Principles of Microeconomics PowerPoint Presentations for Principles of Microeconomics Sixth Canadian Edition by Mankiw/Kneebone/McKenzie Adapted for the Sixth Canadian Edition by Marc Prud’homme University of Ottawa

The theory of consumer choice Chapter 21 Copyright © 2014 by Nelson Education Ltd.

The theory of consumer choice In this chapter a theory is developed that describes how consumers make decisions about what to buy. The theory examines the tradeoffs that people face in their role as consumers. Copyright © 2014 by Nelson Education Ltd.

The theory of consumer choice After developing the basic theory of consumer choice, three questions about household decisions are developed: Do all demand curves slope downward? How do wages affect labour supply? How do interest rates affect household saving? Copyright © 2014 by Nelson Education Ltd.

THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD The study of consumer choice starts by examining the link between income and spending. People consume less than they desire because their spending is constrained, or limited, by their income. Copyright © 2014 by Nelson Education Ltd.

THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD What is the decision facing a consumer who buys two goods? Pepsi Pizza Suppose an income of $1000/month. His entire income each month is spent on Pepsi and pizza. The price of a litre of Pepsi is $2, and the price of a pizza is $10. Of course, real people buy thousands of different kinds of goods. Yet assuming there are only two goods greatly simplifies the problem without altering the basic insights about consumer choice. Copyright © 2014 by Nelson Education Ltd.

THE BUDGET CONSTRAINT: WHAT THE CONSUMER CAN AFFORD Budget constraint: the limit on the consumption bundles that a consumer can afford It shows the tradeoff between Pepsi and pizza that the consumer faces. The slope of the budget constraint equals the relative price of the two goods: the price of one good compared to the price of the other. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.1: The Consumer’s Budget Constraint The graph in Figure 21.1 illustrates the consumption bundles that the consumer can choose. The vertical axis measures the number of litres of Pepsi, and the horizontal axis measures the number of pizzas. Three points are marked on this figure. At point A, the consumer buys no Pepsi and consumes 100 pizzas. At point B, the consumer buys no pizza and consumes 500 L of Pepsi. At point C, the consumer buys 50 pizzas and 250 L of Pepsi. Point C, which is exactly at the middle of the line from A to B, is the point at which the consumer spends an equal amount ($500) on Pepsi and pizza. Of course, these are only three of the many combinations of Pepsi and pizza that the consumer can choose. All the points on the line from A to B are possible. This line, called the budget constraint, shows the consumption bundles that the consumer can afford. In this case, it shows the tradeoff between Pepsi and pizza that the consumer faces. The slope of the budget constraint measures the rate at which the consumer can trade one good for the other. Recall from the appendix to Chapter 2 that the slope between two points is calculated as the change in the vertical distance divided by the change in the horizontal distance (rise over run). From point A to point B, the vertical distance is 500 L, and the horizontal distance is 100 pizzas. Thus, the slope is 5 L per pizza. (Actually, because the budget constraint slopes downward, the slope is a negative number. But for our purposes we can ignore the minus sign.) Notice that the slope of the budget constraint equals the relative price of the two goods—the price of one good compared to the price of the other. A pizza costs 5 times as much as a litre of Pepsi, so the opportunity cost of a pizza is 5 L of Pepsi. The budget constraint’s slope of 5 reflects the tradeoff the market is offering the consumer: 1 pizza for 5 L of Pepsi. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Draw the budget constraint for a person with income of $1000 if the price of Pepsi is $5 per litre and the price of a pizza is $10. What is the slope of this budget constraint? Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Active Learning Budget Constraint Hurley’s income: $1200 Prices: PF = $4 per fish, PM = $1 per mango A. If Hurley spends all his income on fish, how many fish does he buy? B. If Hurley spends all his income on mangos, how many mangos does he buy? C. If Hurley buys 100 fish, how many mangos can he buy? D. Plot each of the bundles from parts A – C on a graph that measures fish on the horizontal axis and mangos on the vertical; connect the dots. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Active Learning Answers Quantity of Mangos B D. Hurley’s budget constraint shows the bundles he can afford. A. $1200/$4 = 300 fish B. $1200/$1 = 1200 mangos C. 100 fish cost $400, $800 left buys 800 mangos C A Copyright © 2014 by Nelson Education Ltd.

PREFERENCES: WHAT THE CONSUMER WANTS The consumer’s choices, however, depend not only on his budget constraint but also on his preferences regarding the two goods. Therefore, the consumer’s preferences are the next piece of our analysis. Copyright © 2014 by Nelson Education Ltd.

