Principle of Microeconomics Chapter 21 Consumer choices Elements of consumer choices Total amount of money available to spend. Price of each item consumers on a perfectly competitive market are price takers. More importantly, relative price between two items. Price is $2 and price is $4 The relative price between apple and orange: 1 apple = ½ orange = price of apple/price units of measure The relative price between orange and apple: 1 orange =2 apple Preference: what consumers like and how much they like it. 1
generic representation of consumer choice From choice over many items to choice over two ggregation Extrapolation Represent a consumer choice a consumption bundle Example: household make choice over apple and oranges consumption bundle could refer to a combination of 2 apples and 3 oranges. Use a point on positive quadrant to represent a consumption bundle. The vertical axis is always the good used as units of measure. consumption bundle of 2 apple and 3 orange is point (2,3) 3 2 Feasible choices for a consumer budget constraint Notation: consumer has total income (I) of $1 to spend on apple and orange Price (P x ) is $2 and price (P y ) is $4. of apply (Q x ) and quantity (Q y ) consumption bundle (Q x, Q y ) is feasible if it costs less than income. Bundles (1,1) (,25) (5,) (2,15) (2,2) Costs 6 1 1 1 12 Budget constraint 2
The boundary of the feasible choice budget line Trace all consumption bundles one can afford when all the money are spent In our example, budget line is formed by bundles (Q x,q y ) such that 25 15 2 5 Budget constraint describe the limit on the consumption bundles that a consumer can afford Raise income, expand the set of choices 35 25 Income raises from 1 to 14 15 2 5 7 Conversely, lower income, shrink the set of choices 3
Price also changes the set of choices Raise the price, shrink the set of choices 25 2 15 Price raises from 4 to 5 2 5 Conversely, lower the price, expand the set of choices More examples of price and the set of choices Price raises from 2 to 4 Price raises from 4 to 5 and price raises from 2 to 4 25 15 25 2 15 2 25 5 2 25 5 4
Slope of the budget line It shows the trade-off between goods on the market Rate at which the consumer can trade one good for the other on the market If one sells an apple, how many oranges can he get? Relative price of the two goods 25 15 Relative price between apple and orange 2 5 More on relative price Relative price between apple and orange = price /price When relative price between apple and orange goes up, we say that apple is relatively more expensive and orange is relatively cheaper. When relative price between apple and orange goes up, on the graph where orange (the unit of account) is on the vertical axis, the slope of the budget line is steeper. When will the relative price between apple and orange go up? Only price goes up. Only price drops. Both price goes up, but % increase price is larger than that. Both price drops, but % decrease price is smaller than that. 5
Describe the impact of following price changes P x = 2, P y = 4, I = 1 (black budget line) x is apple, y is orange case P x P y I 3 4 1 B 3 8 1 C 2 8 1 D 4 8 1 25 12.5 E 2 4 5 F 4 16 2 G 3 6 15 H 3 12 15 25 33.3 5 Preference: how much do consumers like each item Preference is described by an ordering. From scale of 1 to 1 rank each GOP candidate. From scale of -1 to 1 rank the following consumption bundles: (,1), (2,), (1,2), (2,3), (,2) Representation of ordering by a number utility function For example u(,1) = -2 u(1,2) = u(2,3) = 2 Utility function using artificial scales to measure degree of satisfaction. 6
Basic logical requirements for preference ordering Completeness: When compare two bundles, red and blue ) Red is preferred to blue B) Blue is preferred to red C) Indifferent between red and blue D) Don t know Transitivity: If you say that red is better than blue, blue is better than green, then you can t say that green is better than red. No lexicographical ordering. More apple is always better, no matter how much orange I get. If two bundles have the same amount s, then I prefer the one with more oranges. pplication of contour maps --Topographic maps Contour map: 2-D representation of 3-D object 7
Topographic maps of Stone mountain US surface temperature contour maps 8
Graphical representation of preference indifference curves n indifference curve is formed by connecting bundles that gives the same level of satisfaction. typical indifference curve oranges C E D B apples Four properties of indifference curves Higher indifference curves are preferred to lower ones The more, the merrier. Higher indifference curves is to the northeast corner Indifference curves are downward sloping To be indifferent, if have more of one thing must have less of the other thing Indifference curves do not cross Indifference curves are bowed inward (convex towards origin) 9
