Economic Analysis Economic Analysis for Businessfor Business

Session XV: Theory of Session XV: Theory of Consumer Choice (Chapter Consumer Choice (Chapter 21)21)InstructorInstructorSandeep BasnyatSandeep Basnyat98418922819841892281Sandeep_basnyat@yahooSandeep_basnyat@yahoo.com.com

AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : Budget constraintBudget constraintThe consumer’s income: $1000 Prices: $10 per pizza, $2 per pint of Pepsi

A. If the consumer spends all his income on pizza, how many pizzas does he buy?

B. If the consumer spends all his income on Pepsi, how many pints of Pepsi does he buy?

C. If the consumer spends $400 on pizza, how many pizzas and Pepsis does he buy?

D. Plot each of the bundles from parts A-C on a diagram that measures the quantity of pizza on the horizontal axis and quantity of Pepsi on the vertical axis, then connect the dots.

2

AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : AnswersAnswers

3

0

100

200

300

400

500

0 20 40 60 80 100 Pizzas

Pepsis

A

B

D. The budget constraint shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods.

D. The budget constraint shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods.

A. $1000/$10= 100 pizzas

B. $1000/$2= 500 Pepsis

C. $400/$10 = 40 pizzas$600/$2= 300 Pepsis

C

CHAPTER 21 THE THEORY OF CONSUMER

CHOICE

The Slope of the Budget ConstraintThe Slope of the Budget Constraint

From C to D,

“rise” = –100 Pepsis

“run” = +20 pizzas

Slope = –5

Consumer must give up 5 Pepsis to get another pizza. 0

100

200

300

400

500

0 20 40 60 80 100 Pizzas

Pepsis

D

C

CHAPTER 21 THE THEORY OF CONSUMER

CHOICE

The Slope of the Budget ConstraintThe Slope of the Budget ConstraintThe slope of the budget

constraint equals◦the rate at which the consumer

can trade Pepsi for pizza: the opportunity cost of pizza in terms of Pepsi

◦the relative price of pizza: price of one good compared to the other

AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : ExerciseExercise

What happens to the budget constraint if:

A. Income falls to $800

6

0

100

200

300

400

500

0 20 40 60 80 100 Pizzas

Pepsis

AA CC TT II VV E LE L EE AA RR NN II NN G G 2A2A: : AnswersAnswers

7

0

100

200

300

400

500

0 20 40 60 80 100 Pizzas

PepsisConsumer can buy $800/$10 = 80 pizzas

or $800/$2 = 400 Pepsis

or any combination in between.

A fall in income shifts the budget constraint inward.

A fall in income shifts the budget constraint inward.

AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : ExerciseExercise

What happens to the budget constraint if:

B. The price of Pepsi rises to $4/pint.

8

0

100

200

300

400

500

0 20 40 60 80 100 Pizzas

Pepsis

AA CC TT II VV E LE L EE AA RR NN II NN G G 2B2B: : AnswersAnswers

9

0

100

200

300

400

500

0 20 40 60 80 100 Pizzas

PepsisConsumer can still buy 100 pizzas.

But now, can only buy $1000/$4 = 250 Pepsis.

Notice: slope is smaller, relative price of pizza now only 2.5 Pepsis.

An increase in the price of one good pivots the

budget constraint inward.

An increase in the price of one good pivots the

budget constraint inward.

PREFERENCES: WHAT THE PREFERENCES: WHAT THE CONSUMER WANTCONSUMER WANTThe consumer’s preferences allow him to

choose among different bundles of the same goods he wants, for example Pepsi and Pizza, that best suits his tastes.

If the two bundles suit his tastes equally well, the consumer is indifferent between two bundles.

A graphical representation of the bundles of consumption that make the consumer equally happy is called the indifference curve.