Representing Preferences with Indifference Curves Indifference curve: a curve that shows consumption bundles that give the consumer the same level of satisfaction The consumer’s preferences allow him to choose among different bundles of Pepsi and pizza. If you offer the consumer two different bundles, he chooses the bundle that best suits his tastes. If the two bundles suit his tastes equally well, we say that the consumer is indifferent between the two bundles. Just as we have represented the consumer’s budget constraint graphically, we can also represent his preferences graphically with indifference curves. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.2: The Consumer’s Preferences The consumer’s preferences are represented with indifference curves, which show the combinations of Pepsi and pizza that make the consumer equally satisfied. Because the consumer prefers more of a good, points on a higher indifference curve (I2 here) are preferred to points on a lower indifference curve (I1). The marginal rate of substitution (MRS) shows the rate at which the consumer is willing to trade Pepsi for pizza. Copyright © 2014 by Nelson Education Ltd.

Representing Preferences with Indifference Curves Marginal rate of substitution: the rate at which a consumer is willing to trade one good for another The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other. This rate is called the marginal rate of substitution (MRS). Copyright © 2014 by Nelson Education Ltd.

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. Because indifference curves represent a consumer’s preferences, they have certain properties that reflect those preferences. Here we consider four properties that describe most indifference curves. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.3: The Impossibility of Intersecting Indifference Curves A situation like this can never happen. According to these indifference curves, the consumer would be equally satisfied at points A, B, and C, even though point C has more of both goods than point A. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.4: Bowed Indifference Curves Indifference curves are usually bowed inward. This shape implies that the marginal rate of substitution ( MRS) depends on the quantity of the two goods the consumer is consuming. At point A, the consumer has little pizza and much Pepsi, so he requires a lot of extra Pepsi to induce him to give up one of the pizzas: The marginal rate of substitution is 6 L of Pepsi per pizza. At point B, the consumer has much pizza and little Pepsi, so he requires only a little extra Pepsi to induce him to give up one of the pizzas: The marginal rate of substitution is 1 L of Pepsi per pizza Copyright © 2014 by Nelson Education Ltd.

Two Extreme Examples of Indifference Curves The shape of an indifference curve tells us about the consumer’s willingness to trade one good for the other. Perfect substitutes: two goods with straight-line indifference curves Perfect complements: two goods with right- angle indifference curves Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.5: Perfect Substitutes and Perfect Complements When two goods are easily substitutable, such as nickels and dimes, the indifference curves are straight lines, as shown in panel (a). When two goods are strongly complementary, such as left shoes and right shoes, the indifference curves are right angles, as shown in panel (b). Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Draw some indifference curves for Pepsi and pizza. Explain the four properties of these indifference curves. Copyright © 2014 by Nelson Education Ltd.

OPTIMIZATION: WHAT THE CONSUMER CHOOSES The goal of this chapter is to understand how a consumer makes choices. We have the two pieces necessary for this analysis: The consumer’s budget constraint The consumer’s preferences Now we put these two pieces together and consider the consumer’s decision about what to buy. Copyright © 2014 by Nelson Education Ltd.

The Consumer’s Optimal Choices The consumer would like to end up with the best possible combination of Pepsi and pizza. But the consumer must also end up on or below his budget constraint. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.6: The Consumer’s Optimum The consumer chooses the point on his budget constraint that lies on the highest indifference curve. At this point, called the optimum, the marginal rate of substitution equals the relative price of the two goods. Here the highest indifference curve the consumer can reach is I2. The consumer prefers point A, which lies on indifference curve I3, but the consumer cannot afford this bundle of Pepsi and pizza. By contrast, point B is affordable, but because it lies on a lower indifference curve, the consumer does not prefer it. Copyright © 2014 by Nelson Education Ltd.

How Changes in Income Affect the Consumer’s Choices Suppose that income increases so that the consumer can now afford more of both goods. The increase in income, therefore, shifts the budget constraint outward. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.7: An Increase in Income When the consumer’s income rises, the budget constraint shifts out. If both goods are normal goods, the consumer responds to the increase in income by buying more of both of them. Here the consumer buys more pizza and more Pepsi. Copyright © 2014 by Nelson Education Ltd.

How Changes in Income Affect the Consumer’s Choices The indifference curves in Figure 21.7 are drawn under the assumption that both Pepsi and pizza are normal goods. Normal good: a good for which, other things equal, an increase in income leads to an increase in demand Copyright © 2014 by Nelson Education Ltd.

