POSSIBILITIES, PREFERENCES, AND CHOICES

1. 8 POSSIBILITIES, PREFERENCES, AND CHOICES CHAPTER

2. Objectives • After studying this chapter, you will able to • Describe a household’s budget line and show how it changes when prices or income changes • Make a map of preferences by using indifference curves 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 they are cheaper than audio tapes.

4. Consumption Possibilities • Household consumption choices are constrained by its income and the prices of the goods and services available. • The budget line describes the limits to the household’s consumption choices.

5. Consumption Possibilities • Figure 8.1 shows a consumer’s budget line. • Divisible goods can be bought in any quantity desired along the budget line (gasoline, for example) • Indivisible goods must be bought in whole units at the points marked on the budget line (movies, for example).

6. 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 soda PS, the quantity of soda QS, the price of a movie PM, the quantity of movies QM, and income Y. • Lisa’s budget equation is: • PSQS + PMQM = Y.

7. 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 soda. • The term PM/PSis the relative price of a movie in terms of soda.

8. Consumption Possibilities • 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 soda 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 sodas must be forgone to see an additional movie.

9. Consumption Possibilities • 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.

10. Consumption Possibilities • An 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.

11. 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 six-packs a month.

12. 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.

13. Preferences and Indifference Curves • All the points above the indifference curve are preferred to the points on the curve. • And all the points on the indifference curve are preferred to the points below the curve.

14. Preferences and Indifference Curves • The indifference curve in the figure is just one of many curves that form an indifference map. • Call the indifference curve that we’ve just seen I1. • An indifference curve below I1 is I0 . All the points on I1 are preferred to those on I0 .

15. Preferences and Indifference Curves • 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.

16. Preferences and Indifference Curves • Marginal Rate of Substitution • The marginal rate of substitution, (MRS), measures 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.

17. Preferences and Indifference Curves • If the indifference curve is relatively steep, the MRS is high. • In this case, the person is 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 is willing to give up a small quantity of y to get more x.

18. Preferences and Indifference Curves • 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.

19. Preferences and Indifference Curves • Figure 8.4 shows the diminishing MRS of movies for soda. • At point C, Lisa is willing to give up 2 six-packs to see one more movie—her MRS is 2. • At point G, Lisa is willing to give up 1/2 a six-pack to see one more movie—her MRS is 1/2.

20. 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.

21. Predicting Consumer Behavior • The consumer’s best affordable point is: • On the budget line • 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

22. Predicting Consumer Behavior • Here, the best affordable point is C. • Lisa can afford to consume more soda and fewer movies at point F. • And she can afford to consume more movies and less soda at point H. • But she is indifferent between F, I, and H and she clearly prefers C to I.

23. Predicting Consumer Behavior • At point F, Lisa’s MRS is greater than the relative price. • At point H, Lisa’s MRS is less than the relative price.. • At point C, Lisa’s MRS is equal to the relative price.

24. Predicting … • A Change in Price • The effect of a change in the price of a good on the quantity of the good consumed is called the price effect. • Figure 8.7 illustrates the price effect and shows how the consumer’s 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).

25. Predicting … • The price of a movie then falls to $3. • The budget line rotates outward. • Lisa’s best affordable point is now J in part (a). • In part (b), Lisa moves to point B, which is a movement along her demand curve for movies.

26. Predicting … • 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).

27. Predicting … • Lisa’s income decreases and her budget line shifts leftward in part (a). • Her new best affordable point is K in part (a). • Her demand for movies decreases, shown by a leftward shift of her demand curve for movies in part (b).

28. Predicting Consumer Behavior • When a good is a normal good, the quantity consumed changes in the same direction as the change in income. • For Lisa, movies are a normal good. • When a good is an inferior good, the quantity consumed changes in the opposite direction to the change in income.

29. Predicting Consumer Behavior • Substitution Effect and Income Effect • For a normal good, a fall in price always increases the quantity consumed. • We can prove this assertion by dividing the price effect in two parts: • Substitution effect • Income effect

30. Predicting Consumer Behavior • 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.

31. Predicting Consumer Behavior • Initially, Lisa has an income of $30, the price of a movie is $6, and she consumes at point C. • The price of a movie falls from $6 to $3 and her budget line rotates outward. • Lisa’s best affordable point is then J.

32. Predicting Consumer Behavior • We’re going to break the move from C to J into two parts. • The first part is the substitution effect and the second is the income effect.

33. Predicting Consumer Behavior • To isolate the substitution effect, we give Lisa a hypothetical pay cut. • Lisa is now back on her original indifference curve but with a lower price of movies and her best affordable point is K. • The move from C to K is the substitution effect.

34. Predicting Consumer Behavior • The direction of the substitution effect never varies: a fall in price brings an increase in the quantity bought. • The substitution effect is the first reason why the demand curve slopes downward.

35. Predicting Consumer Behavior • To isolate the income effect, we reverse the hypothetical pay cut and restore Lisa’s income to its original level (its actual level). • Lisa is now back on indifference curve I2 and her best affordable point is J. • The move from K to J is the income effect.

36. Predicting Consumer Behavior • For Lisa, movies are a normal good. • When her income increases, she sees more movies—the income effect is positive. • For a normal good, the income effect reinforces the substitution effect and is the second reason why the demand curve slopes downward.

37. Predicting Consumer Behavior • For an inferior good, when income increases, the quantity bought decreases. • 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.

38. Predicting Consumer Behavior • If the negative income effect is stronger than the substitution effect, a lower price for inferior goods brings a decrease in the quantity demanded—the demand curve slopes upward! • This case has not been found in any real-world market.

39. Work-Leisure Choices • Labor Supply • Indifference curves can be used to study the allocation of time between work and leisure. • The two “goods” are leisure and income, which represent all other goods.

40. Work-Leisure Choices • The Labor Supply Curve • By changing the wage rate, we can find a person’s labor 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).

41. 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.

42. 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.

43. Work-Leisure Choices • The move from A to B when the wage rate increases from $5 to $10 means that the labor 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 labor supply curve bends backward above a certain wage rate.

44. Work-Leisure Choices • Historical evidence shows that the average workweek has declined over the centuries, implying that people have preferred to seek greater leisure despite its higher opportunity cost.

45. 8 POSSIBILITIES, PREFERENCES, AND CHOICES CHAPTER THE END