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© 2010 Pearson Addison-Wesley CHAPTER 1

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© 2010 Pearson Addison-Wesley

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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 households consumption choices.

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© 2010 Pearson Addison-Wesley Figure 9.1 shows Lisas budget line. Divisible goods can be bought in any quantity along the budget line (gasoline, for example). Indivisible goods must be bought in whole units at the points marked (movies, for example). Consumption Possibilities

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© 2010 Pearson Addison-Wesley The budget line is a constraint on Lisas choices. Lisa can afford any point on her budget line or inside it. Lisa cannot afford any point outside her budget line. Consumption Possibilities

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© 2010 Pearson Addison-Wesley 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 P S, the quantity of soda Q S, the price of a movie P M, the quantity of movies Q M, and income Y. Lisas budget equation is: P S Q S + P M Q M = Y. Consumption Possibilities

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© 2010 Pearson Addison-Wesley P S Q S + P M Q M = Y Divide both sides of this equation by P S, to give: Q S + (P M /P S )Q M = Y/P S Then subtract (P M /P S )Q M from both sides of the equation to give: Q S = Y/P S – (P M /P S )Q M Y/P S is Lisas real income in terms of soda. P M /P S is the relative price of a movie in terms of soda. Consumption Possibilities

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© 2010 Pearson Addison-Wesley A households real income is the income expressed as a quantity of goods the household can afford to buy. Lisas 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. Relative price is the magnitude of the slope of the budget line. The relative price shows how many cases of soda must be forgone to see an additional movie. Consumption Possibilities

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© 2010 Pearson Addison-Wesley A Change in Prices A rise in the price of the good on the x-axis decreases the affordable quantity of that good and increases the slope of the budget line. Figure 9.2(a) shows the rotation of a budget line after a change in the relative price of movies. Consumption Possibilities

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© 2010 Pearson Addison-Wesley A Change in Income An change in money income brings a parallel shift of the budget line. The slope of the budget line doesnt change because the relative price doesnt change. Figure 9.2(b) shows the effect of a fall in income. Consumption Possibilities

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© 2010 Pearson Addison-Wesley An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. Figure 9.3(a) illustrates a consumers indifference curve. At point C, Lisa sees 2 movies and drinks 6 cases of soda a month. Preferences and Indifference Curves

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© 2010 Pearson Addison-Wesley Preferences and Indifference Curves Lisa can sort all possible combinations of goods into three groups: preferred, not preferred, and just as good as point C. 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 point C and point G.

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© 2010 Pearson Addison-Wesley 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

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© 2010 Pearson Addison-Wesley A preference map is series of indifference curves. Call the indifference curve that weve just seen I 1. I 0 is an indifference curve below I 1. Lisa prefers any point on I 1 to any point on I 0. Preferences and Indifference Curves

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© 2010 Pearson Addison-Wesley I 2 is an indifference curve above I 1. Lisa prefers any point on I 2 to any point on I 1. For example, Lisa prefers point J to either point C or point G. Preferences and Indifference Curves

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© 2010 Pearson Addison-Wesley Marginal Rate of Substitution The marginal rate of substitution, (MRS) measures the rate at which a person is willing to give up good y to get an additional unit of good x while 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

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© 2010 Pearson Addison-Wesley 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

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© 2010 Pearson Addison-Wesley 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, while at the same time remain indifferent as the quantity of good x increases. Preferences and Indifference Curves

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© 2010 Pearson Addison-Wesley Figure 9.4 shows the diminishing MRS of movies for soda. At point C, Lisa is willing to give up 2 cases of soda to see one more movieher MRS is 2. At point G, Lisa is willing to give up 1/2 case of soda to see one more movieher MRS is 1/2. Preferences and Indifference Curves

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© 2010 Pearson Addison-Wesley Degree of Substitutability The shape of the indifference curves reveals the degree of substitutability between two goods. Figure 9.5 shows the indifference curves for ordinary goods, perfects substitutes, and perfect complements. Preferences and Indifference Curves

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© 2010 Pearson Addison-Wesley Predicting Consumer Choices Best Affordable Choice The consumers best affordable choice 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

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© 2010 Pearson Addison-Wesley Here, the best affordable point is C. Lisa can afford to consume more soda and see fewer movies at point F. And she can afford to see more movies and consume less soda at point H. But she is indifferent between F, I, and H and she prefers C to I. Predicting Consumer Choices

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© 2010 Pearson Addison-Wesley At point F, Lisas MRS is greater than the relative price. At point H, Lisas MRS is less than the relative price. At point C, Lisas MRS is equal to the relative price. Predicting Consumer Choices

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© 2010 Pearson Addison-Wesley 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 9.7 illustrates the price effect and shows how the consumers demand curve is generated. Initially, the price of a movie is $8 and Lisa consumes at point C in part (a) and at point A in part (b).