How Changes in Income Affect the Consumer’s Choices Figure 21.8 shows an example in which an increase in income induces the consumer to buy more pizza but less Pepsi. Inferior good: a good for which, other things equal, an increase in income leads to a decrease in demand Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.8: An Inferior Good A good is an inferior good if the consumer buys less of it when his income rises. Here Pepsi is an inferior good: When the consumer’s income increases and the budget constraint shifts outward, the consumer buys more pizza but less Pepsi. Copyright © 2014 by Nelson Education Ltd.

How Changes in Prices Affect the Consumer’s Choices Let’s now use this model of consumer choice to consider how a change in the price of one of the goods alters the consumer’s choices. Suppose, in particular, that the price of Pepsi falls from $2 to $1 per litre. It is no surprise that the lower price expands the consumer’s set of buying opportunities. In other words, a fall in the price of any good shifts the budget constraint outward. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.9: A Change in Price When the price of Pepsi falls, the consumer’s budget constraint shifts outward and changes slope. The consumer moves from the initial optimum to the new optimum, which changes his purchases of both Pepsi and pizza. In this case, the quantity of Pepsi consumed rises, and the quantity of pizza consumed falls. Copyright © 2014 by Nelson Education Ltd.

Income and Substitution Effects The impact of a change in the price of a good on consumption can be decomposed into two effects: Income effect: the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve Substitution effect: the change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution Copyright © 2014 by Nelson Education Ltd.

Income and Substitution Effects How might our consumer respond when he learns that the price of Pepsi has fallen? “Great news! Now that Pepsi is cheaper, my income has greater purchasing power. I am, in effect, richer than I was. Because I am richer, I can buy both more Pepsi and more pizza.” (This is the income effect.) “Now that the price of Pepsi has fallen, I get more litres of Pepsi for every pizza that I give up. Because pizza is now relatively more expensive, I should buy less pizza and more Pepsi.” (This is the substitution effect.) Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. TABLE 21.1: Income and Substitution Effects When the Price of Pepsi Falls Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.10: Income and Substitution Effects The effect of a change in price can be broken down into an income effect and a substitution effect. The substitution effect—the movement along an indifference curve to a point with a different marginal rate of substitution—is shown here as the change from point A to point B along indifference curve I1. The income effect—the shift to a higher indifference curve—is shown here as the change from point B on indifference curve I1 to point C on indifference curve I 2. Copyright © 2014 by Nelson Education Ltd.

Deriving the Demand Curve The demand curve for any good reflects these consumption decisions. A consumer’s demand curve is a summary of the optimal decisions that arise from his budget constraint and indifference curves. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.11: Deriving the Demand Curve Panel (a) shows that when the price of Pepsi falls from $2 to $1, the consumer’s optimum moves from point A to point B, and the quantity of Pepsi consumed rises from 250 to 750 L. The demand curve in panel (b) reflects this relationship between the price and the quantity demanded. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Draw a budget constraint and indifference curves for Pepsi and pizza. Show what happens to the budget constraint and the consumer’s optimum when the price of pizza rises. In your diagram, decompose the change into an income effect and a substitution effect. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Three Applications The basic theory of consumer choice can be used to shed light on three questions about how the economy works. Copyright © 2014 by Nelson Education Ltd.

Do All Demand Curves Slope Downward? As a matter of economic theory, demand curves can sometimes slope upward. In other words, consumers can sometimes violate the law of demand and buy more of a good when the price rises. Giffen good: a good for which an increase in the price raises the quantity demanded Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. FIGURE 21.12: A Giffen Good In this example, when the price if potatoes rises, the consumer’s optimum shifts from point C to point E. In this case, the consumer responds to a higher price of potatoes by buying less meat and more potatoes. Copyright © 2014 by Nelson Education Ltd.

