves do not
cross.
◦ Points A and B should make the consumer
equally happy.
◦ Points B and C should make the consumer
equally happy.
◦ This implies that A and C would make the
consumer equally happy.
◦ But C has more of both goods compared to
A.
The Impossibility of Intersecting Indifference Curves
Quantity
of Pepsi
C
A
B
0
Quantity
of Pizza
Four Properties of Indifference Curves

Property 4: Indifference curves are bowed
inward.
◦ People are more willing to trade away goods
that they have in abundance and less willing to
trade away goods of which they have little.
◦ These differences in a consumer’s marginal
substitution rates cause his or her
indifference curve to bow inward.
Bowed Indifference Curves
Quantity
of Pepsi
14
MRS = 6
A
8
1
4
3
0
B
MRS = 1
1
2
3
6
Indifference
curve
7
Quantity
of Pizza
Two Extreme Examples of Indifference
Curves

Perfect substitutes
◦ Goods that can be exactly substitutable
◦ Consumers value both goods exactly equal

Perfect complements
◦ Goods that need exact combination to form a
product
◦ Consumers benefit extra unit of good A only
if he/she has extra unit of good B
Perfect Substitutes and Perfect Complements
(a) Perfect Substitutes
50 cents
Perfect Substitutes
• Because the MRS is constant,
two goods with straight-line
indifference curves are perfect
substitutes.
• The marginal rate of substitution
is a constant number.
6
4
2
I1
0
1
I2
2
I3
3
$ amount
Perfect Substitutes and Perfect Complements
(b) Perfect Complements
Perfect Complements
Two goods with right-angle
indifference curves are perfect
complements.
Left
Shoes
9
7
I2
5
I1
0
5
7
9
Right Shoes
OPTIMIZATION: HOW THE
CONSUMER CHOOSES?
Step 1:
Consumer chooses to buy on or below his
budget constraint.
 Step 2:
He get the combination of goods on the
highest possible indifference curve.

The Consumer’s Optimum
Consumer optimum occurs at the point
where the highest indifference curve
and the budget constraint are tangent
(slope of budget constraint and
indifference curve is equal).
Quantity
of Pepsi
Optimum
B
A
I3
I2
I1
Budget constraint
0
Note:
Slop of ID curve: MRS
Slop of BC: Relative price of
Pepsi and Pizza
Quantity
of Pizza
The Consumer’s Optimal Choice
The consumer chooses consumption of the two
goods so that the marginal rate of substitution
equals the relative price.
 At the consumer’s optimum, the consumer’s
valuation of the two goods equals the market’s
valuation.

◦ Consumer takes as given the relative price of the two
goods and then chooses an optimum at which his
MRS equals the relative price.
◦ The relative price is the rate at which market is
willing to trade one good for another, whereas the
MRS is the rate at which the consumer is willing to
trade one good for another.
Cases: Income effect and Price Effect

What happens when consumer’s income
level increases? (Income effect)
◦ A) Normal good: consumption increases, and,
◦ B) Inferior good: consumption decreases
An Increase in Income-Normal goods: Pepsi and Pizza
Quantity
of Pepsi
New budget constraint
I2
Initial
optimum
I3
Initial
budget
constraint
0
Which
Indifference
curve would
the consumer
chose?
I1
Quantity
of Pizza
An Increase in Income-Normal goods case
Quantity
of Pepsi
New budget constraint
New optimum
Initial
optimum
Initial
budget
constraint
0
I3
I1
Quantity
of Pizza
Increase in Income- An Inferior Good case (Pepsi)
Quantity
of Pepsi
New budget constraint
Initial
optimum
New optimum
Initial
budget
constraint
0
I1
I2
Quantity
of Pizza
Cases

What happens when consumer’s income
level increase or decreases?
◦ Normal good and inferior good cases


What happens when price of the good(s)
increases or decreases? (Price effect)
Assume that price of Pepsi decreases
from $2 to $1 per pint.
Price Effect
Interaction
Pepsi is
relatively
cheaper
Effect 1
Pizza is
relatively
expensive
Effect
Opportunity
cost of
buying Pizza
is higher
Buy more
Pepsi and less
Pizza
Moves to another
combination of Indifference
curve
Substitution effect
Price Effect
Interaction
Pepsi is
relatively
cheaper
Effect
I1
Can buy
more
goods with
extra
money
Income
level
increased
Jumps to
higher
indifference
curve
Income effect
Effect
Normal
Good Buy more
goods
Inferior Good
- Buy less of
inferior goods
Price Effect