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© 2010 Pearson Addison-Wesley The price of a movie then falls to $4. The budget line rotates outward. Lisas 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 …

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© 2010 Pearson Addison-Wesley A Change in Income The effect of a change in income on the quantity of a good consumed is called the income effect. Figure 9.8 illustrates the effect of a decrease in Lisas income. Initially, Lisa consumes at point J in part (a) and at point B on demand curve D 0 in part (b). Predicting …

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© 2010 Pearson Addison-Wesley Lisas 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 …

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© 2010 Pearson Addison-Wesley Predicting Consumer Choices 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

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© 2010 Pearson Addison-Wesley Initially, Lisa has an income of $40, the price of a movie is $8, and she consumes at point C. Lisas best affordable point is then J. The move from point C to point J is the price effect. The price of a movie falls from $8 to $4 and her budget line rotates outward. Predicting Consumer Choices

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© 2010 Pearson Addison-Wesley Were going to break the move from point C to point J into two parts. The first part is the substitution effect and the second is the income effect. Predicting Consumer Choices

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© 2010 Pearson Addison-Wesley Substitution Effect The substitution effect is the effect of a change in price on the quantity bought when the consumer remains on the same indifferent curve. Predicting Consumer Choices

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© 2010 Pearson Addison-Wesley 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 Choices

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© 2010 Pearson Addison-Wesley The direction of the substitution effect never varies: When the relative price falls, the consumer always substitutes more of that good for other goods. The substitution effect is the first reason why the demand curve slopes downward. Predicting Consumer Choices

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© 2010 Pearson Addison-Wesley Income Effect To isolate the income effect, we reverse the hypothetical pay cut and restore Lisas income to its original level (its actual level). Lisa is now back on indifference curve I 2 and her best affordable point is J. The move from K to J is the income effect. Predicting Consumer Choices

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© 2010 Pearson Addison-Wesley For Lisa, movies are a normal good. With more income to spend, she sees more moviesthe 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 Choices

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© 2010 Pearson Addison-Wesley Inferior Goods For an inferior good, when income increases, the quantity bought decreases. The income effect is negative and works against the substitution effect. So long as the substitution effect dominates, the demand curve still slopes downward. Predicting Consumer Choices

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© 2010 Pearson Addison-Wesley If the negative income effect is stronger than the substitution effect, a lower price for inferior goods brings a decrease in the quantity demandedthe demand curve slopes upward! This case does not appear to occur in the real world. Predicting Consumer Choices

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© 2010 Pearson Addison-Wesley The model of consumer choice can be used to study the allocation of time between work and leisure. The two goods are leisure and incomewhere income represents all other goods. Lisa buys leisure by not supplying labor and by forgoing income. So the price of leisure is the wage rate forgone. Work-Leisure Choices

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© 2010 Pearson Addison-Wesley The Labor Supply Curve By changing the wage rate, we can find a persons labor supply curve. An increase in the 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

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© 2010 Pearson Addison-Wesley 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 as the wage rate rises. When the wage rate rises from $5 to $10 an hour, work increases from 20 to 35 hours a weekthe move from A to B.

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© 2010 Pearson Addison-Wesley But if the income effect is stronger than the substitution effect, the quantity of work hours decreases as the wage rate rises. When the wage rate rises from $10 to $15 an hour, work decreases from 35 to 30 hours a week the move from B to C. Work-Leisure Choices

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© 2010 Pearson Addison-Wesley The move from A to B when the wage rate increases from $5 to $10 an hour 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 an hour means that the labor supply curve bends backward above a certain wage rate. Work-Leisure Choices

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© 2010 Pearson Addison-Wesley Historical evidence shows that the average workweek has fallen steadily as the wage rate has increased. With higher wage rates, people have decided to use their higher incomes in part to buy more leisure. Work-Leisure Choices

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