Chapter 5 The Consumption Decision

1
Chapter 5The Consumption Decision
2
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.

3
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.

4
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.

5
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.

6
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.

7
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.

8
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.

9
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
• The income elasticity of luxuries (movies,
  restaurant meals) is high.
• The income elasticity of necessities (car
  repairs, clothing, furniture) is low.

10
Table 8.1 Some Income Elasticities of Demand
Source H. S. Houthakker and Lester D. Taylor,
Consumer Demand in the United States (Cambridge,
Mass. Harvard University Press, 1970).
11
How Households of Different Incomes Spend Their
Money
12
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
13
Choosing a Point on the Budget Constraint
Individual Preferences (b)

• The consumers 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.

14
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.

15
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.

16
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.

17
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.

18
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).

19
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."

20
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.

21
Willingness to Pay (cont.)
SWEATERS
SWEATERS
22
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.

23
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.

24
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.

25
Consumer Surplus (b)

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

26
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.

27
Consumer Surplus and a Price Floor
28
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.

29
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.

30
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.
• 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.

31
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.

32
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.

33
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.

34
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

35
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
• U.S. medical drug benefit for seniors
• Default was sign up
• By mid-2004 only 10 of seniors had signed up.

36
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.

37
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.