The Impossibility of Intersecting Indifference Curves Oranges C B pples Slope of indifference curve marginal rate of substitution Marginal rate of substitution (MRS) between apple and orange The maximum amount s one is willing to give up to get one more apple MRS between apple and orange at point = 3/1=3 oranges s happy as before, on the same indifference curve 15 12 5.5 5 B 34 1 11 apples Value to consumers measured by numbers s 1
MRS: trade-off between goods from consumers preference point of view. On a typical indifference curve (bowed), MRS is finite and changes along the indifference curve. Two goods are substitutable. They are not perfect substitutes -- The rate at which one can substitute one goods for another changes. Diminishing marginal rate of substitution along the indifference curve. s one good (apple ) become more scarce (move to the left), it takes more other good (orange) to substitute for this one. (apple). Vice versa. Interpretation Relatively(compares among bundles that give the same level of satisfaction) scarce goods are relatively more valuable. Consumers prefer variety When MRS is constant, two goods are perfect substitutes Nickels 6 4 2 I 1 I 2 I 3 1 2 3 Dimes 11
When MRS is either infinite or zero, two goods are perfect complements Left shoes I 2 5 I 1 4 5 6 Right shoes Constrained optimization I want to live at the warmest place in the state of Georgia. 12
Consumers as utility maximizers Try to reach the highest level of satisfaction they could Feasibility budget constraint Levels of satisfaction are represented by indifference curves. 25 feasible 5 Review of geometry Two curves intersect each other Two curves tangent to each other They only touch each other at one point t the tangency point, the slopes of the two curves are equal 13
Where is the optimum? 25 C D B 5 Description of the optimal choice The optimal choice is on the budget line Optimal choice never leave money unspent. Full utilization of one s resources. The optimal choice where an indifference curve tangent to the budget line. Slope of this indifference curve = slope of the budget line MRS between apple and orange = relative price between apple and orange Decision at the margin again Measure marginal benefit and marginal cost of consuming one more apple in number s Optimal choice is the point at which Marginal benefit = marginal cost 14
Basic tools of analyzing consumer choices I: Income effect When nothing else changes, give a consumer more income, where will his optimal choice move to? Parallel shift of budget line Increase the set of possible choices Should achieve a higher level of satisfaction. (new indifference curve) 35 25 Budget raises from 1 to 14 15 2 5 7 n Increase in Income The case of a normal goods New budget constraint New optimum Initial optimum I 2 I 1 Initial budget constraint 15
n Increase in Income The case of an inferior goods New budget constraint New optimum I 2 Initial optimum Initial budget constraint I 1 Everything else stays the same, price goes up Raise the price, reduce the purchasing power of income, reduce the set of choices, though not uniformly as a reduction of income would do. In addition, raise the price, increase the opportunity cost. The budget line has a steeper slope. 25 4 5 16
The overall effect of an increase of price Initial budget constraint new optimum Initial optimum I 2 I 1 New budget constraint This consumer wants less apple because 1) apple is more expensive, 2) he is poorer Basic tools of analyzing consumers choices II: Substitution effect The relative price between two goods changes. If a consumer still has means to stay on the same indifference curve (as happy as before), where will he choose to be? Budget line with high apple price Consumers always have less of more expensive things and more of cheaper things. Budget line with low apple price 17
Separate the income effect and substitution effect of a price rise Budget line with high apple price B C Budget line with low apple price to B is substitution effect, B to C is income effect Consumers demand for apple When nothing else change, a change of price leads consumers to choose a different quantity to maximize their level of satisfaction Price C C Consumers choice Consumers demand for apple 18
Increase of income leads to shift of demand curve The case of a normal good Income increases Price Demand for apple increases B B Price of related goods are all goods substitutes? Price increases Price Demand for apple increases Substitutes, if substitution effect dominates income effect C B B Income effect Substitution effect 19
