Introduction Recall one of the Ten Principles from Chapter 1: People face tradeoffs. Buying more of one good leaves less income to buy other goods. Working more hours means more income and more consumption, but less leisure time. Reducing saving allows more consumption today but reduces future consumption. This chapter explores how consumers make choices like these. THE THEORY OF CONSUMER CHOICE

Household Choice in Output Markets Every household must make three basic decisions: How much of each product, or output, to demand 2. How much labor to supply 3. How much to spend today and how much to save for the future

Household Choice in Output Markets The Determinants of Household Demand Several factors influence the quantity of a given good or service demanded by a single household: The price of the product The income available to the household The household’s amount of accumulated wealth The prices of other products available to the household The household’s tastes and preferences The household’s expectations about future income, wealth, and prices

Household Choice in Output Markets The Budget Constraint budget constraint The limits imposed on household choices by income, wealth, and product prices. TABLE 6.1 Possible Budget Choices of a Person Earning $1,000 Per Month After Taxes Option Monthly Rent Food Other Expenses Total Available? A $ 400 $250 $350 $1,000 Yes B 600 200 1,000 C 700 150 D 100 1,200 No choice set or opportunity set The set of options that is defined and limited by a budget constraint.

Household Choice in Output Markets Preferences, Tastes, Trade-Offs, and Opportunity Cost  FIGURE 6.1 Budget Constraint and Opportunity Set for Ann and Tom A budget constraint separates those combinations of goods and services that are available, given limited income, from those that are not. The available combinations make up the opportunity set. real income Set of opportunities to purchase real goods and services available to a household as determined by prices and money income.

HOUSEHOLD CHOICE IN OUTPUT MARKETS The Equation Of The Budget Constraint In general, the budget constraint can be written: PXX + PYY = I, where PX = the price of X, X = the quantity of X consumed, PY = the price of Y, Y = the quantity of Y consumed, and I = household income.

The Budget Constraint: What the Consumer Can Afford Example: Hurley divides his income between two goods: fish and mangos. A “consumption bundle” is a particular combination of the goods, e.g., 40 fish & 300 mangos. Budget constraint: the limit on the consumption bundles that a consumer can afford The two-good assumption greatly simplifies the analysis without altering the basic insights about consumer choice. If your students remember the Production Possibilities Frontier, you might tell them that a budget constraint is, in essence, a “consumption possibilities frontier” for the consumer: it shows all combinations (bundles) of the two goods that the consumer can afford to buy. THE THEORY OF CONSUMER CHOICE 6

A C T I V E L E A R N I N G 1 Budget Constraint Hurley’s income: $1200 Prices: PF = $4 per fish, PM = $1 per mango A. If Hurley spends all his income on fish, how many fish does he buy? B. If Hurley spends all his income on mangos, how many mangos does he buy? C. If Hurley buys 100 fish, how many mangos can he buy? D. Plot each of the bundles from parts A – C on a graph that measures fish on the horizontal axis and mangos on the vertical, connect the dots. A very straightforward exercise. 7

A C T I V E L E A R N I N G 1 Answers D. Hurley’s budget constraint shows the bundles he can afford. Quantity of Mangos B A. $1200/$4 = 300 fish B. $1200/$1 = 1200 mangos C. 100 fish cost $400, $800 left buys 800 mangos C A Quantity of Fish

The Slope of the Budget Constraint From C to D, “rise” = –200 mangos “run” = +50 fish Slope = – 4 Hurley must give up 4 mangos to get one fish. Quantity of Mangos C D Quantity of Fish THE THEORY OF CONSUMER CHOICE

The Slope of the Budget Constraint The slope of the budget constraint equals the rate at which Hurley can trade mangos for fish the opportunity cost of fish in terms of mangos the relative price of fish: THE THEORY OF CONSUMER CHOICE 10

A C T I V E L E A R N I N G 2 Budget constraint, continued. Show what happens to Hurley’s budget constraint if: A. His income falls to $800. B. The price of mangos rises to PM = $2 per mango Another straightforward problem that will not take much class time. Yet, students will learn these concepts better by figuring out for themselves how the budget line moves in response to income and price changes. 11

A C T I V E L E A R N I N G 2 Answers, part A A fall in income shifts the budget constraint down. Quantity of Mangos Now, Hurley can buy $800/$4 = 200 fish or $800/$1 = 800 mangos or any combination in between. Quantity of Fish

