Possibilities, Preferences, and Choices Michael Parkin ECONOMICS 5e Possibilities, Preferences, and Choices 1

Learning Objectives Calculate and graph a household’s budget line Work out how the budget line changes when prices or income changes Make a map of preferences by using indifference curves 2

Learning Objectives (cont.) Explain the choices that households make Predict the effects of price and income changes on consumption choices Predict the effects of wage changes on work-leisure choices 3

Learning Objectives Calculate and graph a household’s budget line Work out how the budget line changes when prices or income changes Make a map of preferences by using indifference curves 4

Consumption Possibilities Consumption choices are limited by income and prices. A budget line describes the limits to a household’s consumption choices. 5

Consumption Possibilities Divisible and Indivisible Goods Divisible goods can be bought in any quantity desired ex. gasoline Indivisible goods cannot be bought in all quantities ex. movies 6

The Budget Line Lisa’s Income is $30 Consumption Movies ($6) Soda ($3) possibility (per month) (six-packs per month) a 0 10 b 1 8 c 2 6 d 3 4 e 4 2 f 5 0 Instructor Notes: 1) The rows of the table list Lisa’s affordable combinations of movies and soda when her income is $30, the price of soda is $3 a six-pack, and the price of a movie is $6. 2) For example, row a tells us that Lisa exhausts her $30 income when she buys 10 six-packs and sees no movies. 7

The Budget Line Income $30 Movies $6 Soda $3 a b c d e f 10 Affordable Soda (six-packs per month) 8 Unaffordable 6 4 Instructor Notes: Lisa’s budget line shows the boundary between what she can and cannot afford. 2 0 1 2 3 4 5 6 7 8 9 10 Movies (per month) 11

The Budget Equation The budget equation is based upon: Expenditure = Income $3Qs + $6Qm = $30 Qs = 10 – 2Qm The quantity of soda can be found by first setting the quantity of movies. 12

The Budget Equation $30/$3 = 10 six packs Real Income is the maximum quantity of a good that a household can afford to buy. Lisa’s Real Income (in terms of soda) is: Income/Price of soda = y/Ps $30/$3 = 10 six packs 13

Learning Objectives Calculate and graph a household’s budget line Work out how the budget line changes when prices or income changes Make a map of preferences by using indifference curves 15

The Budget Equation Relative Price A relative price is the price of one good divided by the price of another good. Lisa’s relative price of a movie in terms of soda: $6/$3 = 2 six-packs per movie In other words, to see one more movie, Lisa must give up 2 six-packs (i.e. opportunity cost) 16

Changes in Prices and Income A Change in Price a f Price of a movie is... 10 Soda (six-packs per month) 8 6 4 2 …$12 …$6 …$3 0 1 2 3 4 5 6 7 8 9 10 Movies (per month) 19

Changes in Prices and Income A Change in Income a f 10 8 Soda (six-packs per month) 6 4 Instructor Notes: 1) Lisa’s income falls from $30 to $15 while the prices of movies and soda remain constant. 2) The budget line shifts leftward, but its slope does not change. 2 Income $15 Income $30 0 1 2 3 4 5 6 7 8 9 10 Movies (per month) 21

Learning Objectives Calculate and graph a household’s budget line Work out how the budget line changes when prices or income changes Make a map of preferences by using indifference curves 22

Preferences and Indifference Curves An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. 23

A Preference Map An indifference curve 10 8 c 6 4 2 g 0 2 4 6 8 10 Not preferred Preferred 10 8 Soda (six-packs per month) c 6 4 Instructor Notes: 1) If Lisa drinks 6 six-packs of soda and sees 2 movies a month, she consumes at point c. 2) Lisa can compare all other possible combinations of soda and movies to point c and rank them on the scale preferred to point c, not preferred to point c, or indifferent. 3) The boundary between points that she prefers to point c and those that she does not prefer to point c is an indifference curve. 4) Lisa is indifferent between points such as g and c on the indifference curve. 5) She prefers any point above the indifference curve (yellow area) to any point on it, and she prefers any point on the indifference curve to any point below it (gray area). 2 g 0 2 4 6 8 10 Movies (per month) 24

A Preference Map A preference map is a series of indifference curves. A preference map consists of an infinite number of indifference curves; each one slopes downward, and none of them intersects. 25

