C H A P T E R 21 In this chapter, look for the answers to these questions:

The Theory of  How does the represent the Choice choices a consumer can afford?  How do indifference curves represent the P R I N C I P L E S O F consumer’s preferences? N. Gregory Mankiw  What determines how a consumer divides her resources between two ?  How does the theory of explain Premium PowerPoint Slides decisions such as how much a consumer saves, by Ron Cronovich or how much labor she supplies? Modified by Joseph Tao-yi Wang 2010 © 2010 South-Western, a part of Cengage Learning, all rights reserved update 1

Introduction The Budget Constraint: What the Consumer Can Afford  Recall one of the Ten Principles from Chapter 1:  Example: People face tradeoffs . Hurley divides his between two goods:  Buying more of one good leaves fish and mangos. less income to buy other goods.  Working more hours means more income and  A “ bundle” is a particular combination more consumption, but less leisure time. of the goods, e.g. , 40 fish & 300 mangos.  Reducing allows more consumption today  Budget constraint : the limit on the consumption but reduces future consumption. bundles that a consumer can afford  This chapter explores how make choices like these.

THE THEORY OF CONSUMER CHOICE 2 THE THEORY OF CONSUMER CHOICE 3

A C T I V E L E A R N I N G 11 A C T I V E L E A R N I N G 11

Budget Constraint Answers D. Hurley’s budget Quantity Hurley’s income: $12,000 of Mangos constraint shows B : P = $40 per fish, P = $10 per mango the bundles he can F M A. $12000/$40 afford. A. If Hurley spends all his income on fish, = 300 fish how many fish does he buy? B. $12000/$10 C B. If Hurley spends all his income on mangos, = 1200 how many mangos does he buy? mangos C. If Hurley buys 100 fish, how many mangos can he buy? C. 100 fish cost $4000, D. Plot each of the bundles from parts A – C on a $8000 left A graph that measures fish on the horizontal axis buys 800 and mangos on the vertical, connect the dots. Quantity mangos of Fish 4

1 The Slope of the Budget Constraint The Slope of the Budget Constraint

From C to D, Quantity The slope of the budget constraint equals of Mangos “rise” =  the rate at which Hurley –200 mangos can mangos for fish “run” =  the of fish in terms of mangos C +50 fish  the relative of fish: Slope = – 4 D price of fish$ 40 Hurley must = = 4 mangos per fish give up price of mangos$ 10 4 mangos to get one fish.

Quantity of Fish THE THEORY OF CONSUMER CHOICE 6 THE THEORY OF CONSUMER CHOICE 7

A C T I V E L E A R N I N G 22 A C T I V E L E A R N I N G 22 Budget constraint, continued. Answers, part A Quantity A fall in income Show what happens to Hurley’s budget constraint if: Now, of Mangos shifts the budget Hurley constraint down. A. His income falls to $8,000. can buy B. The price of mangos rises to $8,000/$40 = 200 fish PM = $20 per mango or $8,000/$10 = 800 mangos or any combination in between. Quantity of Fish 8

A C T I V E L E A R N I N G 22 Preferences: What the Consumer Wants Answers, part B An increase in the Hurley Quantity : Quantity One of Hurley’s of Mangos price of one good of Mangos indifference curves can still buy shows consumption pivots the budget 300 fish . bundles that give the constraint inward. consumer the same But now he level of satisfaction can only buy B $12,000/$20 = A, B, and all other 600 mangos . bundles on I make 1 A Notice: Hurley equally happy – I 1 slope is smaller, he is indifferent of between them. fish is now only Quantity 2 mangos. Quantity of Fish of Fish THE THEORY OF CONSUMER CHOICE 11

2 Four Properties of Indifference Curves Four Properties of Indifference Curves

One of Hurley’s A few of Hurley’s 1. Indifference curves Quantity 2. Higher indifference Quantity of Mangos indifference curves of Mangos indifference curves are downward- curves are preferred sloping. to lower ones.

