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Econ 1116

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### Ch09

1. 3. Consumption Possibilities <ul><ul><li>Household consumption choices are constrained by its income and the prices of the goods and services available. </li></ul></ul><ul><ul><li>The budget line describes the limits to the household’s consumption choices. </li></ul></ul>
2. 4. <ul><ul><li>Figure 9.1 shows Lisa’s budget line. </li></ul></ul><ul><ul><li>Divisible goods can be bought in any quantity along the budget line (gasoline, for example). </li></ul></ul><ul><ul><li>Indivisible goods must be bought in whole units at the points marked (movies, for example). </li></ul></ul>Consumption Possibilities
3. 5. <ul><ul><li>The budget line is a constraint on Lisa’s choices. </li></ul></ul><ul><ul><li>Lisa can afford any point on her budget line or inside it. </li></ul></ul><ul><ul><li>Lisa cannot afford any point outside her budget line. </li></ul></ul>Consumption Possibilities
4. 6. <ul><li>The Budget Equation </li></ul><ul><ul><li>We can describe the budget line by using a budget equation. </li></ul></ul><ul><ul><li>The budget equation states that </li></ul></ul><ul><ul><li>Expenditure = Income </li></ul></ul><ul><ul><li>Call the price of soda P S , the quantity of soda Q S , the price of a movie P M , the quantity of movies Q M , and income Y . </li></ul></ul><ul><ul><li>Lisa’s budget equation is: </li></ul></ul><ul><li>P S Q S + P M Q M = Y. </li></ul>Consumption Possibilities
5. 7. <ul><li>P S Q S + P M Q M = Y </li></ul><ul><li>Divide both sides of this equation by P S , to give: </li></ul><ul><li>Q S + ( P M /P S )Q M = Y/P S </li></ul><ul><li>Then subtract ( P M /P S )Q M from both sides of the equation to give: </li></ul><ul><li>Q S = Y/P S – ( P M /P S )Q M </li></ul><ul><li>Y/P S is Lisa’s real income in terms of soda. </li></ul><ul><li>P M /P S is the relative price of a movie in terms of soda. </li></ul>Consumption Possibilities
6. 8. <ul><ul><li>A household’s real income is the income expressed as a quantity of goods the household can afford to buy. </li></ul></ul><ul><ul><li>Lisa’s real income in terms of soda is the point on her budget line where it meets the y -axis. </li></ul></ul><ul><ul><li>A relative price is the price of one good divided by the price of another good. </li></ul></ul><ul><ul><li>Relative price is the magnitude of the slope of the budget line. </li></ul></ul><ul><ul><li>The relative price shows how many cases of soda must be forgone to see an additional movie. </li></ul></ul>Consumption Possibilities
7. 9. <ul><ul><li>A Change in Prices </li></ul></ul><ul><ul><li>A rise in the price of the good on the x -axis decreases the affordable quantity of that good and increases the slope of the budget line. </li></ul></ul><ul><ul><li>Figure 9.2(a) shows the rotation of a budget line after a change in the relative price of movies. </li></ul></ul>Consumption Possibilities
8. 10. <ul><ul><li>A Change in Income </li></ul></ul><ul><ul><li>An change in money income brings a parallel shift of the budget line. </li></ul></ul><ul><ul><li>The slope of the budget line doesn’t change because the relative price doesn’t change. </li></ul></ul><ul><ul><li>Figure 9.2(b) shows the effect of a fall in income. </li></ul></ul>Consumption Possibilities
9. 11. <ul><ul><li>An indifference curve is a line that shows combinations of goods among which a consumer is indifferent . </li></ul></ul><ul><ul><li>Figure 9.3(a) illustrates a consumer’s indifference curve. </li></ul></ul><ul><ul><li>At point C , Lisa sees 2 movies and drinks 6 cases of soda a month. </li></ul></ul>Preferences and Indifference Curves
