POSSIBILITIES, PREFERENCES, AND CHOICES

POSSIBILITIES, PREFERENCES, AND CHOICES 8CHAPTE

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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

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.

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.

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).

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.

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/PS is the relative price of a movie in terms of soda.

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.

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.

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.

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.

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.

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.

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 .

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.

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.

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.

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.

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.

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.

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

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.

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.

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).

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.

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).

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).

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.

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

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.

Predicting Consumer Behavior

Initially, Lisa has an income of $30, the price of a movie is $6, and she consumes at point C.

Lisa’s best affordable point is then J.

The price of a movie falls from $6 to $3 and her budget line rotates outward.

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.

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.

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.

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.

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.

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.

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.

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.

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).

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.

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.

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.

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.

8CHAPTER

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POSSIBILITIES, PREFERENCES, AND CHOICES