The Consumer’s PreferencesThe Consumer’s Preferences

Quantityof Pizza

Quantityof Pepsi

0

Indifferencecurve, I1

C

B

A

An indifference curve is a curve that shows consumption bundles that give

the consumer the same level of satisfaction, such as in points A, B or C

If the consumption of pizza is reduced, consumption of Pepsi must increase to

keep him equally happy.

The Consumer’s Preferences-MRSThe Consumer’s Preferences-MRS

Quantityof Pizza

Quantityof Pepsi

0

Indifferencecurve, I1

5MRS

C

B

A

• MRS is the rate at which a consumer is willing to trade one good for another.

• It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.

MRS tells how much Pepsi the consumer requires to be compensated for a one unit increase in pizza consumption

The slope at any point on an indifference curve is the Marginal Rate of Substitution MRS

100

200

30 50

Higher and Lower Indifference Curves: Indifference Higher and Lower Indifference Curves: Indifference MapMap

Quantityof Pizza

Quantityof Pepsi

0

Indifferencecurve, I1

I25

MRS

C

B

A

D

I3

E

Higher indifference curves represent higher level of satisfaction

Four Properties of Indifference Four Properties of Indifference CurvesCurvesHigher indifference curves are

preferred to lower ones.Indifference curves are

downward sloping.Indifference curves do not cross.Indifference curves are bowed

inward.

Four Properties of Indifference Four Properties of Indifference CurvesCurves Property 1: Higher indifference

curves are preferred to lower ones.◦Consumers usually prefer more of

something to less of it. ◦Higher indifference curves represent

larger quantities of goods than do lower indifference curves.

The Consumer’s PreferencesThe Consumer’s Preferences

Quantityof Pizza

Quantityof Pepsi

0

Indifferencecurve, I1

I2

C

B

A

D

Four Properties of Indifference Four Properties of Indifference CurvesCurves Property 2: Indifference curves

are downward sloping.◦A consumer is willing to give up one

good only if he or she gets more of the other good in order to remain equally happy.

◦If the quantity of one good is reduced, the quantity of the other good must increase.

◦For this reason, most indifference curves slope downward.

The Consumer’s PreferencesThe Consumer’s Preferences

Quantityof Pizza

Quantityof Pepsi

0

Indifferencecurve, I1

Four Properties of Indifference Four Properties of Indifference CurvesCurves Property 3: Indifference curves

do not cross.◦Points A and B should make the

consumer equally happy.◦Points B and C should make the

consumer equally happy.◦This implies that A and C would

make the consumer equally happy.◦But C has more of both goods

compared to A.

The Impossibility of Intersecting Indifference CurvesThe Impossibility of Intersecting Indifference Curves

Quantityof Pizza

Quantityof Pepsi

0

C

A

B

Four Properties of Indifference Four Properties of Indifference CurvesCurves Property 4: Indifference curves

are bowed inward.◦People are more willing to trade

away goods that they have in abundance and less willing to trade away goods of which they have little.

◦These differences in a consumer’s marginal substitution rates cause his or her indifference curve to bow inward.

Bowed Indifference CurvesBowed Indifference Curves

Quantityof Pizza

Quantityof Pepsi

0

Indifferencecurve

8

3

A

3

7

B

1

MRS = 6

1MRS = 14

6

14

2

Two Extreme Examples of Two Extreme Examples of Indifference CurvesIndifference CurvesPerfect substitutes

◦Goods that can be exactly substitutable◦Consumers value both goods exactly

equalPerfect complements

◦Goods that need exact combination to form a product

◦Consumers benefit extra unit of good A only if he/she has extra unit of good B

Perfect Substitutes and Perfect ComplementsPerfect Substitutes and Perfect Complements

$ amount0

50 cents

(a) Perfect Substitutes

I1 I2 I3

3

6

2

4

1

2

Perfect Substitutes• Because the MRS is constant,

two goods with straight-line indifference curves are perfect substitutes.

• The marginal rate of substitution is a constant number.