10. 12. Preferences and Indifference Curves <ul><ul><li>Lisa can sort all possible combinations of goods into three groups: preferred, not preferred, and just as good as point C . </li></ul></ul><ul><ul><li>An indifference curve joins all those points that Lisa says are just as good as C . </li></ul></ul><ul><ul><li>G is such a point. Lisa is indifferent between point C and point G. </li></ul></ul>
11. 13. <ul><ul><li>All the points above the indifference curve are preferred to the points on the curve. </li></ul></ul>Preferences and Indifference Curves <ul><ul><li>And all the points on the indifference curve are preferred to the points below the curve. </li></ul></ul>
12. 14. <ul><ul><li>A preference map is series of indifference curves. </li></ul></ul>Preferences and Indifference Curves <ul><ul><li>Call the indifference curve that we’ve just seen I 1 . </li></ul></ul><ul><ul><li>I 0 is an indifference curve below I 1 . </li></ul></ul><ul><ul><li>Lisa prefers any point on I 1 to any point on I 0 . </li></ul></ul>
13. 15. <ul><ul><li>I 2 is an indifference curve above I 1 . </li></ul></ul><ul><ul><li>Lisa prefers any point on I 2 to any point on I 1 . </li></ul></ul>Preferences and Indifference Curves <ul><ul><li>For example, Lisa prefers point J to either point C or point G . </li></ul></ul>
14. 16. <ul><li>Marginal Rate of Substitution </li></ul><ul><ul><li>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 remain indifferent (remain on the same indifference curve). </li></ul></ul><ul><ul><li>The magnitude of the slope of the indifference curve measures the marginal rate of substitution. </li></ul></ul>Preferences and Indifference Curves
15. 17. <ul><ul><li>If the indifference curve is relatively steep , the MRS is high. </li></ul></ul><ul><ul><li>In this case, the person is willing to give up a large quantity of y to get a bit more x . </li></ul></ul><ul><ul><li>If the indifference curve is relatively flat , the MRS is low. </li></ul></ul><ul><ul><li>In this case, the person is willing to give up a small quantity of y to get more x . </li></ul></ul>Preferences and Indifference Curves
16. 18. <ul><ul><li>A diminishing marginal rate of substitution is the key assumption of consumer theory. </li></ul></ul><ul><ul><li>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 remain indifferent as the quantity of good x increases. </li></ul></ul>Preferences and Indifference Curves
17. 19. <ul><ul><li>Figure 9.4 shows the diminishing MRS of movies for soda. </li></ul></ul>Preferences and Indifference Curves <ul><ul><li>At point C , Lisa is willing to give up 2 cases of soda to see one more movie—her MRS is 2. </li></ul></ul><ul><ul><li>At point G , Lisa is willing to give up 1/2 case of soda to see one more movie—her MRS is 1/2. </li></ul></ul>
18. 20. <ul><li>Degree of Substitutability </li></ul><ul><ul><li>The shape of the indifference curves reveals the degree of substitutability between two goods. </li></ul></ul><ul><ul><li>Figure 9.5 shows the indifference curves for ordinary goods, perfects substitutes, and perfect complements. </li></ul></ul>Preferences and Indifference Curves
19. 21. Predicting Consumer Choices <ul><ul><li>Best Affordable Choice </li></ul></ul><ul><ul><li>The consumer’s best affordable choice is </li></ul></ul><ul><ul><li>On the budget line </li></ul></ul><ul><ul><li>On the highest attainable indifference curve </li></ul></ul><ul><ul><li>Has a marginal rate of substitution between the two goods equal to the relative price of the two goods </li></ul></ul>
20. 22. <ul><ul><li>Here, the best affordable point is C . </li></ul></ul>Predicting Consumer Choices <ul><ul><li>Lisa can afford to consume more soda and see fewer movies at point F . </li></ul></ul><ul><ul><li>And she can afford to see more movies and consume less soda at point H . </li></ul></ul><ul><ul><li>But she is indifferent between F , I , and H and she prefers C to I . </li></ul></ul>
