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ECON 102.004 – Principles of Microeconomics

S&W, Chapter 5

The Consumption Decision

Instructor:

Mehmet S. Tosun, Ph.D.

Department of Economics

University of Nevada, Reno

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Lecture Outline

• Consumer Choice

• Income elasticity of demand

• Deriving demand curves

• Income and substitution effects

• Utility

• Beyond the basic competitive model

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Assumption of Rationality

• There are over 100 million households in the United States choosing millions of different types and brands of goods daily.

• Economists assume all of them are rational!– This is not so farfetched.– Rationality simply means not wasting

resources.

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The Budget Constraint

• A consumer has only so much income to spend.• A budget constraint gives all of the combinations

of two goods the consumer can buy if she spends all of her income.

• The budget constraint shows the opportunity set for the consumer given the prices and the consumer's income.

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Intercepts and the Slope of the Budget Constraint (a)

• Intercepts– x‑intercept = M/pX, the most X a consumer can buy.

– y‑intercept = M/pY, the most Y a consumer can buy.

• The slope of the budget constraint = -pX/pY.

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Intercepts and the Slope of the Budget Constraint (b)

• The slope of the budget constraint shows the trade‑off a consumer faces.– If pX = $2 and pY = $1, then 2 Ys trade for 1 X;

– The slope of the budget constraint is –Px/Py = -$2/$1 = -2.

• The ratio of the relative prices, the trade‑off between X and Y, and the slope are all the same.

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What Happens to Consumption When Income Changes (a)

• Changes in income shift the budget constraint parallel to the original, because the slope, which is the price ratio, is unchanged.

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What Happens to Consumption When Income Changes (a) (cont.)

• If income increases, the budget constraint shifts out from the origin, parallel to the old budget constraint.– The increase in income makes consumers better off.– Consumers’ opportunity set expands and they can

buy more goods.

• If income decreases, the budget constraint shifts in toward the origin, parallel to the old budget constraint.

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What Happens to Consumption When Income Changes (b)

• When income increases, consumers choose a new point on a new budget constraint farther from the origin.

• The point they choose depends on their own tastes or preferences.

• When income rises, the consumption of most goods rises: – These are normal goods.

• When income rises, consumption of some goods falls:– These are inferior goods.

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What Happens to Consumption When Income Changes (c)

• Income elasticity of demand: sensitivity of demand to changes in income.

• Income elasticity of demand = %Qd /%income.– Income elasticity for normal goods > 0.

– Income elasticity for inferior goods < 0.

• The income elasticity of luxuries (movies, restaurant meals) is high.

• The income elasticity of necessities (car repairs, clothing, furniture) is low.

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Table 8.1 Some Income Elasticities of DemandElastic (long run) Inelastic (long run)

Motion pictures 3.41 Car repairs .90

Drugs and medicines 3.04 Tobacco products .86

Owner‑occupied housing 2.45 China, glassware, and utensils

.77

Nondurable toys 2.01 Shoe repairs .72

Electricity 1.94 Alcoholic beverages .62

Restaurant meals 1.61 Water .59

Local buses and trains 1.38 Furniture .53

Gasoline and oil 1.36 Clothing .51

Car insurance 1.26

Physicians' services 1.15

Car purchases 1.07

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How Households of Different Incomes Spend Their Money

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Choosing a Point on the Budget Constraint: Individual Preferences (a)• At which point on the budget constraint will an

individual choose to buy?• Depends on the individual's preferences for the goods.

– Few people choose extreme points• Only pizza and no shoes, or only shoes and no pizza.• If we get too much of one thing, we get a little bored with it.

– We like variety and diversity.– Most consumers choose a point on the budget constraint

between the x‑intercept and the y‑intercept.

shoes

shoes,

shoes

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Choosing a Point on the Budget Constraint: Individual Preferences (b)

• The consumer’s choice depends on how they value the two goods.

• When making decisions people look at the marginal value.

• Example: Pizza and shoes– The consumer considers the value of an additional pair of shoes.

– He compares this to the opportunity cost of an additional pair of shoes:

• If he buys one more pair of shoes, how many pizzas must he do without?

– If the value of an additional pair of shoes > the cost of an additional pair of shoes, the consumer buys an additional pair of shoes.

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Deriving Demand Curves

• Use the budget constraint to derive a consumer's demand curve.

• Suppose the price of good X rises: pX.• Geometrically there are two effects:

– The budget constraint is steeper: slope -pX/pY.– The budget constraint rotates toward the origin, so

the consumer loses some area of the opportunity set.

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The Income Effect of a Price Change

• When the price of X rises, pX , consumers lose purchasing power, or real income.– The opportunity set shrinks so the consumer is

poorer.– Because she is poorer, she will change her

consumption of good X.– If X is a normal good, she buys less X.– If X is an inferior good, since she has been made

poorer by the price increase, she buys more X.

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The Substitution Effect of a Price Change

• When the price of X rises, pX ,

– The good X is relatively more expensive compared to good Y.

– The consumer substitutes away from good X toward good Y.

– This effect is represented by the steepness of the new budget constraint.

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Putting the Income and Substitution Effects Together for a Normal Good

• When pX , total change in demand for X = due to the substitution effect + due to the income effect.

• If X is a normal good, the total demand for X falls.– The substitution effect:

• The consumer substitutes away from the relatively more expensive X.

– The income effect: • The price rise reduces real income, so the consumer demands

fewer normal goods such as X.

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Putting the Income and Substitution Effects for an Inferior Good

• Suppose X is an inferior good.• When the price of X rises, pX , the total demand for X falls.

