Consumer Choices and Economic Behavior Chapter 5: Consumer Choices and Economic Behavior

Key Topics The budget constraint Utility Definition, equation, graph, opportunity cost Impact of ΔI, ΔPx, ΔPy Utility Total and marginal Indifference curve: definition, slope Utility maximization

Key Topics 3. Downward-sloping demand factors Diminishing marginal utility Income effect Substitution effect 4. Other consumer decisions Work or leisure Save or borrow

Questions What does it mean if you have a ‘budget constraint’? How can your attainable consumption choices be shown mathematically and graphically?

Budget Constraint The maximum Q combinations of goods that can be purchased given one’s income and the prices of the goods.

Budget Constraint Variables I (or M) = the amount of income or money that a consumer has to spend on specified goods and services. X = the quantity of one specific good or one specific bundle of goods Y = the quantity of a second specific good or second specific bundle of goods Px = the price or per unit cost of X PY = the price or per unit cost of Y

Budget Line Equation Income = expenses I = PxX+PYY Y = l/PY – (Px/PY)X  straight line equation

The Opportunity Set

Budget Line: Axis Intercepts & Slope Vertical Axis Intercept = I/PY = max Y (X = 0) Horizontal Axis Intercept = I/PX = max X (Y = 0) - Slope = PX/PY = ‘inverse’ P ratio = X axis good P/Y axis good P = Y/X

Changes in the Budget Line Changes in Income - Increases lead to a parallel, outward shift in the budget line. - Decreases lead to a parallel, downward shift.

Changes in the Budget Line Changes in Price - A decrease in the price of good X rotates the budget line counter-clockwise. - An increase rotates the budget line clockwise. Y New budget line for a price decrease X

Q. What Are Your Preferences? Lunch A: 1 drink, 1 pizza slice B: 1 drink, 2 pizza slices C: 2 drinks, 1 pizza slice Entertainment A: 1 movie, 1 dinner B: 1 movie, 2 dinners C: 2 movies, 1 dinner For each, indicate which of the following you prefer: A vs B, B vs C, or A vs C

Utility Concepts Utility: satisfaction received from consuming goods Cardinal utility: satisfaction levels that can be measured or specified with numbers (units = ‘utils’) Ordinal utility: satisfaction levels that can be ordered or ranked Marginal utility: the additional utility received per unit of additional unit of an item consumed (ΔU/ ΔX)

Utility Assumptions Complete (or continuous)  can rank all bundles of goods Consistent (or transitive)  preference orderings are logical and consistent Consumptive (nonsatiation)  more of a ‘normal’ good is preferred to less

More of a Good is Preferred to Less The shaded area represents those combinations of X and Y that are unambiguously preferred to the combination X*, Y*. Ceteris paribus, individuals prefer more of any good rather than less. Combinations identified by “?” involve ambiguous changes in welfare since they contain more of one good and less of the other.

Indifference Curve Indifference Curve A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction. Curves further from origin represent higher utility levels

A ‘bad’ good, or an economic ‘bad’ is an item that a consumer does not like or enjoy, which means their total satisfaction level is lower the more of the item they have. This also means the marginal utility of the item is negative.

MRS & MU MRS = - slope of indifference curve = -Y/ X = the rate at which a consumer is willing to exchange Y for 1more (or less) unit of X U = 0 along given indiff curve = MUx(X)+MUY(Y) = 0 = - Y/ X = MUx/MUY = - slope = inverse MU ratio

Consumer Equilibrium (U Max) The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction.

Equal Slopes Condition (for consumer equilibrium) MUX/MUY = PX/PY MUX/PX = MUY/PY

Individual Demand Curve An individual’s demand curve is derived from each new equilibrium point found on the indifference curve as the price of good X is varied.

Diminishing Marginal Utility The law of diminishing marginal utility: The more of one good consumed in a given period, the less satisfaction (utility) generated by consuming each additional (marginal) unit of the same good.

Diminishing Marginal Utility and Downward-Sloping Demand Diminishing marginal utility helps to explain why demand slopes down. Marginal utility falls with each additional unit consumed, so people are not willing to pay as much. 40 Price per meal ($) 25 15 D 5 10 25 Thai meals per month

Income and Substitution Effects of a Price Change (for normal goods) Price of a good or service Household is better off (higher real income) Income effect Household buys more FALLS Opportunity cost of the good falls Substitution effect Household buys more Household is worse off (lower real income) Income effect Household buys less RISES Opportunity cost of the good rises. Substitution effect Household buys less

Household Choices in Labor Markets As in output markets, households face constrained choices in input markets. They must decide: Whether to work How much to work What kind of a job to work at These decisions are affected by: The availability of jobs Market wage rates The skill possessed by the household

The Price of Leisure W = wage rate = the price (or the opportunity cost or lost benefits) of either unpaid work or leisure.

Work vs. Leisure Constraint Income 24W Leisure (hrs/day) 24

The Labor Supply Curve The labor supply curve is a diagram that shows the quantity of labor supplied at different wage rates.

Saving and Borrowing: Present Versus Future Consumption Households can use present income to finance future spending (i.e., save), or they can use future funds to finance present spending (i.e., borrow). In deciding how much to save and how much to spend today, interest rates define the opportunity cost of present consumption in terms of foregone future consumption.

Q1 (next yr) save I1/P borrow Q0 (this yr) I0/P