If the quantity of Hurley prefers every B I fish is reduced, bundle on 2 (like C) C D the quantity of to every bundle on I A 1 A I mangos must be (like A). 2 I I increased to keep 1 He prefers every 1 I I Hurley equally bundle on 1 (like A) 0 I happy. Quantity to every bundle on 0 Quantity of Fish (like D). of Fish

THE THEORY OF CONSUMER CHOICE 12 THE THEORY OF CONSUMER CHOICE 13

Four Properties of Indifference Curves Four Properties of Indifference Curves

Hurley’s 3. Indifference curves Quantity 4. Indifference curves Quantity of Mangos indifference curves of Mangos cannot cross. are bowed inward.

Suppose they did. A Hurley is willing to give Hurley should prefer up more mangos for a 6 B to C, since B has B more of both goods. fish if he has few fish 1 C (A) than if he has Yet, Hurley is indifferent A B many ( B). between B and C: I I 2 1 4 I He likes C as much as A 1 1 I (both are on 4). He likes A as much as B Quantity Quantity I of Fish of Fish (both are on 1). THE THEORY OF CONSUMER CHOICE 14 THE THEORY OF CONSUMER CHOICE 15

The Marginal Rate of Substitution One Extreme Case: Perfect Substitutes

Marginal rate of Quantity MRS = slope of Perfect substitutes : two goods with substitution (MRS) : of Mangos indifference curve straight-line indifference curves, the rate at which a consumer constant MRS is willing to trade one good for A Example: nickels & dimes another. MRS = 6 Consumer is always willing to trade Hurley’s MRS is the two nickels for one dime. amount of mangos he 1 would substitute for B MRS = 2 another fish. I 1 1 MRS falls as you move down along an Quantity indifference curve. of Fish

THE THEORY OF CONSUMER CHOICE 16 THE THEORY OF CONSUMER CHOICE 17

3 Another Extreme Case: Perfect Complements Less Extreme Cases: Perfect complements : two goods with Close Substitutes and Close Complements right-angle indifference curves Quantity Indifference Quantity Indifference Example: Left shoes, right shoes of Pepsi curves for close of hot curves for {7 left shoes, 5 right shoes} substitutes are dog buns close is just as good as not very bowed complements {5 left shoes, 5 right shoes} are very bowed

Quantity Quantity of Coke of hot dogs THE THEORY OF CONSUMER CHOICE 18

Optimization: What the Consumer Chooses Optimization: What the Consumer Chooses

A is the optimum : Quantity Quantity The optimum Consumer the point on the of Mangos At the optimum, of Mangos is the bundle optimization is budget constraint slope of the Hurley most another example that touches the indifference curve prefers out of of “thinking at the highest possible 1200 equals 1200 all the bundles margin.” indifference curve. slope of the budget he can afford. constraint: Hurley prefers B to A, B MRS = PF/PM but he cannot afford B. 600 A 600 A

Hurley can afford C C marginal price of fish and D, of fish D (in terms of but A is on a higher (in terms of indifference curve. mangos) 150 300 Quantity mangos) 150 300 Quantity of Fish of Fish THE THEORY OF CONSUMER CHOICE 20 THE THEORY OF CONSUMER CHOICE 21

The Effects of an Increase in Income A C T I V E L E A R N I N G 33

Quantity Inferior vs. normal goods of Mangos  An increase in income increases the quantity An increase in demanded of normal goods and reduces the income shifts the budget constraint quantity demanded of inferior goods . outward.  Suppose fish is a B but mangos are an . If both goods are A “normal,” Hurley  Use a diagram to show the effects of buys more of each. an increase in income on Hurley’s optimal bundle of fish and mangos.