21. 23. Predicting Consumer Choices <ul><ul><li>At point F , Lisa’s MRS is greater than the relative price. </li></ul></ul><ul><ul><li>At point H , Lisa’s MRS is less than the relative price. </li></ul></ul><ul><ul><li>At point C , Lisa’s MRS is equal to the relative price. </li></ul></ul>
22. 24. Predicting … <ul><li>A Change in Price </li></ul><ul><ul><li>The effect of a change in the price of a good on the quantity of the good consumed is called the price effect . </li></ul></ul><ul><ul><li>Figure 9.7 illustrates the price effect and shows how the consumer’s demand curve is generated. </li></ul></ul><ul><ul><li>Initially, the price of a movie is \$8 and Lisa consumes at point C in part (a) and at point A in part (b). </li></ul></ul>
23. 25. <ul><ul><li>The price of a movie then falls to \$4. </li></ul></ul>Predicting … <ul><ul><li>The budget line rotates outward. </li></ul></ul><ul><ul><li>Lisa’s best affordable point is now J in part (a). </li></ul></ul><ul><ul><li>In part (b), Lisa moves to point B, which is a movement along her demand curve for movies. </li></ul></ul>
24. 26. <ul><li>A Change in Income </li></ul><ul><ul><li>The effect of a change in income on the quantity of a good consumed is called the income effect . </li></ul></ul><ul><ul><li>Figure 9.8 illustrates the effect of a decrease in Lisa’s income. </li></ul></ul><ul><ul><li>Initially, Lisa consumes at point J in part (a) and at point B on demand curve D 0 in part (b). </li></ul></ul>Predicting …
25. 27. <ul><ul><li>Lisa’s income decreases and her budget line shifts leftward in part (a). </li></ul></ul>Predicting … <ul><ul><li>Her new best affordable point is K in part (a). </li></ul></ul><ul><ul><li>Her demand for movies decreases, shown by a leftward shift of her demand curve for movies in part (b). </li></ul></ul>
26. 28. Predicting Consumer Choices <ul><li>Substitution Effect and Income Effect </li></ul><ul><ul><li>For a normal good, a fall in price always increases the quantity consumed. </li></ul></ul><ul><ul><li>We can prove this assertion by dividing the price effect in two parts: </li></ul></ul><ul><ul><li>Substitution effect </li></ul></ul><ul><ul><li>Income effect </li></ul></ul>
27. 29. <ul><ul><li>Initially, Lisa has an income of \$40, the price of a movie is \$8, and she consumes at point C . </li></ul></ul>Predicting Consumer Choices <ul><ul><li>Lisa’s best affordable point is then J . </li></ul></ul><ul><ul><li>The move from point C to point J is the price effect . </li></ul></ul><ul><ul><li>The price of a movie falls from \$8 to \$4 and her budget line rotates outward. </li></ul></ul>
28. 30. <ul><ul><li>We’re going to break the move from point C to point J into two parts. </li></ul></ul><ul><ul><li>The first part is the substitution effect and the second is the income effect. </li></ul></ul>Predicting Consumer Choices
29. 31. <ul><ul><li>Substitution Effect </li></ul></ul><ul><ul><li>The substitution effect is the effect of a change in price on the quantity bought when the consumer remains on the same indifferent curve. </li></ul></ul>Predicting Consumer Choices
30. 32. <ul><ul><li>To isolate the substitution effect, we give Lisa a hypothetical pay cut. </li></ul></ul>Predicting Consumer Choices <ul><ul><li>Lisa is now back on her original indifference curve but with a lower price of movies and her best affordable point is K . </li></ul></ul><ul><ul><li>The move from C to K is the substitution effect . </li></ul></ul>
31. 33. <ul><ul><li>The direction of the substitution effect never varies: </li></ul></ul><ul><ul><li>When the relative price falls, the consumer always substitutes more of that good for other goods. </li></ul></ul><ul><ul><li>The substitution effect is the first reason why the demand curve slopes downward. </li></ul></ul>Predicting Consumer Choices
