EC 500

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EC 500

• Chapter 4
• The Theory of Individual Behavior

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Headline

• Packaging Firm Uses Overtime Pay to Overcome
  Labor Shortage
• Boxes Ltd. Produces corrugated paper containers
  at a small plant in Sunrise Beach, Texas.
  Sunrise Beach is a retirement community with an
  aging population, and over the past decade the
  size of its working population has shrunk. During
  the mid 2000s this labor shortage hampered Boxes
  Ltd.s ability to hire enough workers to meet its
  growing demand and production targets. This is
  despite the fact that it pays 10 per houralmost
  twice the local averageto its workers.

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• Last year, Boxes Ltd. Hired a new manager who
  instituted an overtime wage plan at the firm.
  Under her plan, workers earn 10 per hour for the
  first eight hours worked each day, and 15 per
  hour for each hour worked in a day in excess of
  eight hours. This plan eliminated the firms
  problems, as the firms production levels and
  profits are up by 20 percent this year.
• Why did the new manager institute the overtime
  plan instead of simply raising the wage rate in
  an attempt to attract more workers to the firm?

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Which one do you prefer? Why?

• Cash Gift or In-kind Gift?
• 10 Discount Coupon or Buy-one, Get-one Free?

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Overview

• I. Consumer Behavior
• Indifference Curve Analysis
• Consumer Preference Ordering
• II. Constraints
• The Budget Constraint
• Changes in Income
• Changes in Prices
• III. Consumer Equilibrium
• IV. Indifference Curve Analysis Demand Curves
• Individual Demand
• Market Demand

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1. Indifference Curve Analysis

• Indifference Curve
• A curve that defines the combinations of 2 or
  more goods that give a consumer the same level of
  satisfaction.
• Marginal Rate of Substitution
• The rate at which a consumer is willing to
  substitute one good for another and maintain the
  same satisfaction level.

Good Y
III.
II.
I.
Good X
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Consumer Preference Ordering Properties

• Completeness
• More is Better
• Diminishing Marginal Rate of Substitution
• Transitivity

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Complete Preferences

• Completeness Property
• Consumer is capable of expressing preferences (or
  indifference) between all possible bundles. (I
  dont know is NOT an option!)
• If the only bundles available to a consumer are
  A, B, and C, then the consumer
• is indifferent between A and C (they are on the
  same indifference curve).
• will prefer B to A.
• will prefer B to C.

Good Y
III.
II.
I.
Good X
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More Is Better!

• More Is Better Property
• Bundles that have at least as much of every good
  and more of some good are preferred to other
  bundles.
• Bundle B is preferred to A since B contains at
  least as much of good Y and strictly more of good
  X.
• Bundle B is also preferred to C since B contains
  at least as much of good X and strictly more of
  good Y.
• More generally, all bundles on ICIII are
  preferred to bundles on ICII or ICI. And all
  bundles on ICII are preferred to ICI.

Good Y
III.
II.
I.
A
B
C
Good X
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Diminishing Marginal Rate of Substitution

• Marginal Rate of Substitution
• The amount of good Y the consumer is willing to
  give up to maintain the same satisfaction level
  decreases as more of good X is acquired.
• The rate at which a consumer is willing to
  substitute one good for another and maintain the
  same satisfaction level.
• To go from consumption bundle A to B the consumer
  must give up 50 units of Y to get one additional
  unit of X.
• To go from consumption bundle B to C the consumer
  must give up 16.67 units of Y to get one
  additional unit of X.
• To go from consumption bundle C to D the consumer
  must give up only 8.33 units of Y to get one
  additional unit of X.

Good Y
III.
II.
I.
A
B
C
D
Good X
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Consistent Bundle Orderings

• Transitivity Property
• For the three bundles A, B, and C, the
  transitivity property implies that if C ? B and B
  ? A, then C ? A.
• Transitive preferences along with the
  more-is-better property imply that
• indifference curves will not intersect.
• the consumer will not get caught in a perpetual
  cycle of indecision.

Good Y
III.
II.
I.
A
C
B
2
Good X
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2. The Budget Constraint

• Opportunity Set
• The set of consumption bundles that are
  affordable.
• PxX PyY ? M.
• Budget Line
• The bundles of goods that exhaust a consumers
  income.
• PxX PyY M.
• Market Rate of Substitution
• The slope of the budget line
• -Px / Py

The Opportunity Set
Y
M/PY
M/PX
X
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Changes in the Budget Line
Y

• Changes in Income
• Increases lead to a parallel, outward shift in
  the budget line (M1 gt M0).
• Decreases lead to a parallel, downward shift (M2
  lt M0).
• Changes in Price
• A decreases in the price of good X rotates the
  budget line counter-clockwise (PX0 gt PX1).
• An increases rotates the budget line clockwise
  (not shown).

M0/PY
X
M0/PX
Y
X
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3. Consumer Equilibrium

• The equilibrium consumption bundle is the
  affordable bundle that yields the highest level
  of satisfaction.
• Consumer equilibrium occurs at a point where
• MRS PX / PY.
• Equivalently, the slope of the indifference curve
  equals the budget line.

