Chapter 21: Theory of Consumer Choice We will now try to "get behind the demand curve To get behind the D curve we must study individual behavior How do individuals make consumption decisions? We have assumed the law of demand. Question: Can we derive a demand curve, that obeys the law of demand, by making some simple assumptions about individuals behavior? Theory of Consumer Choice People face tradeoffs (one of the ten principles) Buy more of one good buy less of another good Spend more time enjoying leisure spend less time working have less income have less consumption Spend more today saves less today less consumption in future 1
The Budget Line Definition. The budget line (or budget constraint) shows the limits to a household's consumption choices. Assume P B = $.50 (= price of a loaf of bread) P W = $2.00 (= price of a bottle of wine) I = $10 (= income) Expenditures on: There are many different combinations Wine Bread Income you can buy. 5*$2 + 0*$.5 =$10 4*$2 + 4*$.5 =$10 3*$2 + 8*$.5 =$10 2*$2 + 12*$.5 =$10 1*$2 + 16*$.5 =$10 0*$2 + 20*$.5 =$10 3
Budget line: I = P W *W + P B *B Income spent Income spent on wine on bread Graphing this: I = P W W + P B B P B B = I - P W W B = (I/P B ) - (P W W)/P B B = - (P W /P B ) W + I/P B Slope = - (P W /P B ) = -2/.5 = -4 shows the rate at which I trade one good for another gives the relative prices of the two goods a bottle of wine costs 4 times as much as a loaf of bread the opportunity cost of a bottle of wine is 4 loaves of bread shows that the market trades off 1 bottle of wine for 4 loaves of bread y- intercept = I/P B = all the bread I can buy if I I spend my whole income on bread I/P w = all the wine I can buy if I spend my whole income on wine 4
The budget line is a straight line. shows all combinations of wine and bread that the individual can buy given their income. like a PPF it shows what is attainable. 1. Income (SHIFT) Assume income increases. Budget line shifts outward. What before was unaffordable now may be affordable. Does slope change? No. Prices have not changed so slope is still -(P w /P b ) What factors will affect the budget line? 5
2. Prices (ROTATION) Assume price of bread falls. P B Does this have any effect on the maximum amount of wine you can buy? No. Thus, no change in x-intercept. Does this have any effect on the maximum amount of bread you can buy? Yes. You can buy more. The y-intercept changes. If P w then rotate around maximum bread point (y-axis) (price of good x) 6
Q: What happens if income goes up by 10%, P b by 10 percent and P w by 10 percent. Look at budget constraint: Before changes : P W *W + P B *B = I B = - (P W /P B )*W + I/P B After changes: P W (1.10)*W + P B (1.10)*B = I (1.10) B = - (P W /P B )(1.10/1.10)*W + I/P B (1.10/1.10) No change in slope. No change in y-intercept. No change in x-intercept. 7
Indifference curves Definition. An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. Key point by it s construction you don t care at which point you end up at on this curve. Each point gives you the same level of satisfaction ---- the same utility level. NOTE: ALONG any particular indifference curve you don t care where you consume (which bundle of goods and services). BETWEEN indifference curves you do care about where you consume (which bundle of goods and services) Marginal rate of substitution Slope of IC shows rate at which the consumer is willing to trade off one good for another. This rate is called the marginal rate of substitution or MRS Shows how much bread you would give up for more bottle of wine. 8
Note: the indifference curve is not a straight line! This means that the slope will change. This shows that the rate you are willing to trade bread for wine depends on how much bread and wine you have. The rate at which you will trade wine for bread depends on how thirsty and hungry you are which depends on how much wine and bread you have! Characteristics of indifference curves 1. Downward sloping Why? Will be explained in class. 2. Higher indifference curves are preferred to lower ones Why? Easy. More is better than less! 9
3. Can not cross. Why? We will show a contradiction in class. 10
Combining indifference curves and budget constraints Indifference Curve: shows how you feel about different combinations Budget Line: shows which combinations you can afford We need to combine the two. We will draw some graphs. We will show which bundle maximizes the consumers utility given his/her budget line. Notes 1. Different people have different preferences and will choose different bundles. 2. How do people respond to a price change? Combine the indifference curve-budget line diagram with the demand diagram. We will see that we get the law of demand. Pw Qw Pw Qw 11