McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Chapter 8: Households’ Choices

8-2 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Objectives After studying this chapter, you will be able to:  Describe a household’s budget line and show how it changes when income or price changes  Make a map of preferences and explain the principle of diminishing marginal rate of substitution  Predict the effects of changes in prices and income on consumption choices  Predict the effects of changes in wage rates on work-leisure choices

8-3 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Subterranean Movements  Like the continents floating on the Earth’s mantle, spending patterns change slowly over time, but as they change, business empires rise and fall.  The model of consumer choice that we study in this chapter explains such things as why we download music, even if it costs the same as buying a CD, and why we don’t (much) download audio books, even though these are cheaper than audio tapes.

8-4 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Consumption Possibilities  Household consumption choices are limited by income and by price  A household has a given amount of income and cannot influence the prices of the goods and services it needs to buy.  The budget line describes the limits to the household’s consumption choices.

8-5 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Consumption Possibilities  Divisible and indivisible goods  Divisible goods can be bought in any quantity desired along the budget line (petrol, for example).  Indivisible goods must be bought in whole units at the points marked on the budget line (movies, for example).

8-6 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Consumption Movies Soft drinks possibility (per month) (liters per month) A0 10 B1 8 C2 6 D3 4 E4 2 F5 0 The Budget Line

8-7 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Affordable The Budget Line Movies (per month) Soft drink (litres per month) UnaffordableA B C D E F Income $30 Movies $6 each Soft drink $3 a litre Figure 8.1

8-8 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Consumption Possibilities  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 soft drink P s, the quantity of soft drink Q s, the price of a movie P M, the quantity of movies Q M, and income Y.  Lisa’s budget equation is: P S Q S + P M Q M = Y

8-9 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Consumption Possibilities 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  The term Y/P S is Lisa’s real income in terms of soft drink.  The term P M /P S is the relative price of a movie in terms of soft drink.

8-10 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Consumption Possibilities  Two variables constrain a household’s choices:  Real income  Relative price  A household’s real income is the income expressed as a quantity of goods the household can afford to buy.  Lisa’s real income in terms of soft drink 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.  It is the magnitude of the slope of the budget line.  The relative price shows how many soft drinks must be forgone to see an additional movie.

8-11 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Consumption Possibilities  A change in price  A fall in the price of the good on the x-axis increases the affordable quantity of that good and decreases the slope of the budget line.  Figure 8.2(a) shows the rotation of a budget line after a change in the relative price of movies.

8-12 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Changes in Prices and Income Movies (per month) A F Price of a movie is... …$6 …$12 …$ Soft drink (litres per month) Figure 8.2(a)

8-13 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Consumption Possibilities  A change in the household’s income brings a parallel shift of the budget line.  The slope of the budget line doesn’t change because the relative price doesn’t change.  Figure 8.2(b) shows the effect of a fall in income.

8-14 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia A Change in Income Movies (per month) AF Income $30 Income $15 Soft drink (litres per month) Figure 8.2(b)

8-15 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Preferences and Indifference Curves  An indifference curve is a line that shows combinations of goods among which a consumer is indifferent.  Figure 8.3(a) illustrates a consumer’s indifference curve.  At point C, Lisa consumes 2 movies and 6 litres of soft drink a month.

8-16 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Fig. 8.3(a): An Indifference Curve Soft drink (litres per month) Movies (per month) C G Preferred Indifference curveC G Not preferred Figure 8.3(a)

8-17 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Preferences and Indifference Curves  Lisa can sort all possible combinations of goods into three groups:  preferred,  not preferred, and  indifferent.  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 C and G.

8-18 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Preferences and Indifference Curves  All the points above the indifference curve are preferred over the points on the curve.  And all the points on the indifference curve are preferred over the points below the curve.  An indifference curve above I 1 is I 2. All the points on I 2 are preferred to those on I 1. For example, point J is preferred to either point C or point G

8-19 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Preferences and Indifference Curves  Marginal rate of substitution  The marginal rate of substitution, (MRS) is the rate at which a person is willing to give up good y (the good measured on the y-axis) to get an additional unit of good x (the good measured on the x-axis) and 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.

8-20 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Preferences and Indifference Curves  If the indifference curve is relatively steep, the MRS is high.  In this case, the person would be 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 would be willing to give up a small quantity of y to get more x.

8-21 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Preferences and Indifference Curves  Diminishing marginal rate of substitution  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, and at the same time remain indifferent, as the quantity of good x increases.

