Constraints, Choices, and Demand chapter 5 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Learning Objectives Demonstrate how price and income affect a consumer’s budget line. Determine a consumer’s best choice based on his preferences and budget line. Understand how find a consumer’s best choice by maximizing a utility function. Analyze the effects of changes in prices and income on a consumer’s demand. Show how volume-sensitive prices affect a consumer’s budget line and choices. Explain how economists determine consumers’ preferences based on based on their choices. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Overview Prices and income determine a consumer’s budget constraint Given her preferences and budget constraint, a consumer selects the optimal consumption bundle Changes in price or income affect a consumer’s optimal choice Several new tools will allow us to better represent consumer preferences and behavior Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Income, Prices, and the Budget Constraint A consumer’s income consists of the money he receives during some fixed period of time A consumer can afford to purchase a particular consumption bundle if its cost does not exceed his income for that period Budget constraint: cost of consumption bundle ≤ income Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Example – Budget Constraint   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Example – Budget Constraint   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Changes in Income and the Budget Line Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Changes in Price and the Budget Line Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Properties of Budget Lines Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Choosing Among Affordable Bundles B is preferred to A because it contains more yogurt and more pizza than bundle A D is the best choice because no affordable bundle lies on a higher indifference curve Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Choosing Among Affordable Bundles E is not a best choice because there are other affordable bundles that are better than E (for example, G) Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Special Case – Perfect Complements Maria always buys the same number of left and right shoes, independently of the slope of the budget line Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Interior Solutions   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Boundary Solutions A consumption bundle that does not contain at least a little bit of every good is called a boundary choice Bundle B is the consumer’s best affordable bundle, and a boundary solution Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Properties of Best Choices Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Utility Maximization   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Example – Utility Maximization   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Example – Utility Maximization   Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Prices and Demand Price-consumption curve Individual demand curve Price changes and shifts in demand Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Price-Consumption Curve The price-consumption curve shows how the best affordable consumption bundle changes as the price of a good changes, holding everything else fixed Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Individual Demand Curve An individual demand curve describes the relationship between the price of a good and the amount of a particular consumer purchases, holding everything else fixed The demand curve is similar to the price-consumption curve, with different axes Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Price Changes and Shifts in Demand A change in the price of one good can shift the demand for a second good For example, a decrease in the price of butter (L1 to L3) causes a decrease in the quantity demanded of margarine without a change in the price of margarine Thus, in this example a decrease in the price of butter causes the demand for margarine to shift to the left Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Price Changes and Shifts in Demand The effect of the change in the price of one good on the demand for a second good will depend on whether they are substitutes or complements (or neither) Substitutes: a decrease in P1 leads to a leftward shift in the demand for P2 Complements: a decrease in P1 leads to a rightward shift in the demand for P2 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Income and Demand Income-consumption curve Normal vs. inferior goods Engel curve Changes in income and shifts in the demand curve Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Income-Consumption Curve An income effect is the change in the consumption of a good that results from a change in income The income-consumption curve shows how the best affordable consumption bundle changes as income changes, holding everything else fixed Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Normal vs. Inferior Goods Potatoes are inferior in this region Potatoes are normal in this region Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Normal vs. Inferior Goods Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Properties of Normal and Inferior Goods The income elasticity of demand is positive for normal goods and negative for inferior goods. We can tell whether goods are normal or inferior by examining the slope of the income-consumption curve. At least one good must be normal starting from any particular income level. No good can be inferior at all levels of income. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Engel Curve The Engel curve for a good describes the relationship between income and the amount consumed, holding everything else fixed In this example, yogurt is a normal good at all levels of income (upward sloping Engel curve) Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Engel Curve The Engel curve for a good describes the relationship between income and the amount consumed, holding everything else fixed In this example, potatoes are normal when income is less than $36 and inferior when income is greater than $36 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Income Changes and Shifts in Demand For a normal good, an increase in income shifts the demand curve to the right Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Volume-Sensitive Pricing So far we have assumed that every good is available in unlimited quantities at a single price In practice, the price paid for a good can depend on the volume purchased – volume-sensitive pricing Volume penalty occurs when a good’s price per unit rises with the amount purchased Volume discount occurs when a good’s price per units falls with the amount purchased Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Example – Volume Penalties With a volume penalty on usage over 500 kwh of electricity, the portion of the budget constraint that runs between bundle C and the horizontal axis rotates toward the origin When the government or a supplier limits the amount that each consumer can purchase, we say that the good is rationed Rationing is similar to a very large volume penalty Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Example – Volume Discounts With a volume discount on usage over 500 kwh of electricity, the portion of the budget constraint that runs between bundle C and the horizontal axis rotates away from the origin Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Determining a Consumer’s Preferences Two ways to learn about consumer preferences Ask consumers to tell us what they like and dislike Revealed preference approach: infer a consumer’s preferences from her actual choices Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Principle of Revealed Preference One consumption bundle is revealed preferred to another if the consumer chooses it when both are available If bundle A is purchased, it is revealed preferred to each of the bundles in the yellow area Each bundle in the blue area should be preferred to A The indifference curve running through A must lie entirely in the two unshaded areas Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Principle of Revealed Preference A is revealed preferred to B B is revealed preferred to E and all other bundles in the yellow area By transitivity, A must be preferred to the bundles in the yellow area Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Principle of Revealed Preference G is revealed preferred to A All bundles in the blue rectangle are preferred to G (by more-is-better principle). Thus, they are preferred to A too (by transitivity) If the indifference curve has a declining MRS, all bundles in the blue triangle are also preferred to A Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Review The consumer’s best choice lies on the budget line The affordable bundle that maximizes the utility function is the consumer’s best choice Interior solutions always satisfy the tangency condition When the price of one good changes, the demand curve for another good may shift When income changes, the demand for a good will shift, with the direction of the shift determined by whether the good is normal or inferior at that level of income Consumer choices reveal their preferences Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Looking forward Next, we will learn how we can use demand curves to measure changes in consumer welfare We will dissect the effects of a price change, and we will build a different type of demand curve that will allow us to better analyze consumer welfare We will also apply what we already know about demand to build the supply for labor Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.