Scribd
Upload
16 views39 pages

Lecture 11

Uploaded by

Charity Kwok
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
16 views39 pages

Lecture 11

Uploaded by

Charity Kwok
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 39

Possibilities, Preferences, and Choices

This Chapter

• From last lecture…


• Consumer maximizes her utility under budget constraint
• The budget constraint is described by the budget line
• Utility-maximizing rule: equalizing marginal utility per dollar

• Is there an easy way to visualize the optimal consumption choice?


• Yes – with the indifference curve
• We can show how demand curves are derived graphically
• We can visualize the substitution effect and the income effect of any price change
Consumption Possibilities

A household’s consumption choices are constrained by its income and the


prices of the goods and services available.
The budget line describes the limits to the household’s consumption
choices.
Consumption Possibilities

When Lisa’s income is $40, the price of


movie is $8 and the price of soda is $4…
The budget line is a constraint on Lisa’s
consumption choices.
Lisa can afford any point on her budget
line or inside it.
Lisa cannot afford any point outside her
budget line.
To maximize her total utility, Lisa’s
consumption choice will always be on the
budget line.
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.
Lisa’s budget equation is:
𝑃𝑆 𝑄𝑆 + 𝑃𝑀 𝑄𝑀 = 𝑌.
Consumption Possibilities

Divide both sides of this equation by 𝑃𝑆 , to give:

𝑃𝑀 𝑌
𝑄𝑆 + 𝑄𝑀 =
𝑃𝑆 𝑃𝑆
𝑃𝑀
Then subtract 𝑄𝑀 from both sides of the equation to give:
𝑃𝑆

𝑌 𝑃𝑀
𝑄𝑆 = – 𝑄𝑀
𝑃𝑆 𝑃𝑆
𝑌/𝑃𝑆 is Lisa’s real income in terms of soda.
𝑃𝑀 /𝑃𝑆 is the relative price of a movie in terms of soda.
Consumption Possibilities

A household’s real income is the income expressed as a quantity of goods the


household can afford to buy.
• Lisa’s real income in terms of soda is the point where her budget line 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 cases of soda must be forgone to see an
additional movie.
Consumption Possibilities

A Change in Prices
A change in the price of the good on
the x-axis changes the slope of the
budget line.
Figure (a) shows the rotation of a
budget line after a change in the
relative price of movies.
Consumption Possibilities

A Change in Income
A change in money income brings a
parallel shift of the budget line.
The slope of the budget line doesn’t
change because the relative price
doesn’t change.
Figure (b) shows the effect of a fall in
income.
Preferences and Indifference
Curves
We can represent Lisa’s preference as
a map.
An indifference curve is a line that
shows combinations of goods among
which a consumer is indifferent – the
same total utility.
At point C, Lisa sees 2 movies and
drinks 6 cases of soda a month.
Preferences and Indifference
Curves
Lisa can sort all possible
combinations of goods into three
groups: preferred to C, not preferred
to C, and just as good as C.
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.
Preferences and Indifference
Curves
Lisa prefers any point above the
indifference curve to any point on the
curve.
Lisa prefers any point on the
indifference curve to any point below
the indifference curve.
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.
Contour Map
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 to get an additional unit of good x, while
at the same time remaining indifferent (on the same indifference curve).

The magnitude of the slope of the indifference curve measures the MRS.
Preferences and Indifference
Curves
If the indifference curve is relatively steep, 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, MRS is low.
In this case, the person is willing to give up a small quantity of y to get more x.
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,
while at the same time remaining indifferent as the quantity of good x
increases.
Preferences and Indifference
Curves
The figure shows the diminishing
MRS of movies for soda.
At point C, Lisa is willing to give up
10 cases of soda to see 5 more
movies—her MRS is 2.
At point G, Lisa is willing to give up
4.5 cases of soda to see 9 more
movies—her MRS is 1/2.
Preferences and Indifference
Curves
Degree of Substitutability
The shape of the indifference curves reveals the degree of substitutability
between two goods.
Predicting Consumer Choices

Best Affordable Choice


The consumer’s best affordable choice…
• is on the budget line;
• is on the highest attainable indifference curve;
• has marginal rate of substitution equal to relative price.
Predicting Consumer Choices

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 prefers C to I.
Predicting Consumer Choices

At point F, Lisa’s MRS is greater than


the relative price.
At point H, Lisa’s MRS is less than the
relative price.
At point C, Lisa’s MRS is equal to the
relative price 𝑃𝑀 /𝑃𝑆 .
Predicting Consumer Choices

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.
The figure illustrates the price effect and shows how
the consumer’s demand curve is generated.
Initially, the price of a movie is $8 and Lisa consumes
at point C in part (a) and at point A in part (b).
Predicting Consumer Choices

Now the price of a movie falls to $4.