How Do Wages Affect Labour Supply? The theory of consumer choice can be used to analyze how a person decides to allocate his time between work and leisure. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.13: The Work–Leisure Decision This figure shows Sally’s budget constraint for deciding how much to work, her indifference curves for consumption and leisure, and her optimum. Consider the decision facing Sally, a freelance software designer. Sally is awake for 100 hours per week. She spends some of this time enjoying leisure—riding her bike, watching television, studying economics, and so on. She spends the rest of this time at her computer developing software. For every hour she spends developing software, she earns $50, which she spends on consumption goods. Thus, her wage ($50) reflects the tradeoff Sally faces between leisure and consumption. For every hour of leisure she gives up, she works one more hour and gets $50 of consumption. Figure 21.13 shows Sally’s budget constraint. If she spends all 100 hours enjoying leisure, she has no consumption. If she spends all 100 hours working, she earns a weekly consumption of $5000 but has no time for leisure. If she works a normal 40-hour week, she enjoys 60 hours of leisure and has weekly consumption of $2000. Figure 21.13 uses indifference curves to represent Sally’s preferences for consumption and leisure. Here consumption and leisure are the two “goods” between which Sally is choosing. Because Sally always prefers more leisure and more consumption, she prefers points on higher indifference curves to points on lower ones. At a wage of $50 per hour, Sally chooses a combination of consumption and leisure represented by the point labelled “Optimum.” This is the point on the budget constraint that is on the highest possible indifference curve, which is curve I2. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.14: An Increase in the Wage The two sets of panels of this figure show how a person might respond to an increase in the wage. The graphs on the left show the consumer’s initial budget constraint BC1 and new budget constraint BC2, as well as the consumer’s optimal choices over consumption and leisure. The graphs on the right show the resulting labour supply curve. Because hours worked equal total hours available minus hours of leisure, any change in leisure implies an opposite change in the quantity of labour supplied. In panel (a), when the wage rises, consumption rises and leisure falls, resulting in a labour supply curve that slopes upward. In panel (b), when the wage rises, both consumption and leisure rise, resulting in a labour supply curve that slopes backward. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.14 (continued): An Increase in the Wage Copyright © 2014 by Nelson Education Ltd.

How Do Interest Rates Affect Household Saving? We can use the theory of consumer choice to analyze how people make this decision and how the amount they save depends on the interest rate their savings will earn. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.15: The Consumption–Saving Decision Figure 21.15 shows Sam’s budget constraint. If he saves nothing, he consumes $100 000 when young and nothing when old. If he saves everything, he consumes nothing when young and $110 000 when old. The budget constraint shows these and all the intermediate possibilities. Figure 21.15 uses indifference curves to represent Sam’s preferences for consumption in the two periods. Because Sam prefers more consumption in both periods, he prefers points on higher indifference curves to points on lower ones. Given his preferences, Sam chooses the optimal combination of consumption in both periods of life, which is the point on the budget constraint that is on the highest possible indifference curve. At this optimum, Sam consumes $50 000 when young and $55 000 when old. Copyright © 2014 by Nelson Education Ltd.

FIGURE 21.16: An Increase in the Interest Rate In both panels, an increase in the interest rate shifts the budget constraint outward. In panel (a), consumption when young falls, and consumption when old rises. The result is an increase in saving when young. In panel (b), consumption in both periods rises. The result is a decrease in saving when young. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Explain how an increase in the wage can potentially decrease the amount that a person wants to work. Copyright © 2014 by Nelson Education Ltd.

Classroom Activity You Can’t Always Get What You Want Think about maximizing your own utility. Specifically, assume that billionaire Bill Gates offers to buy you the one thing that would increase your happiness by the greatest amount. It can’t be money, or a financial instrument, but he will buy for you any single thing that you feel would makes you happy. Write your requested item. What did you choose? “Why don’t you buy that item for yourself? Isn’t it the one thing that will increase your happiness by the largest amount? Why not buy it today?” Activity 1–You Can’t Always Get What You Want Type: In-class activity Topics: Budget constraints Materials needed: None Time: 5 minutes Class limitations: Works in any size class Purpose: This activity shows consumers are restricted by their limited incomes and by the prices of goods. Instructions: Ask the students to think about maximizing their own utility. Specifically, ask them to assume that billionaire Bill Gates offers to buy them the one thing that would increase their happiness by the greatest amount. It can’t be money, or a financial instrument, but he will buy them any single thing they feel would make them happy. Have them write their requested item. Ask a few students what they chose. Then ask the class, “Why don’t you buy that item for yourself? Isn’t it the one thing that will increase your happiness by the largest amount? Why not buy it today?” The answer, of course, is they can’t afford it. Consumers’ purchases are constrained by their incomes. But that’s not the only constraint. Ask them to estimate the cost of their selected items and write it next to the items. Now, have them assume Bill Gates is too busy to go shopping, so he gives them the money instead. He doesn’t put any restrictions on the use of the cash; all he wants is to see them maximize their happiness. This eliminates the income barrier. Ask the class how many of them would spend the entire amount of money buying that single good. Some students would buy that item, but most would buy a variety of things. Using the money for a single expensive item may not be the best way to allocate their newfound wealth. Buying several cheap things may give a higher level of happiness. Points for Discussion 1) Consumers have limited income. 2) Goods have prices. Together these things determine the consumer’s budget constraint. Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. The end Chapter 21 Copyright © 2014 by Nelson Education Ltd.