Y
M/PY
M/PX
X
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Price Changes and Consumer Equilibrium

• Substitute Goods
• An increase (decrease) in the price of good X
  leads to an increase (decrease) in the
  consumption of good Y.
• Examples
• Coke and Pepsi.
• Verizon Wireless or T-Mobile.
• Complementary Goods
• An increase (decrease) in the price of good X
  leads to a decrease (increase) in the consumption
  of good Y.
• Examples
• DVD and DVD players.
• Computer CPUs and monitors.

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Complementary Goods (example)
When the price of good X falls and the
consumption of Y rises, then X and Y are
complementary goods. (PX1 gt PX2)
Pretzels (Y)
M/PY1
B
A
0
Beer (X)
M/PX1
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Income Changes and Consumer Equilibrium

• Normal Goods
• Good X is a normal good if an increase (decrease)
  in income leads to an increase (decrease) in its
  consumption.
• Inferior Goods
• Good X is an inferior good if an increase
  (decrease) in income leads to a decrease
  (increase) in its consumption.

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4. Decomposing the Income and Substitution Effects
Initially, bundle A is consumed. A decrease in
the price of good X expands the consumers
opportunity set. The substitution effect (SE)
causes the consumer to move from bundle A to B.
A higher real income allows the consumer to
achieve a higher indifference curve. The
movement from bundle B to C represents the income
effect (IE). The new equilibrium is achieved at
point C.
Y
A
I
X
0
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5. Individual Demand Curve

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

P0
P1
X0
X1
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Market Demand

• The market demand curve is the horizontal
  summation of individual demand curves.
• It indicates the total quantity all consumers
  would purchase at each price point.

Individual Demand Curves
Market Demand Curve
50
40
D2
D1
DM
Q
1 2 3
Q
1 2
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6. A Classic Marketing Application Buy-one,
Get-one Deal
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• Points
• New budget constraint is ADEF.
• Why horizontal?
• Why parallel?
• Choice
• Before
• After

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Cash Gift vs. In-kind Gift
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• Points
• New budget constraint is on the BC line.
• Why?
• Choice
• Before
• After

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Deadweight loss of Christmas Gifts

• Dear Economist,I don't want to be a Scrooge,
  but every year the Christmas extravaganza seems
  like a pointless hassle. Isn't it all just a
  waste of time and money?Yours,-- "Ebenezer",
  LondonDear Ebenezer,I have some sympathy with
  you. Christmas presents are wasteful, and we even
  know how wasteful 16 per cent. This figure comes
  from surveys by economist Joel Waldfogel, who
  asked how much cash his respondents would have
  been willing to pay to buy their Christmas
  presents. The answer is, sadly, 16 per cent less
  than what they cost.The most inappropriate
  gifts, costing 50 per cent more than their value
  to the recipients, come from elderly relatives.
  Sensibly, many elect to give cash instead.
  Unsurprisingly, friends and partners give less
  wasteful gifts. It's interesting to note that the
  most wasteful presents are those that cost
  roughly between Pounds 25 and Pounds 50 -
  expensive enough to assuage the guilt of a
  hurried choice, but cheap enough not to require
  double-checking with those close to the
  recipient.

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• But giving isn't the only example of seasonal
  waste. While some Christmas cards are sent out of
  genuine goodwill, many Christmas card exchanges
  are sub-optimal equilibria. In other words, both
  parties are only sending cards to reciprocate
  last year's card. Both would happily agree to
  stop, but it is embarrassing to be the first
  after so many years of mechanical
  exchange.However, rather than abandoning
  Christmas altogether as a lost cause, bear in
  mind that there is an emotional side to our
  annual ritual. Waldfogel's research explicitly
  excludes the "sentimental value" of gifts. You
  can make sure that the sentimental benefits
  outweigh the cost by giving smaller presents but
  taking more care over them. If you must give to
  those whose tastes you do not understand, send
  cash.As for Christmas cards, wipe your
  Christmas card list and send cards only to those
  who you truly wish to. It may feel awkward to
  strike so many people off your list, but it will
  at least spare them the hassle of sending you a
  card next year.If you feel that further
  explanation is required, send them a copy of this
  article - surely the ultimate yuletide
  gift.Merry Christmas.
• http//www.timharford.com/deareconomist/2003/12/de
  adweight-loss-of-christmas.html

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Answering the Headline

• The question posed at the beginning of the
  chapter asked why Boxes Ltd. paid a higher
  overtime wage only on hours in excess of eight
  hours per day instead of offering workers a
  higher wage for every hour worked during a given
  day. Since Boxes Ltd. already pays twice the
  local market wage rate to workers, it is unlikely
  that increasing the wage would attract more
  workers to the firm. Thus, the key to the
  expanding its output is to get its current
  workers to work more hours. We will show that the
  overtime wage plan is a more effective means of
  increasing worker hours than simply raising the
  wage.

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Conclusion

• Indifference curve properties reveal information
  about consumers preferences between bundles of
  goods.
• Completeness.
• More is better.
• Diminishing marginal rate of substitution.
• Transitivity.
• Indifference curves along with price changes
  determine individuals demand curves.
• Market demand is the horizontal summation of
  individuals demands.

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Exercises and Homework

• In class
• Q. 1, 10, 17
• Homework
• Q. 3, 6, 11