Quantity of Fish THE THEORY OF CONSUMER CHOICE 22 23

4 A C T I V E L E A R N I N G 33 The Effects of a Price Change Answers Quantity Initially, Quantity of Mangos of Mangos PF = $40 If mangos are 1200 PM = $10 initial inferior, the new optimum optimum will new PF falls to $20 contain fewer optimum mangos. budget constraint 600 A rotates outward, 500 B Hurley buys more fish and fewer mangos. 150 300 600 Quantity 350 of Fish Quantity of Fish 24 THE THEORY OF CONSUMER CHOICE 25

The Income and Substitution Effects The Income and Substitution Effects Initial A fall in the price of fish has two effects on Quantity In this example, optimum at A. of Mangos Hurley’s optimal consumption of both goods. the effect on mangos is  Income effect PF falls. negative. A fall in PF boosts the purchasing power of Hurley’s : income, allows him to buy more mangos and more from A to B, fish. buy more fish and A  Substitution effect fewer mangos. C A fall in PF makes mangos more expensive relative Income effect: B to fish, causes Hurley to buy fewer mangos & more from B to C, fish. buy more of both Quantity goods. Notice: The net effect on mangos is ambiguous. of Fish

THE THEORY OF CONSUMER CHOICE 26 THE THEORY OF CONSUMER CHOICE 27

A C T I V E L E A R N I N G 44 A C T I V E L E A R N I N G 44 The substitution effect in two cases Answers

Do you think the substitution effect would be ButIn the both substitution graphs, the effect relative is bigger price for changes substitutes bythan the complements.same amount. bigger for substitutes or complements? Quantity of Pepsi Quantity of  Draw an indifference curve for Coke and Pepsi, hot dog buns and, on a separate graph, one for hot dogs and hot dog buns.  On each graph, show the effects of a relative A price change (keeping the consumer on the initial A indifference curve). B B

Quantity Quantity 28 of Coke of hot dogs

5 Deriving Hurley’s for Fish Application 1: Giffen Goods BA:: WhenWhen P PFF== $2,$4, HurleyHurley demandsdemands 350150 fish.fish.  Do all goods obey the ?

Quantity Price of  Suppose the goods are potatoes and meat, of Mangos Fish and potatoes are an inferior good.  If price of potatoes rises, A  substitution effect: buy less potatoes $4 A  income effect: buy more potatoes B B  If income effect > substitution effect, $2 then potatoes are a , a good for which DFish an increase in price raises the quantity demanded.

150 350 Quantity 150 350 Quantity of Fish of Fish 30 THE THEORY OF CONSUMER CHOICE 31

Application 1: Could This Happen in the Real World??? Giffen Goods  Do Giffen goods actually exist?  Jensen, Robert T., and Nolan H. Miller (2008), “Giffen Behavior and Subsistence Consumption.” American Economic Review , 98(4): 1553–77.

THE THEORY OF CONSUMER CHOICE 32 THE THEORY OF CONSUMER CHOICE 33

Application 2: and Labor Supply Application 2: Wages and Labor Supply

Budget constraint At the optimum,  Shows a person’s tradeoff between consumption the MRS between and leisure. leisure and  Depends on how much time she has to divide consumption between leisure and working. equals the .  The relative price of an hour of leisure is the amount of consumption she could buy with an hour’s wages. Indifference curve  Shows “bundles” of consumption and leisure that give her the same level of satisfaction.

THE THEORY OF CONSUMER CHOICE 34 THE THEORY OF CONSUMER CHOICE 35

6 Application 2: Wages and Labor Supply Application 2: Wages and Labor Supply

An increase in the wage has two effects For this person, So her labor supply on the optimal quantity of labor supplied. SE > IE increases with the wage  Substitution effect (SE) : A higher wage makes leisure more expensive relative to consumption. The person chooses less leisure, i.e., increases quantity of labor supplied.  Income effect (IE) : With a higher wage, she can afford more of both “goods.” She chooses more leisure, i.e., reduces quantity of labor supplied.