A Preference Map 10 I2 I0 8 Soda (six-packs per month) c 6 j 4 Instructor Notes: 1) A preference map consists of an infinite number of indifference curves. 2) This graph shows just three that are part of Lisa’s preference map. 3) Each indifference curve shows points among which Lisa is indifferent. For example, she is indifferent between point c and point g on indifference curve I1. 4. But, she prefers any point on a higher indifference curve to any point on a lower indifference curve. For example, Lisa prefers point j to point c or g, so she prefers any point on indifference curve I2 to any point on indifference curve I1. 2 g I1 0 2 4 6 8 10 Movies (per month) 26

Learning Objectives (cont.) Explain the choices that households make Predict the effects of price and income changes on consumption choices Predict the effects of wage changes on work-leisure choices 27

Marginal Rate of Substitution The marginal rate of substitution (MRS) is the rate at which a person will give up one good in order to get more of another good and at the same time remain indifferent. 28

Marginal Rate of Substitution The marginal rate of substitution (MRS) is measured by the slope of an indifference curve. Steep indifference curves have a high MRS. Flat indifference curves have a low MRS. 29

Marginal Rate of Substitution 10 8 Soda (six-packs per month) MRS = 2 6 c 4 Instructor Notes: 1) The red line at point g tells us that Lisa is willing to give up 4.5 six-packs to see 9 movies. 2) Her marginal rate of substitution at point g is 4.5 divided by 9, which equals 1/2. 3) As Lisa consumes more movies and her consumption of soda decreases, her marginal rate of substitution diminishes. MRS = 1/2 2 g 0 2 4 6 8 10 Movies (per month) 32

Marginal Rate of Substitution Notice: As the consumption of movies increases, the MRS decreases. This is referred to as the diminishing marginal rate of substitution. 33

The Degree of Substitutability The shape of the indifference curves reveals the degree of substitutability between two goods. 34

Degree of Substitutability Ordinary goods Soda (cans) 10 8 6 4 Instructor Notes: 1) This graph shows the indifference curves for two ordinary goods: movies and soda. 2) To consume less soda and remain indifferent, one must see more movies. 3) The number of movies that compensates for a reduction in soda increases as less soda is consumed. 2 0 2 4 6 8 10 Movies 35

Degree of Substitutability Perfect substitutes 10 Marker pens at the local supermarket 8 6 4 Instructor Notes: 1) This graph shows the indifference curves for two perfect substitutes. 2) For the consumer to remain indifferent, one fewer marker pen from the local supermarket must be replaced by one extra marker from the campus bookstore. 2 0 2 4 6 8 10 Marker pens at the campus bookstore 36

Degree of Substitutability Perfect complements Left running shoes 5 4 3 2 Instructor Notes: 1) This graph shows the indifference curves for two perfect complements--two goods that cannot be substituted for each other at all. 2) Having two left running shoes with one right running shoe is no better than having one of each. 3) But having two of each is preferred to having one of each. 1 0 1 2 3 4 5 Right running shoes 37

Predicting Consumer Behavior Individuals maximize their utility given their income budget line when they: Are on their their highest attainable indifference curve. Have a marginal rate of substitution between the two goods equal to their relative price. 38

The Best Affordable Point 10 I2 Best affordable point Soda (six-packs per month) I0 f 8 c 6 4 Instructor Notes: 1) Lisa’s best affordable point is c. 2) At this point, she is on her budget line and also on the highest attainable indifference curve. 3) At a point such as h, Lisa is willing to give up more movies in exchange for soda than she has to. She can move to point i, which is just as good as point h and have some unspent income. 4) She can spend that income and move to c, a point that she prefers to point i. i 2 1 h I1 0 2 4 6 8 10 Movies (per month) 39

Learning Objectives (cont.) Explain the choices that households make Predict the effects of price and income changes on consumption choices Predict the effects of wage changes on work-leisure choices 40

Predicting Consumer Behavior What effect will changes in prices and income have on the best affordable point? 41

A Change in Price Price effect The effect of a change in price on quantity of a good consumed. A change in the price of a good will shift the budget line and will change the best affordable combination. 42

Price Effect and Demand Curve 10 Best affordable point: movies $6 Soda (six-packs per month) 8 c Best affordable point: movies $3 6 j 5 4 Instructor Notes: 1) If the price of a movie falls from $6 to $3, she consumes at point j. 2) The increase in movies from 2 to 5 per month per month and the decreases in soda from 6 to 5 six-packs is the price effect. I2 2 I1 0 2 4 6 8 10 5 Movies (per month) 44