A C T I V E L E A R N I N G 2 Answers, part B An increase in the price of one good pivots the budget constraint inward. Hurley can still buy 300 fish. But now he can only buy $1200/$2 = 600 mangos. Notice: slope is smaller, relative price of fish is now only 2 mangos. Quantity of Mangos Quantity of Fish

Preferences: What the Consumer Wants Indifference curve: shows consumption bundles that give the consumer the same level of satisfaction One of Hurley’s indifference curves Quantity of Mangos I1 B A, B, and all other bundles on I1 make Hurley equally happy – he is indifferent between them. A Quantity of Fish THE THEORY OF CONSUMER CHOICE

Four Properties of Indifference Curves One of Hurley’s indifference curves Quantity of Mangos 1. Indifference curves are downward-sloping. If the quantity of fish is reduced, the quantity of mangos must be increased to keep Hurley equally happy. B A I1 Quantity of Fish THE THEORY OF CONSUMER CHOICE

Four Properties of Indifference Curves A few of Hurley’s indifference curves Quantity of Mangos 2. Higher indifference curves are preferred to lower ones. I2 I1 Hurley prefers every bundle on I2 (like C) to every bundle on I1 (like A). I0 C D A He prefers every bundle on I1 (like A) to every bundle on I0 (like D). Quantity of Fish THE THEORY OF CONSUMER CHOICE

Four Properties of Indifference Curves Hurley’s indifference curves Quantity of Mangos 3. Indifference curves cannot cross. Suppose they did. Hurley should prefer B to C, since B has more of both goods. Yet, Hurley is indifferent between B and C: He likes C as much as A (both are on I4). He likes A as much as B (both are on I1). B C I4 A I1 Quantity of Fish THE THEORY OF CONSUMER CHOICE

Four Properties of Indifference Curves Quantity of Fish Quantity of Mangos 4. Indifference curves are bowed inward. A Hurley is willing to give up more mangos for a fish if he has few fish (A) than if he has many (B). 6 1 B Hurley has more fish at B than at A, so an extra fish would be less valuable at B than at A. 2 1 I1 THE THEORY OF CONSUMER CHOICE

The Marginal Rate of Substitution MRS = slope of indifference curve Marginal rate of substitution (MRS): the rate at which a consumer is willing to trade one good for another. Quantity of Fish Quantity of Mangos A MRS = 6 Hurley’s MRS is the amount of mangos he would substitute for another fish. 1 B At A, Hurley has few fish, so an additional fish is very valuable to him. At B, Hurley already has lots of fish, so an additional one is not as valuable to him. MRS = 2 1 I1 MRS falls as you move down along an indifference curve. THE THEORY OF CONSUMER CHOICE

One Extreme Case: Perfect Substitutes Perfect substitutes: two goods with straight-line indifference curves, constant MRS Example: nickels & dimes Consumer is always willing to trade two nickels for one dime. It is hard to think of examples of perfect substitutes. (Even nickels and dimes are probably not perfect substitutes: I’d rather carry 10 dimes in my pocket than 20 nickels.) But it’s easy to think of examples that are close substitutes, and therefore are likely to have indifference curves that are not very bowed: 1) Movies (at the movie theater) and videos at home. A consumer might be willing to trade two videos for one night at the movies. 2) Coke and Pepsi (for consumers that do not perceive much difference between them). 3) Vacations in Hawaii and vacations in the Bahamas THE THEORY OF CONSUMER CHOICE 20

Another Extreme Case: Perfect Complements Perfect complements: two goods with right-angle indifference curves Example: Left shoes, right shoes {7 left shoes, 5 right shoes} is just as good as {5 left shoes, 5 right shoes} Again, It is hard to think of examples of perfect complements. But it’s easy to think of examples that are good though not perfect complements, and therefore are likely to have indifference curves that are very bowed: 1) Tickets to rock concerts and parking at the arena in which the concert takes place 2) Hot dogs and hot-dog buns 3) Brewed Starbucks coffee and 20 spoons of sugar (If you don’t get this one, you probably haven’t tried brewed Starbucks coffee!) THE THEORY OF CONSUMER CHOICE 21