Perfect Substitutes and Perfect ComplementsPerfect Substitutes and Perfect Complements

Right Shoes0

LeftShoes

(b) Perfect Complements

I1

I2

7

7

5

5

Perfect ComplementsTwo goods with right-angle indifference curves are perfect complements.

9

9

OPTIMIZATION: HOW THE OPTIMIZATION: HOW THE CONSUMER CHOOSES?CONSUMER CHOOSES?

Step 1: Consumer chooses to buy on or below his budget constraint.

Step 2:He get the combination of goods on the highest possible indifference curve.

The Consumer’s OptimumThe Consumer’s Optimum

Quantityof Pizza

Quantityof Pepsi

0

Budget constraint

I1I2

I3

Optimum

AB

Consumer optimum occurs at the point where the highest indifference curve

and the budget constraint are tangent (slope of budget constraint and

indifference curve is equal).

Note:Slop of ID curve: MRSSlop of BC: Relative price of Pepsi and Pizza

The Consumer’s Optimal ChoiceThe Consumer’s Optimal ChoiceThe consumer chooses consumption of

the two goods so that the marginal rate of substitution equals the relative price.

At the consumer’s optimum, the consumer’s valuation of the two goods equals the market’s valuation.◦ Consumer takes as given the relative price of

the two goods and then chooses an optimum at which his MRS equals the relative price.

◦ The relative price is the rate at which market is willing to trade one good for another, whereas the MRS is the rate at which the consumer is willing to trade one good for another.

Cases: Income effect and Price Cases: Income effect and Price EffectEffect

What happens when consumer’s income level increases? (Income effect)◦A) Normal good: consumption

increases, and,◦B) Inferior good: consumption

decreases

An Increase in Income-Normal goods: Pepsi and An Increase in Income-Normal goods: Pepsi and PizzaPizza

Quantityof Pizza

Quantityof Pepsi

0

New budget constraint

I1

I2

Initialbudgetconstraint

Initialoptimum

I3

I4

Which Indifference curve would the consumer chose?

An Increase in Income-Normal goods caseAn Increase in Income-Normal goods case

Quantityof Pizza

Quantityof Pepsi

0

New budget constraint

I1

I3

Initialbudgetconstraint

Initialoptimum

New optimum

Increase in Income- An Inferior Good case (Pepsi)Increase in Income- An Inferior Good case (Pepsi)

Quantityof Pizza

Quantityof Pepsi

0

Initialbudgetconstraint

New budget constraint

I1 I2

Initialoptimum

New optimum

CasesCasesWhat happens when consumer’s

income level increase or decreases?◦Normal good and inferior good cases

What happens when price of the good(s) increases or decreases? (Price effect)Assume that price of Pepsi

decreases from $2 to $1 per pint.

Price EffectPrice Effect

Effect 1

Pepsi is relativel

y cheaper

Pizza is relativel

y expensi

ve

Opportunity cost of buying Pizza is higher

Buy more Pepsi and less Pizza

Interaction Effect

Substitution effect

Moves to another combination of

Indifference curve

Price EffectPrice Effect

Effect I1

Pepsi is relativel

y cheaperCan buy

more goods with extra

money

Jumps to higher

indifference curve

Normal Good -

Buy more goods

Interaction Effect

Income effect

Income level

increased

Inferior Good - Buy

less of inferior goods

Price EffectPrice EffectTotal Price Effect =

Substitution effect + Income Effect

Quantityof Pizza

Quantityof Pepsi

0

I1

I2A

Initial optimum

New budget constraint

Initialbudgetconstraint

Substitution effect

B

C New optimum

A Change in Price- Price of Pepsi decreases from $2 A Change in Price- Price of Pepsi decreases from $2 to $1 to $1

Income effectTotal effect

5-38

Total effect of Price decrease of Total effect of Price decrease of Good X on Quantity demanded of Good X on Quantity demanded of Good XGood XTotal effect of price decrease

= Substitution effect

+ Income effect 9= 5 + 4

Total effect of price decrease

= Substitution effect

+ Income effect 3= 5 + (-2)

Generalization: Income and Generalization: Income and Substitution EffectsSubstitution Effects

The Income Effect◦ The income effect is the change in

consumption that results when a price change moves the consumer to a higher or lower indifference curve

The Substitution Effect◦ The substitution effect is the change in

consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution.

