The Theory of Consumer Choice. UAPP693 Economics in the Public & Nonprofit Sectors Steven W. Peuquet, Ph.D.

Transcription

1 The Theory of Consumer Choice UAPP693 Economics in the Public & Nonprofit Sectors Steven W. Peuquet, Ph.D. 1

2 These slides are for use only as part of a formal instructional course and may not be copied, scanned, or duplicated, in whole or in part for commercial purposes. Portions are copyrighted by Cengage Learning. All Rights Reserved. 2

3 Budget Constraint Budget constraint Limit on the consumption bundles that a consumer can afford It shows the trade-off between goods Slope of the budget constraint Rate at which the consumer can trade one good for the other Relative price of the two goods 3

4 The Consumer s Budget Constraint The budget constraint shows the various bundles of goods that the consumer can buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The table and graph show what the consumer can afford if his income is $1,000, the price of pizza is $10, and the price of Pepsi is $2. 4

5 The Consumer s Budget Constraint Quantity of Pepsi 500 B 250 C Consumer s budget constraint A Quantity of Pizza The budget constraint shows the various bundles of goods that the consumer can buy for a given income. Here the consumer buys bundles of pizza and Pepsi. The table and graph show what the consumer can afford if his income is $1,000, the price of pizza is $10, and the price of Pepsi is $2. 5

6 Preferences Indifference curve Shows consumption bundles that give the consumer the same level of satisfaction Combinations of goods on the same curve Same satisfaction Slope of indifference curve Marginal rate of substitution Rate at which a consumer is willing to trade one good for another Not the same at all points 6

7 The Consumer s Preferences Quantity of Pepsi C B MRS 1 A D I 2 Indifference curve, I 1 0 Quantity of Pizza The consumer s preferences are represented with indifference curves, which show the combinations of pizza and Pepsi that make the consumer equally satisfied. Because the consumer prefers more of a good, points on a higher indifference curve (I 2 here) are preferred to points on a lower indifference curve (I 1 ). The marginal rate of substitution (MRS) shows the rate at which the consumer is willing to trade Pepsi for pizza. It measures the quantity of Pepsi the consumer must be given in exchange for 1 pizza. 7

8 Preferences Four properties of indifference curves 1. Higher indifference curves are preferred to lower ones Higher indifference curves more goods 2. Indifference curves are downward sloping 3. Indifference curves do not cross 4. Indifference curves are bowed inward 8

9 Impossibility of Intersecting Indifference Curves Quantity of Pepsi A C B 0 Quantity of Pizza A situation like this can never happen. According to these indifference curves, the consumer would be equally satisfied at points A, B, and C, even though point C has more of both goods than point A. 9

10 Bowed Indifference Curves 14 Quantity of Pepsi MRS=6 1 A MRS= B Indifference curve Quantity of Pizza Indifference curves are usually bowed inward. This shape implies that the marginal rate of substitution (MRS) depends on the quantity of the two goods the consumer is consuming. At point A, the consumer has little pizza and much Pepsi, so he requires a lot of extra Pepsi to induce him to give up one of the pizzas: The marginal rate of substitution is 6 pints of Pepsi per pizza. At point B, the consumer has much pizza and little Pepsi, so he requires only a little extra Pepsi to induce him to give up one of the pizzas: The marginal rate of substitution is 1 pint of Pepsi per pizza. 10

11 Preferences Extreme examples of indifference curves Perfect substitutes Two goods with straight-line indifference curves Marginal rate of substitution constant Perfect complements Two goods with right-angle indifference curves 11

12 Perfect Substitutes and Perfect Complements Nickels (a) Perfect Substitutes (b) Perfect Complements Left shoes I 2 5 I 1 2 I 1 I 2 I Dimes Right shoes When two goods are easily substitutable, such as nickels and dimes, the indifference curves are straight lines, as shown in panel (a). When two goods are strongly complementary, such as left shoes and right shoes, the indifference curves are right angles, as shown in panel (b). 12

13 Optimization Optimum Point where indifference curve and budget constraint touch Best combination of goods available to the consumer Slope of indifference curve Equals slope of budget constraint Marginal rate of substitution = Relative price 13

14 The Consumer s Optimum Quantity of Pepsi 0 Budget constraint Optimum A B I 1 I 2 I 3 Quantity of Pizza The consumer chooses the point on his budget constraint that lies on the highest indifference curve. At this point, called the optimum, the marginal rate of substitution equals the relative price of the two goods. Here the highest indifference curve the consumer can reach is I 2. The consumer prefers point A, which lies on indifference curve I 3, but the consumer cannot afford this bundle of pizza and Pepsi. By contrast, point B is affordable, but because it lies on a lower indifference curve, the consumer does not prefer it. 14

15 Optimization Higher income Consumer can afford more of both goods Shifts the budget constraint outward New optimum Normal good Good for which an increase in income raises the quantity demanded 15

16 An Increase in Income Quantity of Pepsi and Pepsi consumption New budget constraint 1. An increase in income shifts the budget constraint outward... New optimum Initial optimum I 2 0 I 1 Initial budget constraint raising pizza consumption... Quantity of Pizza When the consumer s income rises, the budget constraint shifts out. If both goods are normal goods, the consumer responds to the increase in income by buying more of both of them. Here the consumer buys more pizza and more Pepsi. 16

17 Optimization Inferior good Good for which an increase in income reduces the quantity demanded Price of one good falls Rotates the budget constraint outward Steeper slope Change in relative price Income effect Substitution effect 17