Less Extreme Cases: Close Substitutes and Close Complements Indifference curves for close substitutes are not very bowed Indifference curves for close complements are very bowed Quantity of hot dog buns Quantity of Pepsi When the two goods are close but not perfect substitutes (like Coke and Pepsi), indifference curves are slightly bowed. When the two goods are close but not perfect complements (like hot dogs and buns), indifference curves are very bowed, having a very sharp (but not quite 90-degree) angle. Later in this PowerPoint chapter, an Active Learning exercise asks students to illustrate the substitution effect for these two cases. They will see that a relative price change causes a much bigger movement along an indifference curve when the goods are substitutes than when they are complements. Quantity of Coke Quantity of hot dogs

Optimization: What the Consumer Chooses A is the optimum: the point on the budget constraint that touches the highest possible indifference curve. Quantity of Mangos The optimum is the bundle Hurley most prefers out of all the bundles he can afford. 1200 Hurley prefers B to A, but he cannot afford B. B A 600 Simply put, optimization means buying the bundle that makes the consumer happiest, given his or her income. Hurley can afford C and D, but A is on a higher indifference curve. C D 150 300 Quantity of Fish THE THEORY OF CONSUMER CHOICE

Optimization: What the Consumer Chooses Quantity of Mangos Consumer optimization is another example of “thinking at the margin.” At the optimum, slope of the indifference curve equals slope of the budget constraint: 1200 MRS = PF/PM A 600 marginal value of fish (in terms of mangos) price of fish (in terms of mangos) Consumer optimization is another example of “thinking at the margin.” Remember that MRS = marginal value of the good on the X-axis (fish) in terms of the good on Y-axis (mangos). If MRS > Pf/Pm, the value of another fish is greater than its cost, so Hurley can make himself happier by decreasing his mango purchases and using the proceeds to buy another fish. If MRS < Pf/Pm, the value of another fish is less than its cost, so Hurley should move along his budget line to a bundle with less fish and more mangos to make himself happier. 150 300 Quantity of Fish THE THEORY OF CONSUMER CHOICE

The Effects of an Increase in Income Quantity of Mangos An increase in income shifts the budget constraint outward. B If both goods are “normal,” Hurley buys more of each. A In Active Learning 2, students determined that a fall in income shifts the budget constraint downward. They should readily accept, then, that an increase in income shifts the budget line upward/outward. Quantity of Fish THE THEORY OF CONSUMER CHOICE

Income and Substitution Effects The Income Effect Price changes affect households in two ways. First, if we assume that households confine their choices to products that improve their well-being, then a decline in the price of any product, ceteris paribus, will make the household unequivocally better off. In other words, if a household continues to buy the same amount of every good and service after the price decrease, it will have income left over. That extra income may be spent on the product whose price has declined, hereafter called good X, or on other products. The change in consumption of X due to this improvement in well-being is called the income effect of a price change.

Income and Substitution Effects The Substitution Effect When the price of a product falls, that product also becomes relatively cheaper. That is, it becomes more attractive relative to potential substitutes. A fall in the price of product X might cause a household to shift its purchasing pattern away from substitutes toward X. This shift is called the substitution effect of a price change. Everything works in the opposite direction when a price rises, ceteris paribus. When the price of a product rises, that item becomes more expensive relative to potential substitutes and the household is likely to substitute other goods for it.

Income and Substitution Effects  FIGURE 6.4 Diminishing Marginal Utility and Downward-Sloping Demand For normal goods, the income and substitution effects work in the same direction. Higher prices lead to a lower quantity demanded, and lower prices lead to a higher quantity demanded.

The Effects of a Price Change Initially, PF = $4 PM = $1 Quantity of Mangos 1200 600 initial optimum PF falls to $2 budget constraint rotates outward, Hurley buys more fish and fewer mangos. new optimum 600 500 350 In Active Learning 2, students determined that an increase in the price of a good pivots the budget constraint inward. Here, the price of a good is falling, so the budget line pivots outward. 150 300 Quantity of Fish THE THEORY OF CONSUMER CHOICE

The Income and Substitution Effects A fall in the price of fish has two effects on Hurley’s optimal consumption of both goods. Income effect A fall in PF boosts the purchasing power of Hurley’s income, allows him to buy more mangos and more fish. Substitution effect A fall in PF makes mangos more expensive relative to fish, causes Hurley to buy fewer mangos & more fish. Notice: The net effect on mangos is ambiguous. On the previous slide, the fall in the price of fish caused a net decrease in Hurley’s demand for mangos: the substitution effect is greater than the income effect, as depicted on the following slide. However, it could have gone the other way: if the income effect were greater than the substitution effect, then Hurley’s demand for mangos would have risen. THE THEORY OF CONSUMER CHOICE 30

