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Chapter 6:. Consumer Choices and Economic Behavior. Key Topics. The budget constraint Definition, equation, graph, opportunity cost Impact of Δ I, Δ P x , Δ P y Utility Total and marginal Indifference curve: definition, slope Utility maximization. Key Topics.

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Chapter 6:

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## Chapter 6:

Consumer Choices and Economic Behavior

### Key Topics

• The budget constraint

• Definition, equation, graph, opportunity cost

• Impact of ΔI, ΔPx, ΔPy

• Utility

• Total and marginal

• Indifference curve: definition, slope

• Utility maximization

### Key Topics

3.Downward-sloping demand factors

• Diminishing marginal utility

• Income effect

• Substitution effect

4.Other consumer decisions

• Work or leisure

• Save or borrow

### Questions

• What does it mean if you have a ‘budget constraint’?

• How can your attainable consumption choices be shown mathematically and graphically?

### Budget Constraint

• The maximum Q combinations of goods

that can be purchased given one’s income and the prices of the goods.

### Budget Constraint Variables

I (or M) =the amount of income or money that a consumer has to spend on specified goods and services.

X=the quantity of one specific good or one specific bundle of goods

Y=the quantity of a second specific good or second specific bundle of goods

Px=the price or per unit cost of X

PY=the price or per unit cost of Y

### Budget Line Equation

Income = expenses

I = PxX+PYY

Y = l/PY – (Px/PY)X

 straight line equation

### Budget Line: Axis Intercepts & Slope

• Vertical Axis Intercept

=I/PY

=max Y (X = 0)

• Horizontal Axis Intercept

=I/PX

=max X (Y = 0)

• - Slope

=PX/PY

= ‘inverse’ P ratio

= X axis good P/Y axis good P

= Y/X

### Changes in the Budget Line

• Changes in Income

outward shift in the budget line.

downward shift.

### Changes in the Budget Line

• Changes in Price

-A decrease in the price of good X rotates the budget line counter-clockwise.

-An increase rotates the budget line clockwise.

Y

New budget line for

a price decrease

X

### Q. What Are Your Preferences?

• Lunch

A:1 drink, 1 pizza slice

B:1 drink, 2 pizza slices

C:2 drinks, 1 pizza slice

• Entertainment

A:1 movie, 1 dinner

B:1 movie, 2 dinners

C:2 movies, 1 dinner

For each, indicate which of the following you prefer:

A vs B, B vs C, or A vs C

### Utility Concepts

• Utility:

• Cardinal utility:

satisfaction levels that can be measured or specified with numbers (units = ‘utils’)

• Ordinal utility:

satisfaction levels that can be ordered or ranked

• Marginal utility:

### Utility Assumptions

• Complete (or continuous)  can rank all bundles of goods

• Consistent (or transitive)  preference orderings are logical and consistent

• Consumptive (nonsatiation)  more of a ‘normal’ good is preferred to less

### More of a Good is Preferred to Less

The shaded area represents those combinations of X and Y that are unambiguously preferred to the combination X*, Y*. Ceteris paribus, individuals prefer more of any good rather than less. Combinations identified by “?” involve ambiguous changes in welfare since they contain more of one good and less of the other.

### Indifference Curve

Indifference Curve

• A curve that defines the

combinations of 2 or more

goods that give a consumer

the same level of satisfaction.

• Curves further from origin represent higher utility levels

Assume Bob and Jan are students who actually ENJOY going to their classes and learning new things. Each have been asked to rank the following combinations of classes in terms of their preferences:

Preferences:Bob:a > b > c

Jan:c > b > a

Show and explain graphically with economic concepts.

Econ (#)

6

5

c

4

b

3

2

a

1

Math (#)

1

2

3

4

5

6

• A ‘bad’ good, or an economic ‘bad’ is an item that a consumer does not like or enjoy, which means their total satisfaction level is lower the more of the item they have. This also means the marginal utility of the item is negative.

### MRS & MU

• MRS

=- slope of indifference curve

=-Y/ X

=the rate at which a consumer is willing to exchange Y for 1more (or less) unit of X

U=0 along given indiff curve

=MUx(X)+MUY(Y) = 0

=- Y/ X = MUx/MUY

=- slope = inverse MU ratio

### Consumer Equilibrium (U Max)

• The equilibrium

consumption

bundle is the

affordable bundle

that yields the

highest level of satisfaction.

### Equal Slopes Condition (for consumer equilibrium)

• MUX/MUY = PX/PY

• MUX/PX = MUY/PY

### Individual Demand Curve

• An individual’s demand curve is derived from each new equilibrium point found on the indifference curve as the price of good X is varied.

### Diminishing Marginal Utility

• The law of diminishing marginal utility:

The more of one good consumed in a given period, the less satisfaction (utility) generated by consuming each additional (marginal) unit of the same good.

### Diminishing Marginal Utility and Downward-Sloping Demand

• Diminishing marginal utility helps to explain why demand slopes down.

• Marginal utility falls with each additional unit consumed, so people are not willing to pay as much.

40

25

Price per meal (\$)

15

D

0

25

5

10

Thai meals per month

### Income and Substitution Effects of a Price Change (for normal goods)

Price of a

good or

service

Household is

better off

(higher real income)

Income

effect

Household

FALLS

Opportunity

cost of the

good falls

Substitution

effect

Household

Household is

worse off

(lower real income)

Income

effect

Household

RISES

Opportunity

cost of the

good rises.

Substitution

effect

Household

### Household Choices in Labor Markets

As in output markets, households face constrained choices in input markets. They must decide:

• Whether to work

• How much to work

• What kind of a job to work at

These decisions are affected by:

• The availability of jobs

• Market wage rates

• The skill possessed by the household

### The Price of Leisure

• W = wage rate

=the price (or the opportunity cost or lost benefits of either unpaid work or leisure.

### Work vs. Leisure Constraint

Income

24W

Leisure (hrs/day)

24

### The Labor Supply Curve

• The labor supply curve is a diagram that shows the quantity of labor supplied at different wage rates.

### Saving and Borrowing: Present Versus Future Consumption

• Households can use present income to finance future spending (i.e., save), or they can use future funds to finance present spending (i.e., borrow).

• In deciding how much to save and how much to spend today, interest rates define the opportunity cost of present consumption in terms of foregone future consumption.

Q1

(next yr)

save

I1/P

borrow

Q0 (this yr)

I0/P