Economic Analysis for Business Session XV: Theory of Consumer Choice (Chapter 21) Instructor Sandeep Basnyat 9841892281 Sandeep_basnyat@yahoo.com

A C T I V E L E A R N I N G 1: Budget constraint The consumer’s income: $1000 Prices: $10 per pizza, $2 per pint of Pepsi A. If the consumer spends all his income on pizza, how many pizzas does he buy? B. If the consumer spends all his income on Pepsi, how many pints of Pepsi does he buy? C. If the consumer spends $400 on pizza, how many pizzas and Pepsis does he buy? D. Plot each of the bundles from parts A-C on a diagram that measures the quantity of pizza on the horizontal axis and quantity of Pepsi on the vertical axis, then connect the dots. 2

A C T I V E L E A R N I N G 1: Answers D. The budget constraint shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods. Pepsis A. $1000/$10 = 100 pizzas B. $1000/$2 = 500 Pepsis C. $400/$10 = 40 pizzas $600/$2 = 300 Pepsis B C A Pizzas 3

The Slope of the Budget Constraint Pepsis From C to D, “rise” = –100 Pepsis “run” = +20 pizzas Slope = –5 Consumer must give up 5 Pepsis to get another pizza. C D Pizzas CHAPTER 21 THE THEORY OF CONSUMER CHOICE

The Slope of the Budget Constraint The slope of the budget constraint equals the rate at which the consumer can trade Pepsi for pizza: the opportunity cost of pizza in terms of Pepsi the relative price of pizza: price of one good compared to the other CHAPTER 21 THE THEORY OF CONSUMER CHOICE

A C T I V E L E A R N I N G 2: Exercise Pepsis What happens to the budget constraint if: A. Income falls to $800 Pizzas 6

A C T I V E L E A R N I N G 2A: Answers Pepsis A fall in income shifts the budget constraint inward. Consumer can buy $800/$10 = 80 pizzas or $800/$2 = 400 Pepsis or any combination in between. Pizzas 7

A C T I V E L E A R N I N G 2: Exercise Pepsis What happens to the budget constraint if: B. The price of Pepsi rises to $4/pint. Pizzas 8

A C T I V E L E A R N I N G 2B: Answers An increase in the price of one good pivots the budget constraint inward. Pepsis Consumer can still buy 100 pizzas. But now, can only buy $1000/$4 = 250 Pepsis. Notice: slope is smaller, relative price of pizza now only 2.5 Pepsis. Pizzas 9

PREFERENCES: WHAT THE CONSUMER WANT The consumer’s preferences allow him to choose among different bundles of the same goods he wants, for example Pepsi and Pizza, that best suits his tastes. If the two bundles suit his tastes equally well, the consumer is indifferent between two bundles. A graphical representation of the bundles of consumption that make the consumer equally happy is called the indifference curve.

The Consumer’s Preferences Quantity An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction, such as in points A, B or C Indifference curve, I1 of Pepsi C B A Quantity If the consumption of pizza is reduced, consumption of Pepsi must increase to keep him equally happy. of Pizza

The Consumer’s Preferences-MRS The slope at any point on an indifference curve is the Marginal Rate of Substitution MRS Quantity Indifference curve, I1 of Pepsi MRS is the rate at which a consumer is willing to trade one good for another. It is the amount of one good that a consumer requires as compensation to give up one unit of the other good. C 200 B 5 MRS 100 A 30 50 Quantity MRS tells how much Pepsi the consumer requires to be compensated for a one unit increase in pizza consumption of Pizza

Higher and Lower Indifference Curves: Indifference Map Quantity Indifference curve, I1 Higher indifference curves represent higher level of satisfaction of Pepsi C I3 E B D 5 MRS A Quantity of Pizza

Four Properties of Indifference Curves Higher indifference curves are preferred to lower ones. Indifference curves are downward sloping. Indifference curves do not cross. Indifference curves are bowed inward.

Four Properties of Indifference Curves Property 1: Higher indifference curves are preferred to lower ones. Consumers usually prefer more of something to less of it. Higher indifference curves represent larger quantities of goods than do lower indifference curves.