The Income and Substitution Effects Initial optimum at A. PF falls. Substitution effect: from A to B, buy more fish and fewer mangos. Income effect: from B to C, buy more of both goods. Quantity of Mangos In this example, the net effect on mangos is negative. A C This diagram decomposes the movement from the old optimum (A) to the new one (C) into two parts. The first part, from A to B, represents the substitution effect. It shows the change in the optimal bundle due to the relative price change, holding constant the consumer’s level of well-being. The second part, from B to C, represents the income effect. It shows the change in the optimal bundle due to the increase in the purchasing power of the consumer’s income. The dashed line through point B is parallel to the new budget line through point C, indicating that we are holding relative prices constant to see how the increase in income affects the optimal bundle. B Quantity of Fish THE THEORY OF CONSUMER CHOICE

Application 1: Giffen Goods Do all goods obey the Law of Demand? Suppose the goods are potatoes and meat, and potatoes are an inferior good. If price of potatoes rises, substitution effect: buy less potatoes income effect: buy more potatoes If income effect > substitution effect, then potatoes are a Giffen good, a good for which an increase in price raises the quantity demanded. THE THEORY OF CONSUMER CHOICE 32

Application 1: Giffen Goods An increase in the price of potatoes rotates the budget line inward. The substitution effect would cause the consumer to buy fewer potatoes. Imagine moving down along indifference curve I1 until reaching the point where its slope just equals the slope of the new budget line. At that point, demand for potatoes is lower, because consumers are substituting meat for potatoes. But if potatoes are an inferior good, the income effect causes demand for potatoes to rise: the price increase makes the consumer generally worse off. The consumer responds by buying less meat (the normal good) and more potatoes (the inferior good). If potatoes are a Giffen good, the income effect exceeds the substitution effect, so the net effect of a price increase on demand for potatoes is positive!!! As the book notes, Giffen goods are extremely rare – if they exist at all! THE THEORY OF CONSUMER CHOICE 33

The Basis of Choice: Utility utility The satisfaction, or reward, a product yields relative to its alternatives. The basis of choice. Diminishing Marginal Utility marginal utility (MU) The additional satisfaction gained by the consumption or use of one more unit of something. total utility The total amount of satisfaction obtained from consumption of a good or service. law of diminishing marginal utility The more of any one good consumed in a given period, the less satisfaction (utility) generated by consuming each additional (marginal) unit of the same good.

The Basis of Choice: Utility  FIGURE 6.3 Graphs of Frank’s Total and Marginal Utility Marginal utility is the additional utility gained by consuming one additional unit of a commodity—in this case, trips to the club. When marginal utility is zero, total utility stops rising. TABLE 6.2 Total Utility and Marginal Utility of Trips to the Club Per Week Trips to Club Total Utility Marginal Utility 1 12 2 22 10 3 28 6 4 32 5 34

The Basis of Choice: Utility Allocating Income To Maximize Utility TABLE 6.3 Allocation of Fixed Expenditure per Week Between Two Alternatives (1) Trips to Club per Week (2) Total Utility (3) Marginal Utility (MU) (4) Price (P) (5) Marginal Utility per Dollar (MU/P) 1 12 $3.00 4.0 2 22 10 3.00 3.3 3 28 6 2.0 4 32 1.3 5 34 0.7 (1) Basketball Games per Week 21 $6.00 3.5 33 6.00 42 9 1.5 48 1.0 51 .5

The Basis of Choice: Utility The Utility-Maximizing Rule In general, utility-maximizing consumers spread out their expenditures until the following condition holds: utility-maximizing rule Equating the ratio of the marginal utility of a good to its price for all goods. diamond/water paradox A paradox stating that (1) the things with the greatest value in use frequently have little or no value in exchange and (2) the things with the greatest value in exchange frequently have little or no value in use.

The Basis of Choice: Utility Diminishing Marginal Utility and Downward-Sloping Demand  FIGURE 6.4 Diminishing Marginal Utility and Downward-Sloping Demand At a price of $40, the utility gained from even the first Thai meal is not worth the price. However, a lower price of $25 lures Ann and Tom into the Thai restaurant 5 times a month. (The utility from the sixth meal is not worth $25.) If the price is $15, Ann and Tom will eat Thai meals 10 times a month—until the marginal utility of a Thai meal drops below the utility they could gain from spending $15 on other goods. At 25 meals a month, they cannot tolerate the thought of another Thai meal even if it is free.