THREE APPLICATIONSTHREE APPLICATIONSDo all demand curves slope

downward?How do wages affect labour

supply?How do interest rates affect

household savings?

THREE APPLICATIONSTHREE APPLICATIONSDo all demand curves slope downward?

◦Demand curves can sometimes slope upward.◦This happens when a consumer buys more of a

good when its price rises.◦Giffen goods

Economists use the term Giffen good to describe a good that violates the law of demand.

Giffen goods are goods for which an increase in the price raises the quantity demanded.

The income effect dominates the substitution effect. They have demand curves that slope upwards.

Application I: A Giffen GoodApplication I: A Giffen Good

Quantityof Meat

Quantity ofPotatoes

0

I2I1

Initial budget constraint

New budgetconstraint

D

A

B

2. . . . which increasespotatoconsumptionif potatoes

are a Giffengood.

Optimum with lowprice of potatoes

Optimum with highprice of potatoes

E

C1. An increase in the price ofpotatoes rotates the budgetconstraint inward . . .

Reasons:1.Potatoes are a strongly inferior good. When the price of potatoes rises, the consumer is poorer. The income effect makes the consumer want to buy less meat and more potatoes2.Because potatoes are more expensive, substitution effect makes the consumer want to buy more meat but income effect is so strong that it exceeds the substitution effects

◦When wage rate increases, a) If people find that spending more time on

leisure activity incur higher opportunity costs, the substitution effect is greater than the income effect for them and they work more.

b) If people find that increase in wage rate is an increase in their income level, income effect is greater than the substitution effect for them and they spend more time on leisure and works less or the same amount.

What happens when the What happens when the wage rate increases?wage rate increases?

Application II: The Work-Leisure DecisionApplication II: The Work-Leisure Decision

Hours of Leisure0

Consumption

$5,000

100

I3

I2

I1

Optimum

2,000

60

What happens when the wage increases?

An Increase in the Wage: Substitution effect-Income An Increase in the Wage: Substitution effect-Income effecteffect

Hours ofLeisure

0

Hours of work(a) For a person with substitution effect. . .

I1

I2BC2

BC1

2. . . . hours of leisure decrease . . .

1. When the wage rises . . .

Hours ofLeisure

0

(b) For a person with Income effect . . .

I1

I2

BC2

BC1

1. When the wage rises . . .

2. . . . hours of leisure increase . . .

Hours of work

How do interest rates affect How do interest rates affect household saving?household saving?

◦If the substitution effect of a higher interest rate is greater than the income effect, households save more.

◦If the income effect of a higher interest rate is greater than the substitution effect, households spend more and save less or remain constant.

Application III: The Consumption-Saving DecisionApplication III: The Consumption-Saving Decision

Consumptionwhen Young

0

Consumptionwhen Old

$110,000

100,000

I3

I2

I1

Budgetconstraint

55,000

$50,000

Optimum

What happens when the bank interest rate increases?

An Increase in the Interest Rate-Substitution and An Increase in the Interest Rate-Substitution and Income EffectIncome Effect

0

(a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving

Consumptionwhen Old

I1

I2

BC1

BC2

0

I1 I2

BC1

BC2

Consumptionwhen Old

Consumptionwhen Young

1. A higher interest rate rotatesthe budget constraint outward . . .

1. A higher interest rate rotatesthe budget constraint outward . . .

2. . . . resulting in lowerconsumption when young and, thus, higher saving.

2. . . . resulting in higherconsumption when youngand, thus, lower saving.

Consumptionwhen Young

Thus, an increase in the interest rate could either encourage or discourage saving.

Thank youThank you