Possibilities, Preferences, and Choices

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CHAPTER
Possibilities, Preferences, and Choices
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After studying this chapter you will be able to

• Describe a households budget line and show how
  it changes when prices or income change
• 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
  incomeon consumption choices
• Predict the effects of changes in wage rates on
  work-leisure choices

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Subterranean Movements

• Like the continents floating on the earths
  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 as the prices of a music download, iPod, and
  CD burner have fallen, people are buying more
  downloads and fewer CDs.
• Why we dont (much) buy too many electronic
  textbooks, even though they are cheaper than
  printed textbooks.

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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
  households consumption choices.

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Consumption Possibilities

• Figure 8.1 shows Lisas budget line.

Divisible goods can be bought in any quantity
along the budget line (gasoline, for
example). Indivisible goods must be bought in
whole units at the points marked (movies, for
example). Lisa can afford any point on the budget
line or inside it.
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Consumption Possibilities

• The budget line is a constraint on Lisas choices.

Lisa can afford any point on her budget line or
inside it. Lisa cannot afford any point outside
her budget line.
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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.
• Lisas budget equation is
• PSQS PMQM Y.

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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 Lisas real income in terms of
  soda.
• The term PM/PS is the relative price of a movie
  in terms of soda.

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Consumption Possibilities

• A households real income is the income expressed
  as a quantity of goods the household can afford
  to buy.
• Lisas 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.
• Relative price 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.

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Consumption Possibilities

• A Change in Prices
• A rise in the price of the good on the x-axis
  decreases the affordable quantity of that good
  and increases 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.

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Consumption Possibilities

• A Change in Income
• An change in money income brings a parallel shift
  of the budget line.
• The slope of the budget line doesnt change
  because the relative price doesnt change.
• Figure 8.2(b) shows the effect of a fall in
  income.

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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 consumers
  indifference curve.
• At point C, Lisa consumes 2 movies and 6
  six-packs a month.

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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.
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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.
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Preferences and Indifference Curves

• A preference map is series of indifference
  curves.

Call the indifference curve that weve just seen
I1.
I0 is an indifference curve below I1. Lisa
prefers any point on I1 to any point on I0 .
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Preferences and Indifference Curves

• I2 is an indifference curve above I1.
• Lisa prefers any point on I2 to any point on I1 .

For example, Lisa prefers point J to either point
C or point G.
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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.

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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.

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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.

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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 movieher MRS is 2.
At point G, Lisa is willing to give up 1/2 a
six-pack to see one more movieher MRS is 1/2.
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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, perfects substitutes, and perfect
  complements.

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Predicting Consumer Behavior

• The consumers 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

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Predicting Consumer Behavior

• Here, the best affordable point is C.

Lisa can afford to consume more soda and see
fewer movies at point F. And she can afford to
see more movies and consume less soda at point
H. But she is indifferent between F, I, and H and
she clearly prefers C to I.
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Predicting Consumer Behavior
At point F, Lisas MRS is greater than the
relative price. At point H, Lisas MRS is less
than the relative price. At point C, Lisas MRS
is equal to the relative price.
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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 consumers 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).

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Predicting

• The price of a movie then falls to 3.

The budget line rotates outward.
Lisas 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.
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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 Lisas income.
• Initially, Lisa consumes at point J in part (a)
  and at point B on demand curve D0 in part (b).

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Predicting

• Lisas 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).
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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

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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.
Lisas best affordable point is then J. The move
from point C to point J is the price effect.
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Predicting Consumer Behavior

• Were going to break the move from point C to
  point J into two parts.
• The first part is the substitution effect and the
  second is the income effect.

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Predicting Consumer Behavior

• 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.

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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.
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Predicting Consumer Behavior

• The direction of the substitution effect never
  varies
• When the relative price falls, the consumer
  always substitutes more of that good for other
  goods.
• The substitution effect is the first reason why
  the demand curve slopes downward.

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Predicting Consumer Behavior

• Income Effect
• To isolate the income effect, we reverse the
  hypothetical pay cut and restore Lisas 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.
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Predicting Consumer Behavior

• For Lisa, movies are a normal good.
• When her income increases, she sees more
  moviesthe 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.

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Predicting Consumer Behavior

• Inferior Good
• 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.

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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
  demandedthe demand curve slopes upward!
• This case does not appear to occur in the real
  world.

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Work-Leisure Choices

• The model of consumer choice can be used to study
  the allocation of time between work and leisure.
• The two goods are leisure and incomewhere
  income represents all other goods.
• Lisa buys leisure by not supplying labor and by
  forgoing income.
• So the price of leisure is the wage rate
  forgone.

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Work-Leisure Choices

• The Labor Supply Curve
• By changing the wage rate, we can find a persons
  labor supply curve.
• An increase in the wage rate makes leisure
  relatively more expensive (higher opportunity
  cost to not working) and has a substitution
  effect toward less leisure (toward more work).

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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 as the wage rate rises.
• When the wage rate rises from 5 to 10 an hour,
  work increases from 20 to 35 hours a weekthe
  move from A to B.

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Work-Leisure Choices

• But if the income effect is stronger than the
  substitution effect, the quantity of work hours
  decreases as the wage rate rises.
• When the wage rate rises from 10 to 15 an hour,
  work decreases from 35 to 30 hours a week the
  move from B to C.

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Work-Leisure Choices

• The move from A to B when the wage rate increases
  from 5 to 10 an hour 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 an hour means that the labor
supply curve bends backward above a certain wage
rate.
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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.

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THE END