The budget line rotates outward.
Lisa’s 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.
Predicting Consumer Choices

A Change in Income
The effect of a change in income on buying plans is
called the income effect.
The figure illustrates the effect of a decrease in Lisa’s
income with no change in the prices.
Initially, Lisa consumes at point J in part (a) and at
point B on demand curve 𝐷0 in part (b).
Predicting Consumer Choices

When Lisa’s income decreases, 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).
Predicting Consumer Choices

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
Predicting Consumer Choices

Initially, Lisa has an income of $40,


the price of a movie is $8, and she
consumes at point C.
The price of a movie falls from $8 to
$4 and her budget line rotates
outward.
Lisa’s best affordable point is then J.
The move from point C to point J is
the price effect.
Predicting Consumer Choices

We’re going to break the move from


point C to point J into two parts:
1. The substitution effect
2. The income effect
Predicting Consumer Choices

Substitution Effect
The substitution effect is the effect of
a change in price on the quantity
bought when the consumer remains
on the same indifference curve.
Predicting Consumer Choices

To isolate the substitution effect, we


give Lisa a hypothetical pay cut.
Lisa is now back on her original
indifference curve but with the price
of a movie at $4.
Her best affordable point is K.
The move from C to K is the
substitution effect.
Predicting Consumer Choices

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.
Predicting Consumer Choices

Income Effect
To isolate the income effect, we
reverse the hypothetical pay cut and
restore Lisa’s 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.
Predicting Consumer Choices

For Lisa, movies are a normal good.


With more income to spend, she sees
more movies—the 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.
Case: Sugary Drinks

Taxes could greatly reduce consumption of sugar-sweetened drinks, according


to a new study released by the Pan American Health Organization (PAHO).
• A 25% increase in the price of sugar-sweetened beverages resulting from higher excise taxes
would likely lead to a 34% reduction in consumption of these drinks, the study shows.

Why should we reduce consumption of sugary drinks?


• Consumption of sugary drinks leads to obesity, which brings heart disease, diabetes, and other
serious diseases, including severe cases of Covid 19.
• In the Americas, 64 percent of men and 61 per cent of women are overweight or obese.

Taxes on sugar-sweetened beverages are increasingly being adopted by


governments globally and have been implemented in more than 73 countries.
Case: Sugary Drinks

• Sam has a budget of $30 a month to allocate


to both sugary and healthy drinks.
• Both types of drink have the same price, 75
cents per can.
• With this budget and price, Sam can buy 40
cans of drinks per month in any combination
of sugary and healthy.
• The government imposes a tax on sugary
drinks of 25 cents per can, so the price of a
can of sugary drink rises to $1.00.
• At this price, Sam can afford only 30 cans of
sugary drinks per month, but she can still
afford 40 cans of healthy drinks.
Case: Sugary Drinks

• Before the tax, she consumed 25 cans of


sugary drinks and 15 cans of healthy drinks
at point a on indifference curve 𝐼1 .
• With the tax, Sam’s best affordable choice is
point B on indifference curve 𝐼0 .
• She decreases sugary drinks from 25 to 15 cans
and increases her consumption of healthy
drinks from 15 to 20 cans.
• Her total consumption of drinks decreases
from 40 to 35 cans per month.
Case: Sugary Drinks

• The substitution effect is the change from point


A to point K along the indifference curve 𝐼1 .
• A decrease of sugary drinks from 25 to 18 cans and
an increase in healthy drinks from 15 to 23 cans.
• The income effect is the change from point K on
𝐼1 to point B on 𝐼0 .
• A decrease in the quantity of sugary drinks from
18 to 15 cans and a decrease in the quantity of
healthy drinks from 23 to 20 cans.
• For Sam, sugary drinks and healthy drinks are
normal goods. a fall in Sam’s real income decreases
her consumption of both drinks.
• Sam’s demand for sugary drinks is less price-
elastic than that of an average person (Why?)
Predicting Consumer Choices

Inferior Goods
For an inferior good, when income increases, the quantity bought decreases.
The income effect is negative and works against the substitution effect.
As long as the substitution effect dominates the income effect, the demand
curve still slopes downward.
Predicting Consumer Choices

If the negative income effect is stronger than the substitution effect, a lower
price for inferior goods brings a decrease in the quantity demanded—the
demand curve slopes upward!
Again, this case rarely appears to occur in the real world (Giffen good).

Back to the Facts


The best affordable choices determine spending patterns.
Changes in prices and incomes change the best affordable point and change
consumption patterns.

You might also like