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Chapter 8:

Chapter 8:. Households’ Choices. 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

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Chapter 8:

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  1. Chapter 8: Households’ Choices

  2. 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

  3. 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.

  4. 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.

  5. 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).

  6. The Budget Line Consumption Movies Soft drinks possibility (per month) (liters per month) A 0 10 B 1 8 C 2 6 D 3 4 E 4 2 F 5 0

  7. Income $30 Movies $6 each Soft drink $3 a litre A B C D E F The Budget Line Figure 8.1 10 8 Unaffordable Soft drink (litres per month) 6 4 Affordable 2 0 1 2 3 4 5 6 7 8 9 10 Movies (per month)

  8. 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 Ps, the quantity of soft drink Qs, the price of a movie PM, the quantity of movies QM, and income Y. • Lisa’s budget equation is: PSQS + PMQM = Y

  9. Consumption Possibilities PSQS + PMQM = Y • Divide both sides of this equation by PS, to give: QS + (PM /PS )QM = Y/PS • Then subtract (PM /PS)QM from both sides of the equation to give: QS = Y/PS – (PM /PS )QM • The term Y/PS is Lisa’s real income in terms of soft drink. • The term PM /PSis the relative price of a movie in terms of soft drink.

  10. 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.

  11. 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.

  12. A …$12 …$6 …$3 F Changes in Prices and Income Figure 8.2(a) Price of a movie is... 10 8 Soft drink (litres per month) 6 4 2 0 1 2 3 4 5 6 7 8 9 10 Movies (per month)

  13. 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.

  14. A Income $15 Income $30 F A Change in Income Figure 8.2(b) 10 8 Soft drink (litres per month) 6 4 2 0 1 2 3 4 5 6 7 8 9 10 Movies (per month)

  15. 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.

  16. Indifference curve Fig. 8.3(a): An Indifference Curve Figure 8.3(a) 10 Preferred 8 C C 6 Soft drink (litres per month) 4 Not preferred G G 2 0 2 4 6 8 10 Movies (per month)

  17. 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.

  18. 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 I1 is I2 . All the points on I2 are preferred to those on I1. For example, point J is preferred to either point C or point G

  19. 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.

  20. 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.

  21. 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.

  22. 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.

  23. The Degree of Substitutability Figure 8.5(a) Soda (cans) 10 Ordinary Goods 8 6 4 2 0 2 4 6 8 10 Movies

  24. The Degree of Substitutability Figure 8.5(b) 10 Perfect substitutes 8 Marker pens at the local supermarket 6 4 2 0 2 4 6 8 10 Marker pens at the campus bookstore

  25. The Degree of Substitutability Figure 8.5(c) 5 Left running shoes Perfect complements 4 3 2 1 0 1 2 3 4 5 Right running shoes

  26. 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

  27. 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.

  28. F Best affordable point C I H The Best Affordable Point Figure 8.6 10 Soft drink (litres per month) 8 6 4 I2 2 I1 I0 0 2 4 6 8 10 Movies (per month)

  29. 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).

  30. Best affordable point: movies $6 C Best affordable point: movies $3 J Price Effect and Demand Curve Figure 8.7(a) 10 Soft drink (litres per month) 8 6 4 I2 2 I1 0 2 4 5 6 8 10 Movies (per month)

  31. A B Price Effect and Demand Curve Figure 8.7(b) 6 5 Price (dollars per movie) 4 3 2 Lisa’s demand curve for movies 1 0 2 4 5 6 8 10 Movies (per month)

  32. 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 D0 in part (b).

  33. Income $30 J K Income $21 Income Effect and Change in Demand Figure 8.8(a) 10 8 6 Soft drink (litres per month) 4 3 I2 2 I1 0 2 4 5 6 8 10 Movies (per month)

  34. B C D0 D1 Demand Curve Figure 8.8(b) 6 5 Price (dollars per movie) 4 3 2 1 0 2 4 5 6 8 10 Movies (per month)

  35. 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.

  36. 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.

  37. 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

  38. 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

  39. 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).

  40. 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.

  41. 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.

  42. 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.

  43. END CHAPTER 8

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