– The substitution effect: • The consumer substitutes away from the relatively more expensive X.

– The income effect: • The price rise reduces real income, so the consumer demands more of an inferior good

such as X.

• The income effect offsets (partially) the substitution effect, however, the income effect is small.– The substitution effect dominates and total demand for good X falls when pX

rises for an inferior good.• Note: goods so inferior that the income effect outweighs the substitution effect and total demand increases

when the price rises are Giffen goods (these are very rare).

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Utility

• The benefits derived from consuming are called utility (happiness).

• One cannot compare the utilities of different people.– One cannot say, "You are happier than I am."– However one can say, "You would be willing to

pay more than I would for some good."

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Willingness to Pay• Economists use “willingness to pay” as a criterion to measure utility

or happiness.– Marginal utility: how much extra utility or happiness a consumer

receives from one additional unit of the good.

– Marginal willingness to pay = how much the consumer will pay for the next unit.

• Marginal willingness to pay is a way of measuring, in dollars, marginal utility.

• As a consumer buys more sweaters, each successive sweater provides less additional utility: – Diminishing marginal utility.

• Successive increments of a good eventually become less desirable.• The willingness to pay for additional units also diminishes.

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Willingness to Pay (cont.)

SWEATERS SWEATERS

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Maximizing Utility (a)

• This says the consumer receives more utility per dollar from consuming good X than good Y.

• She should buy more X and less Y.– If she buys more X, MUX falls due to diminishing

marginal utility.– If she buys less Y, MUY increases.

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Maximizing Utility (b)

• Since MU = p for all goods, it must be the case that for all goods,– MUX/pX = MUY/pY = MUz/pz.– These ratios say that if the consumer is maximizing her utility then the extra utility

per dollar must be equal for all goods.• To see why this must be the case, suppose that these equalities do not

hold:– MUX/pX > MUY/pY.– This says the consumer receives more utility per dollar from consuming good X

than good Y.– She should buy more X and less Y.– If she buys more X, MUX falls due to diminishing marginal utility.

– If she buys less Y, MUY increases.

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Consumer Surplus (a)• Consumer surplus measures consumers' total happiness in

dollar terms.– Consumer surplus uses the “willingness to pay” criterion.

• Consumer surplus is the difference between what the consumer is willing to pay and what they actually pay.– This difference represents the "savings" consumers receive

because the market price is lower than what they are willing to pay.

– Consumer surplus represents the total bargain consumers receive from buying a good at a price less than what they would be willing to pay.

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Consumer Surplus (b)

• Consumer surplus is the area under the demand curve out to the equilibrium quantity and above the price consumers actually pay.

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Loss of Consumer Surplus

• When the price rises, consumer surplus falls for two reasons.• Fewer goods are bought, so fewer consumers receive

consumer surplus; the price > willingness to pay for those consumers who leave the market.

• Consumers who continue to buy the product receive less consumer surplus since they "save" less due to the higher price.

• The loss of consumer surplus measures how much the worse off consumers are due to the price increase.

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Consumer Surplus and a Price Floor

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Consumer Surplus and Taxes

• Taxes on goods tend to increase the price of the good being taxed.

• The loss of consumer surplus measures the total harm of the tax to consumers.

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The Basic Model of Consumer Choice

• The basic model of the theory of consumer choice provides powerful insights into the behavior of consumers and suppliers.– It is not without its critics and criticisms.

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Criticisms of the Basic Model• Few consumers make economic decisions by

consciously examining budget constraints and computing marginal utility.– True but irrelevant– It is like saying a physicist's explanation of how billiard balls

travel cannot be correct because the players do not work out the equations beforehand.

• Consumers do not really know what they want.– True– Judging by their purchases, many consumers seem to have

ill-formed and unstable preferences.

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Criticisms of the Basic Model cont’d

• Consumers lack complete information about prices, and hence cannot know their budget constraints.

• The interaction of preferences and prices may make a person's decision process very complex; e.g., the price of an object may influence a person's attitude toward it.

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Behavioral Economics

• Combines the insights of psychology and economics to study how people make choices.– Should base theory of consumption on how

people actually choose.• Laboratory experiments are often used.

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Insights of Behavioral Economics (a)

• Endowment effects: possessing something can alter preferences of owner– Experiment: mugs randomly distributed to college

students –- very few were traded when in principle around half should have been.

– Experiment: college students were given either a lottery ticket or $2 and could trade them – not very many did.

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Insights of Behavioral Economics (b)

• Loss Aversion: related to endowment effects– People seem particularly sensitive to loss.

– A person with $1,100 who loses $100 feels worse than a person with $900 who finds $100.

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Insights of Behavioral Economics (c)• Status Quo Bias:

– A reference level of consumption is important.• The first person had a reference level of $1,100, the second had

a reference level of $900.

– The difference between actual consumption and reference level consumption is important.

– Why? » An accustomed standard of living» “Keeping up with the Jones”

• The basic consumption model -- the level of consumption matters

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Tendency for People to Accept the Default Option

• When 401(k) retirement participation is automatic very few people opt-out.– Default option is not to participate, a smaller

proportion opt-in

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Implications of Behavioral Economics

• The simple model of consumer choice is incomplete.• Do we need to change basic ideas?

– No. People still respond to incentives.• Demand curves still slope downward.

• Behavioral Economics shows that people have a greater reluctance to change than the basic model predicts.– May be the reason not all mutually beneficial trades are

made.

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Beyond the Basic Model

• While there are valid critiques of the basic consumption model they only show that the model is not complete.– The model is still useful.

• By being explicit about our assumptions, we can know which ones (if any) are not valid in a particular instance.