32. 34. <ul><ul><li>Income Effect </li></ul></ul><ul><ul><li>To isolate the income effect, we reverse the hypothetical pay cut and restore Lisa’s income to its original level (its actual level). </li></ul></ul><ul><ul><li>Lisa is now back on indifference curve I 2 and her best affordable point is J . </li></ul></ul><ul><ul><li>The move from K to J is the income effect. </li></ul></ul>Predicting Consumer Choices
33. 35. <ul><ul><li>For Lisa, movies are a normal good. </li></ul></ul><ul><ul><li>With more income to spend, she sees more movies—the income effect is positive. </li></ul></ul><ul><ul><li>For a normal good, the income effect reinforces the substitution effect and is the second reason why the demand curve slopes downward. </li></ul></ul>Predicting Consumer Choices
34. 36. <ul><ul><li>Inferior Goods </li></ul></ul><ul><ul><li>For an inferior good, when income increases, the quantity bought decreases. </li></ul></ul><ul><ul><li>The income effect is negative and works against the substitution effect. </li></ul></ul><ul><ul><li>So long as the substitution effect dominates, the demand curve still slopes downward. </li></ul></ul>Predicting Consumer Choices
35. 37. <ul><ul><li>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! </li></ul></ul><ul><ul><li>This case does not appear to occur in the real world. </li></ul></ul>Predicting Consumer Choices
36. 38. <ul><ul><li>The model of consumer choice can be used to study the allocation of time between work and leisure. </li></ul></ul><ul><ul><li>The two “goods” are leisure and income—where income represents all other goods. </li></ul></ul><ul><ul><li>Lisa buys leisure by not supplying labor and by forgoing income. </li></ul></ul><ul><ul><li>So the “price” of leisure is the wage rate forgone. </li></ul></ul>Work-Leisure Choices
37. 39. <ul><li>The Labor Supply Curve </li></ul><ul><ul><li>By changing the wage rate, we can find a person’s labor supply curve. </li></ul></ul><ul><ul><li>An increase in the wage rate makes leisure relatively more expensive (higher opportunity cost to not working) and </li></ul></ul><ul><ul><li>has a substitution effect toward less leisure (toward more work). </li></ul></ul>Work-Leisure Choices
38. 40. Work-Leisure Choices <ul><ul><li>A higher wage also has a positive income effect on leisure. </li></ul></ul><ul><ul><li>If the income effect is weaker than the substitution effect, the quantity of work hours increases as the wage rate rises. </li></ul></ul><ul><ul><li>When the wage rate rises from \$5 to \$10 an hour, work increases from 20 to 35 hours a week—the move from A to B . </li></ul></ul>
39. 41. <ul><ul><li>But if the income effect is stronger than the substitution effect, the quantity of work hours decreases as the wage rate rises. </li></ul></ul><ul><ul><li>When the wage rate rises from \$10 to \$15 an hour, work decreases from 35 to 30 hours a week —the move from B to C. </li></ul></ul>Work-Leisure Choices
40. 42. <ul><ul><li>The move from A to B when the wage rate increases from \$5 to \$10 an hour means that the labor supply curve slopes upward over this range. </li></ul></ul>Work-Leisure Choices <ul><ul><li>The move from B to C when the wage rate increases from \$10 to \$15 an hour means that the labor supply curve bends backward above a certain wage rate. </li></ul></ul>
41. 43. <ul><ul><li>Historical evidence shows that the average workweek has fallen steadily as the wage rate has increased. </li></ul></ul><ul><ul><li>With higher wage rates, people have decided to use their higher incomes in part to “buy” more leisure. </li></ul></ul>Work-Leisure Choices