The Theory of Consumer Choice

1. 21 The Theory ofConsumer Choice

2. Budget Constraint: What the Consumer can Afford • Budget constraint • Limit on the consumption bundles that a consumer can afford • Trade-off between goods • Slope of the budget constraint • Rate at which the consumer can trade one good for the other • Change in the vertical distance • Divided by the change in the horizontal distance • Relative price of the two goods

3. 1 The consumer’s budget constraint (table)

4. 1 Quantity of Pepsi The consumer’s budget constraint (graph) 500 A C B Consumer’s budget constraint 250 0 Quantity of Pizza 50 100 The budget constraint shows the various bundles of goods that the consumer can buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The table and graph show what the consumer can afford if his income is $1,000, the price of pizza is $10, and the price of Pepsi is $2.

5. Preferences: What the Consumer Wants • Indifference curve • Shows consumption bundles that give the consumer the same level of satisfaction • Combinations of goods on the same curve • Same satisfaction • Slope of indifference curve • Marginal rate of substitution • Rate at which a consumer is willing to trade one good for another • Not the same at all points

6. 2 The consumer’s preferences Quantity Of Pepsi A D C B MRS I2 Indifference curve, I1 1 0 Quantity of Pizza The consumer’s preferences are represented with indifference curves, which show the combinations of pizza and Pepsi 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. It measures the quantity of Pepsi the consumer must be given in exchange for 1 pizza.

7. Preferences: What the Consumer Wants • Four properties of indifference curves • Higher indifference curves are preferred to lower ones • Higher indifference curves – more goods • Indifference curves are downward sloping • Indifference curves do not cross • Indifference curves are bowed inward

8. 3 The impossibility of intersecting indifference curves Quantity Of Pepsi B A C 0 Quantity of Pizza 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.

9. 4 Quantity Of Pepsi 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 pints 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 pint of Pepsi per pizza. A 14 B MRS=8 MRS=1 8 1 1 0 Quantity of Pizza 4 Indifference curve 3 2 3 6 7

10. Preferences: What the Consumer Wants • Two extreme examples of indifference curves • Perfect substitutes • Two goods with straight-line indifference curves • Marginal rate of substitution – constant • E.g.: nickels and dimes bundles • Perfect complements • Two goods with right-angle indifference curves • E.g.: right shoe and left shoe bundle

11. 5 Perfect substitutes and perfect complements Nickels Left shoes (b) Perfect Complements (a) Perfect Substitutes 6 4 I1 2 I2 0 0 Dimes Right shoes I2 I1 7 3 2 1 5 I3 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). 5 7

12. Optimization: What the Consumer Chooses • The consumer’s optimal choices • Optimum • Point where indifference curve and budget constraint touch • Best combination of goods available to the consumer • Slope of indifference curve • Equals slope of budget constraint • Marginal rate of substitution = relative price

13. 6 The consumer’s optimum Quantity of Pepsi Budget constraint A Optimum B I2 I1 Quantity of Pizza 0 I3 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 pizza and Pepsi. By contrast, point B is affordable, but because it lies on a lower indifference curve, the consumer does not prefer it.

14. Optimization: What the Consumer Chooses • How changes in income affect the consumer’s choices • Higher income • Consumer can afford more of both goods • Shifts the budget constraint outward • New optimum

15. 7 New budget constraint An Increase in Income Quantity of Pepsi 1. An increase in income shifts the budget constraint outward . . . 3. . . . and Pepsi consumption Initial optimum New optimum Initial budget constraint 2. . . . raising pizza consumption . . . I2 I1 Quantity of Pizza 0 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.

16. Optimization: What the Consumer Chooses • How changes in income affect the consumer’s choices • Normal good • Good for which an increase in income raises the quantity demanded • Inferior good • Good for which an increase in income reduces the quantity demanded

17. 8 New budget constraint An inferior good Quantity of Pepsi 1. When an increase in income shifts the budget constraint outward . . . Initial optimum 3. . . . but Pepsi consumption falls, making Pepsi an inferior good New optimum Initial budget constraint I2 Quantity of Pizza 0 I1 2. . . . pizza consumption rises, making pizza a normal 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.

18. Optimization: What the Consumer Chooses • How changes in prices affect the consumer’s choices • Price of one good falls • Rotates the budget constraint outward • Steeper slope • Change in relative price • Income effect • Substitution effect

19. 9 A change in price Quantity of Pepsi New budget constraint 1,000 A New optimum B D Initial optimum 1. A fall in the price of Pepsi rotates the budget constraint outward. . . Initial budget constraint 500 3. . . . and raising Pepsi consumption I2 Quantity of Pizza 0 I1 2. . . . reducing pizza consumption 100 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 pizza and Pepsi. In this case, the quantity of Pepsi consumed rises, and the quantity of pizza consumed falls.