8-22 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Preferences and Indifference Curves  Degree of substitutability  The shape of the indifference curves reveals the degree of substitutability between two goods.  Figure 8.5 shows the indifference curves for ordinary goods, perfect substitutes, and perfect complements.

8-23 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Soda (cans) Movies The Degree of Substitutability Ordinary Goods Figure 8.5(a)

8-24 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Marker pens at the local supermarket The Degree of Substitutability Perfect substitutes Marker pens at the campus bookstore Figure 8.5(b)

8-25 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Left running shoes The Degree of Substitutability Perfect complements Right running shoes Figure 8.5(c)

8-26 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Predicting Consumer Behaviour  The consumer’s best affordable point:  Is on the budget line  Is 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

8-27 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Predicting Consumer Behaviour  In Figure 8.6 on the following slide, the best affordable point is C.  Here Lisa can afford to consume more soft drinks and fewer movies at point F.  And she can afford to consume more movies and less soft drinks at point H.  But she is indifferent between F, I, and H and she clearly prefers C to I.

8-28 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Soft drink (litres per month) Movies (per month) The Best Affordable Point I1I1 I2I2 I0I0 Best affordable point H F C I Figure 8.6

8-29 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Predicting Consumer Behaviour  Change in price  The effect of a change in the price of a good on the quantity consumed is the price effect.  Figure 8.7(b) illustrates the price effect and shows how a demand curve is generated.  Initially, the price of a movie is $6 and Lisa consumes at point C in part (a) and at point A in part (b).

8-30 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Soft drink (litres per month) Movies (per month) Price Effect and Demand Curve I1I1 I2I2 C Best affordable point: movies $6 Best affordable point: movies $3 J Figure 8.7(a)

8-31 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Movies (per month) Price Effect and Demand Curve 6 Lisa’s demand curve for movies A B Price (dollars per movie) Figure 8.7(b)

8-32 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Predicting Consumer Behaviour  A change in income  The effect of a change in income on the quantity of a good consumed is called the income effect.  Figure 8.8 illustrates the effect of a decrease in Lisa’s income.  Initially, Lisa consumes at point J in part (a) and at point B on demand curve D 0 in part (b).

8-33 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Soft drink (litres per month) Movies (per month) Income Effect and Change in Demand Income $30 3 I2I2 I1I1 Income $21 J K Figure 8.8(a)

8-34 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Price (dollars per movie) Movies (per month) Demand Curve 6 D0D0 D1D1 C B Figure 8.8(b)

8-35 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Predicting Consumer Behaviour  Substitution effect  The substitution effect is the effect of a change in price on the quantity bought when the consumer remains indifferent between the original situation and the new situation.  For a normal good, a fall in price always increases the quantity consumed.

8-36 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Predicting Consumer Behaviour  Inferior goods  For an inferior good, when income increases, the quantity bought decreases. The income effect is negative  For an inferior good, the income effect works against the substitution effect.  So long as the substitution effect dominates, the demand curve still slopes downward.

8-37 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Predicting Consumer Behaviour  If the negative income effect is stronger than the substitution effect, the demand curve would slope upward.  This case doesn’t appear to occur in the real world

8-38 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Work-Leisure Choices  Labour supply  Allocate the 168 hours per week between working – called labour – and all other activities (including sleeping) – called leisure.  The theory of household choice can be used to decide how to allocate our time between labour and leisure  The more we spend on leisure, the smaller is our income.  An income-time budget line describes the relationship between leisure and the income

8-39 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Work-Leisure Choices  The labour supply curve  By changing the wage rate, we can find a person’s labour supply curve.  A higher wage rate makes leisure relatively more expensive (higher opportunity cost to not working) and has a substitution effect toward less leisure (toward more work).

8-40 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia 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 with the wage rate.  The move from A to B when the wage rate rises from $5 to $10 illustrates this case.

8-41 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Work-Leisure Choices  But if the income effect is stronger than the substitution effect, the quantity of work hours decreases with the wage rate.  The move from B to C when the wage rate increases from $10 to $15 an hour illustrates this case.  The move from A to B when the wage rate increases from $5 to $10 means that the labour supply curve slopes upward over this range.  The move from B to C when the wage rate increases from $10 to $15 means that the labour supply curve bends backward above a certain wage rate.

8-42 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia Work-Leisure Choices  The move from A to B when the wage rate increases from $5 to $10 means that the labour supply curve slopes upward over this range.  The move from B to C when the wage rate increases from $10 to $15 means that the labour supply curve bends backward above a certain wage rate.

8-43 McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia END CHAPTER 8