THE THEORY OF CONSUMER CHOICE 36 THE THEORY OF CONSUMER CHOICE 37

Application 2: Wages and Labor Supply Could This Happen in the Real World??? For this person, So his labor supply falls Cases where the income effect on labor supply is SE < IE when the wage rises very strong:  Over last 100 years, technological progress has increased labor demand and real wages. The average workweek fell from 6 to 5 days.  When a person wins the lottery or receives an inheritance, his wage is unchanged – hence no substitution effect. But such persons are more likely to work fewer hours, indicating a strong income effect.

THE THEORY OF CONSUMER CHOICE 38 THE THEORY OF CONSUMER CHOICE 39

Application 3: Rates and Saving Application 3: Interest Rates and Saving  A person lives for two periods. Budget constraint shown is for 10% .  Period 1: young, works, earns $100,000 At the optimum, consumption = $100,000 minus amount saved the MRS between  Period 2: old, retired current and future consumption = saving from Period 1 consumption equals plus interest earned on saving the interest rate.  The interest rate determines the relative price of consumption when young in terms of consumption when old.

THE THEORY OF CONSUMER CHOICE 40 THE THEORY OF CONSUMER CHOICE 41

7 A C T I V E L E A R N I N G 55 A C T I V E L E A R N I N G 55 EfEffectsfects of a change in the interest rate Answers  Suppose the interest rate rises. The interest rate rises.  Describe the income and substitution effects on Substitution effect current and future consumption, and on saving.  Current consumption becomes more expensive relative to future consumption.  Current consumption falls, saving rises, future consumption rises. Income effect  Can afford more consumption in both the present and the future. Saving falls.

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Application 3: Interest Rates and Saving Application 3: Interest Rates and Saving

In this case, In this case, SE > IE and SE < IE and saving rises saving falls

THE THEORY OF CONSUMER CHOICE 44 THE THEORY OF CONSUMER CHOICE 45

CONCLUSION: CHAPTER SUMMARY Do People Really Think This Way?  People do not make spending decisions by writing down their budget constraints and  A consumer’s budget constraint shows the indifference curves. possible combinations of different goods she can  Yet, they try to make the choices that maximize buy given her income and the prices of the goods. their satisfaction given their limited resources. The slope of the budget constraint equals the  The theory in this chapter is only intended as a relative price of the goods. metaphor for how consumers make decisions.  An increase in income shifts the budget constraint  It explains consumer behavior fairly well in many outward. A change in the price of one of the goods situations and provides the basis for more pivots the budget constraint. advanced economic analysis.

THE THEORY OF CONSUMER CHOICE 46 47

8 CHAPTER SUMMARY CHAPTER SUMMARY

 A consumer’s indifference curves represent her  The consumer optimizes by choosing the point on preferences. An indifference curve shows all the her budget constraint that lies on the highest bundles that give the consumer a certain level of indifference curve. At this point, the marginal rate happiness. The consumer prefers points on higher of substitution equals the relative price of the two indifference curves to points on lower ones. goods.  The slope of an indifference curve at any point is  When the price of a good falls, the impact on the the marginal rate of substitution – the rate at which consumer’s choices can be broken down into two the consumer is willing to trade one good for the effects, an income effect and a substitution effect. other.

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CHAPTER SUMMARY CHAPTER SUMMARY

 The income effect is the change in consumption  The theory of consumer choice can be applied in that arises because a lower price makes the many situations. It can explain why demand consumer better off. It is represented by a curves can potentially slope upward, why higher movement from a lower indifference curve to a wages could either increase or decrease labor higher one. supply, and why higher interest rates could either  The substitution effect is the change that arises increase or decrease saving. because a price change encourages greater consumption of the good that has become relatively cheaper. It is represented by a movement along an indifference curve. 50 51

Indifference Curve Analysis  Budget Constraint  Indifference Curve  MRS

 Optimal Choice at MRS = P 1 / P 2  Substitution Effect + Income Effect

 Homework: Mankiw, Ch.21, pp. 480-482, Problem 5, 6, 10, 11, 13.

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