Consumer Choice Theory Public Finance and The Price System 4 th Edition Browning, Browning Johnny Patta KK Pengelolaan Pembangunan dan Pengembangan Kebijakan SAPPK - ITB

Objectives Presenting a simple model of consumer behavior that permits the students to determine how consumer choices among goods are affected by objective circumstances  prices, incomes and subsidies 2

Explaining the way a consumer’s tastes or subjective preferences can be shown using indifference curves Considering how objective conditions such as income can be represented Treating consumer’s preferences and income jointly in a single model Examining several implications of the model 3

The Consumer’s Preferences 4

The Consumer’s Preference Consumers have different tastes or preference  reflected in their consumption decisions The consumption of goods and services provides satisfaction or utility to consumer Consumer will arrange their personal consumption to maximize satisfaction 5

Assumptions about the Consumer’s Preference Patterns 1.The consumer is able to rank different combinations or bundles of goods in terms of desirability 2.The consumer’s preferences are transitive  A > B, B > C, A > C 3.The consumer always prefers more of a commodity to less 6

Indifference Curve Consumer tastes can be represented by indifference curve Indifference curve is a locus of points indicating different combinations of goods that yield the consumer the same level of satisfaction  figure A-1 7

Figure A-1 Indifference Curve 8

Characteristic of Indifference Curve 1.Indifference curves are convex 2.Indifference curves that lie farther from the origin represent higher levels of utility 3.Indifference curves cannot intersect  an intersecting indifference curves are inconsistent with our transitivity assumptions 9

Intersecting Indifference Curves This seems to imply that B and C are equally desirable However B is more preferable than C NON TRANSITIVE A and B yield the same level of satisfaction A and C yield the same level of satisfaction 10

The Consumer’s Budget

The Consumer’s Budget Higher indifference curves correspond to higher levels of well being  a rational utility-maximizing consumer will want to achieve the highest indifference curve possible However, the consumer is constrained by the level of money income 12

The Budget Line The Budget Line shows all combinations of quantities of X and Y that a consumer can purchase per year The slope of the budget line is equal to the negative of the price ratio The slope at any point shows how much of one good must be given up to get an additional unit of the other 13

The Budget Line 14

Budget Line: Income and Price Changes The position of the budget line depends on the size of the budget If the income increase, the budget line will be farther from the origin and vise versa A changes in the price of goods and services also affect the budget line The slope of any budget line indicates the price of one good relative to that of the other 15

Income Changes and the Budget Line 16

Price Changes and the Budget Line 17

The Consumer in Equilibrium

The Consumer in Equilibrium The budget line shows the combinations of goods from which a consumer can choose The indifference curves show how the consumer subjectively ranks all combinations of goods It is assumed that the consumer will choose the most preferred combination of X and Y from among the combinations attainable An equilibrium will occur at a point, where the budget line and the indifference curve are tangent 19

The Equilibrium of the Consumer 20

Equilibrium In equilibrium, the marginal rate of substitution (MRS) between X and Y for the consumer is equal to the price ratio The price ratio is the rate at which the consumer is subjectively willing to substitute X for Y  it is equal to the rate at which market exchange can occur 21

Consumer Equilibrium – An Alternative Representation 22

When the consumer is in equilibrium, the market price of good is a measure of the marginal value of the good to the consumer 23

Changes in Income A line connecting the consumer equilibrium yields the income consumption curve The Income Consumption Curve identifies the various quantities of X that will be consumed at different income levels If the curve is upward sloping to the right, X will be considered a normal goods Normal goods  as income rises, when prices are unchanged, the consumption of X increases 24

Changes in Income (2) In contrast to normal goods, there are inferior goods A good is an inferior good if the quantity consumed falls when income rises In this case, the income consumption curve slopes backward to the left 25

Income Changes and Consumption Choices (1) 26

Income Changes and Consumption Choices (2) 27

Changes in Prices Recall that a variation in price is reflected by a change in the slope of the budget line If the price of X falls, the budget line will become flatter, rotating to the right If the price rises, the budget line will become steeper, rotating toward the origin 28

Derivation of the Consumer’s Demand Curve (1) 29

Derivation of the Consumer’s Demand Curve (2) 30

Substitution and Income Effects of Price Changes When the price of a good changes, the consumer is affected in two distinct ways 1.The income effect 2.The substitution effect 31

The Income Effects The income effects stems from the fact that the consumer is better off as a result of the price change because his or her budget now increase The consumer can buy the same amount of beef as before and still have more income left over to spend on other goods and services 32

The price change raises the consumer’s real income With a higher real income, the consumer can now afford to purchase more of all goods (including beef) So, when the price of beef decreases, the consumer, as a result of income effect, will expand his or her purchases of beef if it is a normal good 33

The Substitution Effects The substitution effects result from the consumer’s decision to substitute the now cheaper good (beef), for other good (poultry, etc) To the consumer, beef (because of its lower prices) has become a more attractive buy Therefore, the consumer will chose to purchase more beef relative to other types of meat and poultry 34

The Price Changes The decrease in the price of beef has caused the consumer’s purchases of beef to increase for 2 independent reasons 1.The income effect makes the consumer better off by increasing real income 2.The substitution effect leads the consumer to substitute the cheaper good for the now relatively more expensive ones 35

Income and Substitution Effects of a Price Reduction 36

An Application

An Application Let us examine individual labor supply decisions associated with changes in wage rates Assumes that workers can vary the amount of time they work The more hours are worked, the less leisure time will be available The more leisure consumed, the less time will be available to spend at work 38

Income-Leisure Choice of the Worker 39

Effect of Wage Changes on Labor Supply 40

Effect of Wage Changes on Labor Supply (2) 41

If the wage rate changes, the budget line will rotate around the horizontal intercept An increase in the wage rate has two effects on labor supply decision: an income effect and a substitution effect The income effect is a result of the fact that the higher wage rate raises the worker’s income for any amount of the work effort supplied The higher income associated with higher rates encourages the increased consumption of leisure (reduced work effort) The substitution effect, on the other hand, encourages greater work effort 42

The income and the substitution effects work in opposing directions, it is impossible to predict whether a person will work more, less, or the same amount in response to changes in wage rate If the income effect is greater than the substitution effect, then work effort will fall in response to a higher wage rate (1) If the substitution effect predominates, then the work effort will rise in response to an increase in wages (2) The response of labor supply to changes in wages rates is of particular interest to us in public finance, because many taxes fall on labor income and consequently affect labor supply decisions 43

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