Price of related goods are all goods substitutes? Price increases Demand for apple increases Price Complements, if substitution effect is dominated by income effect C B B Income effect Substitution effect Optimal choice when goods are perfect compliments 25 is still when there is a indifference curve touch the budget line. feasible 5 2
Price increases when orange and apple are compliments Price Demand for apple decreases 25 B B 5 Exception of law of demand Giffen good Law of demand: When the price of a good rises, demand for the good falls - - downward sloping demand curve Giffen good: n increase in the price of the good raises the quantity demanded. upward sloping demand curve price change has both income effect and substitution effect Giffen goods are inferior goods, so that income effect and substitution effect goes the opposite direction. This is the case where income effect dominates substitution effect 21
Potato during Irish famine of Potatoes Income effect C B Substitution effect I 2 I 1 of Meat Household labor supply Consumption bundles: (goods and services, leisure) Time constraint labor supply Prices Price of goods and services is P price index (CPI) Price of leisure is its opportunity cost nominal hourly wage, W (current dollars) Real wage is nominal wage adjusted for inflation, w (constant dollars) 22
Budget constraint of consumption-leisure choice In current dollars In constant dollars Relative price between time and goods Consumption $219 w = 25 876h leisure In constant dollars Budget constraint with non-wage income Consumption $224 w = 25 $5 876h leisure 23
Consumption-leisure choice w = 25 Consumption $22 $5 $5 696h 876h leisure US average working hour = 18 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 -- ndrew Carnegie Consumption $22 676h 876h leisure Income effect 24
Budget constraint when wage increases In constant dollars Consumption 219 w = 3 w = 25 876 leisure Labor supply curve Wage increases for most of workers Consumption Wage BC 2 1. When real wage rises... Labor supply B I 2 BC 1 I 1 Leisure 2.... hours of leisure decrease... 3.... and hours of labor increase Hours of Labor Supplied Demand for leisure is downward sloping 25
Labor supply for some high wage workers Consumption BC 2 Wage Labor supply 1. When the wage rises... I 2 I 1 BC 1 2.... hours of leisure increase... Hours of Leisure 3.... and hours of labor decrease Hours of Labor Supplied Leisure is Giffen good?! Longer time horizon Hours per worker decreases starting as early as 19. Year 19 1929 1945 1973 1993 Hours per week 54.3 48 38.8 38 37.2 More recent change 26
Decompose the impact of a real wage increase In constant dollars 1) Real wage increase increases the price of leisure (P y ). (blue line) a) Substitution effect, b) Negative income effect, 2) Real wage increase increases c income I bigger positive income effect. (red line) 219 w = 3 w = 25 876 h Household saving decision supply of capital Consumption bundle: (consumption now, consumption in the future) What is the relative price between consumption now and consumption in the future? It is gross (real) interest rate. Bank pays 5% interest rate on your saving. The gross (nominal) interest rate is 15% = 1.5 Inflation rate is 2%. Real interest rate is 5%-2%= 3% The gross real interest rate is 13%. 27
Budget constraint in saving decision Household has total income of $1 now that can be spend now or in the future. Nominal interest rate is 5% and there is no inflation. Consumption in the future 11 15 r=1% 1 Consumption now Household saving decision Consumption in the future 15 saving 1 Consumption now 28
n Increase in the Interest Rate (a) Higher Interest Rate Raises Saving Consumption when old BC 2 (b) Higher Interest Rate Lowers Saving Consumption when old BC 2 I 2 I 2 BC 1 I 1 I 1 Consumption when Young BC 1 Consumption when Young THE ECONOMIC WY OF LOOKING T LIFE Gary Becker --1992 Nobel price winner His research uses the economic approach to analyze social issues that range beyond those usually considered by economists. Examples Discrimination Crime Education Fertility choice Marriage and Divorce Suicide ddiction 29
s an economy grows, it goes through a demographic transition from high mortality rate and high birth rate to low mortality rate and low birth rate. (experience of England from Soares) and quality tradeoffs Consumption bundles (quantity of kids, quality of kids) as an inferior goods Quality quantity 3
Relative price between quantity and quality of kids Cost of quantity = material cost + time cost Cost of quality = cost of education benefits of education Relative price between quantity and quality increases Quality quantity 31