20. Optimization: What the Consumer Chooses • Income effect • Change in consumption • When a price change moves the consumer • To a higher or lower indifference curve • Substitution effect • Change in consumption • When a price change moves the consumer • Along a given indifference curve • To a point with a new marginal rate of substitution

21. 1 Income and substitution effects when the price of Pepsi falls

22. 10 Income and substitution effects Quantity of Pepsi 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 I2. New budget constraint B C Initial optimum New optimum Initial budget constraint A I2 Quantity of Pizza 0 I1 Income effect Substitution effect Income effect Substitution effect

23. Optimization: What the Consumer Chooses • Deriving the demand curve • Quantity demanded of a good for any given price • Initial optimum point • Initial price of the good • Initial quantity of the good • A change in price of the good (new price) • New optimum • New optimum quantity

24. 11 Deriving the demand curve New budget constraint Quantity of Pepsi Price of Pepsi (b) The Demand Curve for Pepsi (a) The Consumer’s Optimum A A B B I1 I2 Quantity of Pepsi 0 0 Quantity of Pizza 750 250 $2 1 Initial budget constraint 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 pints. Demand curve in panel (b) reflects this relationship between the price and the quantity demanded. 750 250 Demand

25. Three Applications • Do all demand curves slope downward? • Law of demand • When the price of a good rises, people buy less of it • Downward slope of the demand curve • Giffen good • An increase in the price of the good raises the quantity demanded • Income effect dominates the substitution effect • Demand curve – slopes upward

26. 12 A Giffen good Quantity of Potatoes Initial budget constraint D New budget constraint B C A Optimum with high price of potatoes 1. An increase in the price of potatoes rotates the budget constraint inward . . . Optimum with low price of potatoes 2. . . . which increases potato consumption if potatoes are a Giffen good. Quantity of Meat 0 I1 E In this example, when the price of 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. I2

27. The search for Giffen goods • Potatoes - Giffen good during the Irish potato famine of the 19th century • Price of potatoes rose • Large income effect • People – cut back on the luxury of meat • Buy more of the staple food of potatoes • Chinese province of Hunan, rice • Poor households exhibited Giffen behavior • Lower price of rice (with subsidy voucher) • Households - reduce their consumption of rice • Higher price of rice (remove the subsidy) • Households – increase consumption of rice

28. Three Applications • How do wages affect labor supply? • Trade-off between leisure and consumption • Bundle of goods: leisure and work • Given wage • Budget constraint • Optimum

29. 13 The work-leisure decision Consumption $5,000 100 Optimum I2 I1 Hours of leisure 0 I3 2,000 This figure shows Sally’s budget constraint for deciding how much to work, her indifference curves for consumption and leisure, and her optimum. 60

30. Three Applications • How do wages affect labor supply? • Increase in wage • Budget constraint shifts outward • Steeper • New optimum • If enjoy less leisure • Work more • Upward-sloping labor supply curve • Substitution effect dominates

31. Three Applications • How do wages affect labor supply? • Increase in wage • Budget constraint shifts outward • Steeper • New optimum • If enjoy more leisure • Work less • Backward-sloping labor supply curve • Income effect dominates

32. 14 An increase in the wage (a) . . . the labor supply curve slopes upward. (a) For a person with these preferences . . . BC2 Wage Consumption A B 1. When the wage rises . . . BC1 I2 I1 0 0 Hours of Labor Supplied Hours of Leisure 2. . . . hours of leisure decrease . . . 3. . . . and hours of labor increase Labor supply The two 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 labor-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 labor supplied. In panel (a), when the wage rises, consumption rises and leisure falls, resulting in a labor-supply curve that slopes upward.

33. 14 An increase in the wage (b) . . . the labor supply curve slopes backward (b) For a person with these preferences . . . BC2 Wage Consumption 1. When the wage rises . . . I2 I1 BC1 0 0 Hours of Labor Supplied Hours of Leisure 2. . . . hours of leisure increase . . . 3. . . . and hours of labor decrease The two 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 labor-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 labor supplied. In panel (b), when the wage rises, both consumption and leisure rise, resulting in a labor-supply curve that slopes backward. Labor supply

34. Income effects on labor supply: historical trends, lottery winners,& Carnegie conjecture • Labor- supply curve, over long periods • Slope backward • A hundred years ago • People worked six days a week • Today • Five-day workweeks • Length of the workweek has been falling • Wage of the typical worker (adjusted for inflation) has been rising

35. Income effects on labor supply: historical trends, lottery winners,& Carnegie conjecture • Explanation: Advances in technology • Higher worker productivity • Increase in demand for labor • Higher equilibrium wages • Greater reward for working • Income effect dominates substitution effect • More leisure • Less work

36. Income effects on labor supply: historical trends, lottery winners,& Carnegie conjecture • Winners of lotteries • Large increase in incomes • Large outward shifts in budget constraints • Same slope • No substitution effect • Income effect on labor supply • Substantial • People who win the lottery – tend to quit their jobs

37. Income effects on labor supply: historical trends, lottery winners,& Carnegie conjecture • Andrew Carnegie, 19th century • “The parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would” • Income effect on labor supply – substantial

38. Three Applications • How do interest rates affect household saving? • Income decision • Consume today or Save for future • Bundle of goods • Consumption today and Consumption in the future • Relative price = interest rates • Optimum: Budget constraint & Indifference curves

39. 15 The consumption-saving decision Consumption when Old $110,000 100,000 Optimum I2 I1 Consumption when Young 0 I3 55,000 This figure shows the budget constraint for a person deciding how much to consume in the two periods of his life, the indifference curves representing his preferences, and the optimum. $50,000

40. Three Applications • How do interest rates affect household saving? • Increase in interest rates • Budget constraint – shifts outward • Steeper • Consumption in the future – rises • If consume less today • Substitution effect dominates; Save more • If consume more today • Income effect dominates; Save less

41. 16 An increase in the interest rate BC2 BC2 (b) Higher Interest Rate Lowers Saving (a) Higher Interest Rate Raises Saving Consumption When old Consumption When old 1. A higher interest rate rotates the budget constraint outward . . . 1. A higher interest rate rotates the budget constraint outward . . . BC1 I2 I2 I1 I1 BC1 0 0 Consumption when Young Consumption when Young 2. . . . resulting in lower consumption when young and, thus, higher saving. 2. . . . resulting in higher consumption when young and, thus, lower saving. 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.