18 An Inferior Good Quantity of Pepsi New budget constraint 1. When an increase in income shifts the budget constraint outward but Pepsi consumption falls, making Pepsi an inferior good Initial optimum New optimum Initial budget constraint I 1 I pizza consumption rises, making pizza a normal good... 0 Quantity of Pizza A good is an inferior good if the consumer buys less of it when his income rises. Here Pepsi is an inferior good: When the consumer s income increases and the budget constraint shifts outward, the consumer buys more pizza but less Pepsi. 18

19 Quantity of Pepsi 1,000 D A Change in Price New budget constraint and raising Pepsi consumption Initial budget constraint B New optimum I 2 1. A fall in the price of Pepsi rotates the budget constraint outward... Initial optimum I 1 A reducing pizza consumption Quantity of Pizza When the price of Pepsi falls, the consumer s budget constraint shifts outward and changes slope. The consumer moves from the initial optimum to the new optimum, which changes his purchases of both pizza and Pepsi. In this case, the quantity of Pepsi consumed rises, and the quantity of pizza consumed falls. 19

20 Optimization Income effect Change in consumption When a price change moves the consumer To a higher or lower indifference curve 20

21 Optimization Substitution effect Change in consumption When a price change moves the consumer Along a given indifference curve To a point with a new marginal rate of substitution 21

22 Income and Substitution Effects When the Price of Pepsi Falls 22

23 Income and Substitution Effects Quantity of Pepsi Income effect Substitution effect Initial budget constraint 0 New budget constraint B C New optimum A Substitution effect Income effect I 2 Initial optimum I 1 Quantity of Pizza The effect of a change in price can be broken down into an income effect and a substitution effect. The substitution effect the movement along an indifference curve to a point with a different marginal rate of substitution is shown here as the change from point A to point B along indifference curve I 1. The income effect the shift to a higher indifference curve is shown here as the change from point B on indifference curve I 1 to point C on indifference curve I 2. 23

24 Optimization Deriving the demand curve Quantity demanded of a good for any given price Initial optimum point Initial price of the good Initial quantity of the good A change in price of the good (new price) New optimum New optimum quantity 24

25 Deriving the Demand Curve (a) The Consumer s Optimum Quantity of Pepsi Price of Pepsi (b) The Demand Curve for Pepsi New budget constraint 750 B $2 A I A I 1 1 B Demand 0 Initial budget Quantity Quantity constraint of Pizza of Pepsi Panel (a) shows that when the price of Pepsi falls from $2 to $1, the consumer s optimum moves from point A to point B, and the quantity of Pepsi consumed rises from 250 to 750 pints. Demand curve in panel (b) reflects this relationship between the price and the quantity demanded. 25

26 Application Example How do wages affect labor supply? Trade-off between leisure and consumption Bundle of goods: leisure and work Given wage Budget constraint Optimum 26

27 The Work-Leisure Decision Consumption $5,000 2,000 Optimum I 3 This figure shows Sally s budget constraint for deciding how much to work, her indifference curves for consumption and leisure, and her optimum. I 2 I Hours of leisure 27

28 How do wages affect labor supply? Increase in wage - budget constraint shifts outward: Steeper If enjoy less leisure Work more Upward-sloping labor supply curve Substitution effect dominates If enjoy more leisure Work less Backward-sloping labor supply curve Income effect dominates 28

29 Consumption An Increase in the Wage (a) (a) For a person with these preferences the labor supply curve slopes upward. Wage BC 2 B Labor supply I 2 BC 1 A 1. When the wage rises... 0 I 1 0 Hours of Leisure hours of leisure decrease and hours of labor increase Hours of Labor Supplied The two panels of this figure show how a person might respond to an increase in the wage. The graphs on the left show the consumer s initial budget constraint, BC 1, and new budget constraint, BC 2, as well as the consumer s optimal choices over consumption and leisure. The graphs on the right show the resulting laborsupply curve. Because hours worked equal total hours available minus hours of leisure, any change in leisure implies an opposite change in the quantity of labor supplied. In panel (a), when the wage rises, consumption rises and leisure falls, resulting in a labor-supply curve that slopes upward. 29

30 An Increase in the Wage (b) (b) For a person with these preferences.... the labor supply curve slopes backward Consumption Wage BC 2 1. When the wage rises... Labor supply I 1 I 2 BC 1 0 Hours of Leisure hours of leisure increase and hours of labor decrease Hours of Labor Supplied The two panels of this figure show how a person might respond to an increase in the wage. The graphs on the left show the consumer s initial budget constraint, BC 1, and new budget constraint, BC 2, as well as the consumer s optimal choices over consumption and leisure. The graphs on the right show the resulting laborsupply curve. Because hours worked equal total hours available minus hours of leisure, any change in leisure implies an opposite change in the quantity of labor supplied. In panel (b), when the wage rises, both consumption and leisure rise, resulting in a labor-supply curve that slopes backward. 30

31 Income effects on labor supply Labor- supply curve, over long periods Slope backward A hundred years ago People worked six days a week Today Five-day workweeks Length of the workweek has been falling Wage of the typical worker (adjusted for inflation) has been rising 31

32 Income effects on labor supply Explanation: Advances in technology Higher worker productivity Increase in demand for labor Higher equilibrium wages Greater reward for working Income effect dominates substitution effect More leisure Less work 32

33 Income effects on labor supply Winners of lotteries Large increase in incomes Large outward shifts in budget constraints Same slope No substitution effect Income effect on labor supply Substantial People who win the lottery tend to quit their jobs 33

34 Income effects on labor supply Andrew Carnegie, 19 th century The parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would Income effect on labor supply substantial 34

35 That s it for today. Thanks! 35