Price Effect and Demand Curve 0 2 4 6 8 10 1 2 3 4 5 Movies (per month) 6 Lisa’s demand curve for movies a b Price (dollars per movie) Instructor Notes: 1) When the price of a movie falls to $3, she sees 5 movies a month, at point b. 2) Lisa’s demand curve traces out her best affordable quantity of movies as the price of a movie varies. 46

Predicting Consumer Behavior What effect will changes in Lisa’s income have on the best affordable point? 47

A Change in Income The effect of a change in income on consumption. Income effect The effect of a change in income on consumption. A change in income will shift the budget line and will change the best affordable combination. 48

Income Effect and Change in Demand 10 Income $30 8 Soda (six-packs per month) 6 j Instructor Notes: 1) A change in income shifts the budget line and changes the best affordable point and changes consumption. 2) In the graph, when Lisa’s income decreases from $30 to $21, she consumes less of both movies and soda. 4 Income $21 3 I2 2 I1 0 2 4 6 8 10 Movies (per month) 50

Income Effect and Change in Demand 6 D1 5 Price (dollars per movie) 4 c b 3 Instructor Notes: 1) When Lisa’s income decreases to $21, her demand curve for movies shifts leftward to D1. 2) Lisa’s demand for movies decreases because she now sees fewer movies at each price. 2 1 D0 0 2 4 6 8 10 Movies (per month) 52

Substitution Effect and Income Effect The effect of a change in price on the quantity bought when the consumer (hypothetically) remains indifferent between the original and the new situation. 53

Substitution Effect and Income Effect The change in consumption that results from a change in the consumer’s income, ceteris paribus. The substitution and income effects can be calculated using the indifference curves and budget line. 54

Substitution Effect and Income Effect Price Effect 10 Income $30 Movies $3 8 Soda (six-packs per month) c 6 j 5 Instructor Notes: 1) If the price of a movie falls from $6 to $3, she consumes at point j. 2) The increase in movies from 2 to 5 per month per month and the decreases in soda from 6 to 5 six-packs is the price effect. 4 I2 2 Income $30 Movies $6 I1 0 2 4 6 8 10 5 Movies (per month) 44

Substitution Effect and Income Effect Substitution effect and price effect 10 Substitution effect Soda (six-packs per month) 8 7 c Income effect 6 j 5 Instructor Notes: 1) If the price of a movie falls from $6 to $3, she consumes at point j. 2) The increase in movies from 2 to 5 per month per month and the decreases in soda from 6 to 5 six-packs is the price effect. 4 k 3 I2 2 I1 0 2 4 6 8 10 5 Movies (per month) 44

Learning Objectives (cont.) Explain the choices that households make Predict the effects of price and income changes on consumption choices Predict the effects of wage changes on work-leisure choices 58

Work-Leisure Choices Households must also make choices on how to allocate their time between labor and leisure. More leisure means less income. We buy leisure by foregoing income. The relationship between leisure and income is described by the income-time budget line. 59

Work-Leisure Choices As wage rates increase, people substitute labor for leisure — substitution effect. However, higher wage rates lead to higher income which causes people to shift toward more leisure — income effect. 60

The Supply of Labor Time allocation decision I0 I1 I2 c b a I1 Z $15 Income (dollars per week) $10 c 450 b Instructor Notes: 1) But if the wage rate increase from $10 to $15, Lisa increases her leisure to 138 hour and decreases her work to 30 hour a week at point c. 2) The income effect has caused her to move toward more leisure. 350 $5 a I1 100 Z 100 133 138 148 168 Leisure (hours per week) 64

The Supply of Labor c b a LS 15 10 5 0 20 30 35 Labor (hour per week) Wage rate (dollar per hour) Instructor Notes: 1) The graph shows Lisa’s labor supply curve--the change in Lisa’s hours of work as the wage rate changes. 2) Lisa’s labor supply curve slopes upward between point a and b and then bends back between points b and c. 3) The reason is that leisure is a normal good, and at a high enough wage rate, the positive income effect of a higher wage rate outweighs the negative substitution effect. 5 a 0 20 30 35 Labor (hour per week) 66

Labor Supply Real World Applications Work week declines. Women in the workforce. 67