Total Price Effect =
Substitution effect + Income Effect
A Change in Price- Price of Pepsi decreases from $2 to $1
Quantity
of Pepsi
New budget constraint
Substitution
Income
Total effect
effect
effect
C New optimum
B
Initial optimum
Initial
budget
constraint
A
I2
I1
0
Quantity
of Pizza
Total effect of Price decrease of Good X on
Quantity demanded of Good X
Total effect of = Substitution+ Income
price
effect
effect
decrease 9 = 5
+ 4
Total effect of = Substitution+ Income
price
effect
effect
decrease 3 = 5
+ (-2)
5-38
Generalization: Income and Substitution Effects

The Income Effect
◦ The income effect is the change in consumption that
results when a price change moves the consumer to a
higher or lower indifference curve

The Substitution Effect
◦ The substitution effect is the change in consumption that
results when a price change moves the consumer along
an indifference curve to a point with a different marginal
rate of substitution.
THREE APPLICATIONS
Do all demand curves slope downward?
 How do wages affect labour supply?
 How do interest rates affect household
savings?

THREE APPLICATIONS

Do all demand curves slope downward?
◦ Demand curves can sometimes slope upward.
◦ This happens when a consumer buys more of
a good when its price rises.
◦ Giffen goods
 Economists use the term Giffen good to describe a
good that violates the law of demand.
 Giffen goods are goods for which an increase in the
price raises the quantity demanded.
 The income effect dominates the substitution effect.
 They have demand curves that slope upwards.
Reasons:
Application I: A Giffen Good
Quantity of
Potatoes
Initial budget constraint
B
Optimum with high
price of potatoes
Optimum with low
price of potatoes
D
E
2. . . . which
increases
potato
consumption
if potatoes
are a Giffen
good.
1. An increase in the price of
potatoes rotates the budget
constraint inward . . .
C
New budget
constraint
0
1. Potatoes 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
2. Because potatoes are more
expensive, substitution effect
makes the consumer want to
buy more meat but income
effect is so strong that it
exceeds the substitution
effects
I2
A
I1
Quantity
of Meat
What happens when the wage rate
increases?
◦ When wage rate increases,
a) If people find that spending more time on
leisure activity incur higher opportunity costs,
the substitution effect is greater than the income
effect for them and they work more.
b) If people find that increase in wage rate is an
increase in their income level, income effect is
greater than the substitution effect for them and
they spend more time on leisure and works less
or the same amount.
Application II: The Work-Leisure Decision
Consumption
What happens
when the wage
increases?
$5,000
Optimum
I3
2,000
I2
I1
0
60
100
Hours of Leisure
An Increase in the Wage: Substitution effect-Income effect
(a) For a person with substitution effect. . .
Hours of work
(b) For a person with Income effect
Hours of work
...
BC2
1. When the wage rises . . .
1. When the wage rises . . .
BC1
BC1
BC2 I2
I2
I1
I1
0
2. . . . hours of leisure decrease . . .
Hours of
Leisure
0
2. . . . hours of leisure increase . . .
Hours of
Leisure
How do interest rates affect
household saving?
◦ If the substitution effect of a higher interest
rate is greater than the income effect,
households save more.
◦ If the income effect of a higher interest rate is
greater than the substitution effect,
households spend more and save less or
remain constant.
Application III: The Consumption-Saving Decision
Consumption Budget
when Old constraint
What happens
when the bank
interest rate
increases?
$110,000
55,000
Optimum
I3
I2
I1
0
$50,000
100,000
Consumption
when Young
An Increase in the Interest Rate-Substitution and Income Effect
(a) Higher Interest Rate Raises Saving
Consumption
when Old
(b) Higher Interest Rate Lowers Saving
Consumption
when Old
BC2
BC2
1. A higher interest rate rotates
the budget constraint outward . . .
1. A higher interest rate rotates
the budget constraint outward . . .
BC1
BC1
I2
I1
I2
I1
0
2. . . . resulting in lower
consumption when young
and, thus, higher saving.
Consumption
when Young
0
2. . . . resulting in higher
consumption when young
and, thus, lower saving.
Consumption
when Young
Thus, an increase in the interest rate could either encourage or
discourage saving.
Thank you