The Consumer’s Preferences Quantity I2 Indifference curve, I1 of Pepsi C B D A Quantity of Pizza

Four Properties of Indifference Curves Property 2: Indifference curves are downward sloping. A consumer is willing to give up one good only if he or she gets more of the other good in order to remain equally happy. If the quantity of one good is reduced, the quantity of the other good must increase. For this reason, most indifference curves slope downward.

The Consumer’s Preferences Quantity Indifference curve, I1 of Pepsi Quantity of Pizza

Four Properties of Indifference Curves Property 3: Indifference curves do not cross. Points A and B should make the consumer equally happy. Points B and C should make the consumer equally happy. This implies that A and C would make the consumer equally happy. But C has more of both goods compared to A.

The Impossibility of Intersecting Indifference Curves Quantity of Pepsi C A B Quantity of Pizza

Four Properties of Indifference Curves Property 4: Indifference curves are bowed inward. People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little. These differences in a consumer’s marginal substitution rates cause his or her indifference curve to bow inward.

Bowed Indifference Curves Quantity of Pepsi Indifference curve 14 2 1 MRS = 6 8 3 A 4 6 3 7 B 1 MRS = 1 Quantity of Pizza

Two Extreme Examples of Indifference Curves Perfect substitutes Goods that can be exactly substitutable Consumers value both goods exactly equal Perfect complements Goods that need exact combination to form a product Consumers benefit extra unit of good A only if he/she has extra unit of good B

Perfect Substitutes and Perfect Complements (a) Perfect Substitutes 50 cents Perfect Substitutes Because the MRS is constant, two goods with straight-line indifference curves are perfect substitutes. The marginal rate of substitution is a constant number. 3 6 I3 2 4 I2 1 2 I1 $ amount

Perfect Substitutes and Perfect Complements (b) Perfect Complements Perfect Complements Two goods with right-angle indifference curves are perfect complements. Left Shoes I1 I2 9 7 5 Right Shoes

OPTIMIZATION: HOW THE CONSUMER CHOOSES? Step 1: Consumer chooses to buy on or below his budget constraint. Step 2: He get the combination of goods on the highest possible indifference curve.

The Consumer’s Optimum Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent (slope of budget constraint and indifference curve is equal). Quantity I3 of Pepsi I2 Budget constraint I1 Optimum B A Note: Slop of ID curve: MRS Slop of BC: Relative price of Pepsi and Pizza Quantity of Pizza

The Consumer’s Optimal Choice The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price. At the consumer’s optimum, the consumer’s valuation of the two goods equals the market’s valuation. Consumer takes as given the relative price of the two goods and then chooses an optimum at which his MRS equals the relative price. The relative price is the rate at which market is willing to trade one good for another, whereas the MRS is the rate at which the consumer is willing to trade one good for another.

Cases: Income effect and Price Effect What happens when consumer’s income level increases? (Income effect) A) Normal good: consumption increases, and, B) Inferior good: consumption decreases

An Increase in Income-Normal goods: Pepsi and Pizza Quantity of Pepsi New budget constraint I2 I1 Which Indifference curve would the consumer chose? I3 Initial optimum I4 Initial budget constraint Quantity of Pizza

An Increase in Income-Normal goods case Quantity of Pepsi New budget constraint I3 I1 New optimum Initial optimum Initial budget constraint Quantity of Pizza

Increase in Income- An Inferior Good case (Pepsi) Quantity of Pepsi New budget constraint I2 I1 Initial optimum New optimum Initial budget constraint Quantity of Pizza

Cases What happens when consumer’s income level increase or decreases? Normal good and inferior good cases What happens when price of the good(s) increases or decreases? (Price effect) Assume that price of Pepsi decreases from $2 to $1 per pint.

Price Effect Effect 1 Substitution effect Interaction Effect Pepsi is relatively cheaper Opportunity cost of buying Pizza is higher Buy more Pepsi and less Pizza Effect 1 Pizza is relatively expensive Moves to another combination of Indifference curve Substitution effect

Price Effect Effect I1 Income effect Interaction Effect Normal Good - Buy more goods Pepsi is relatively cheaper Income level increased Effect I1 Can buy more goods with extra money Jumps to higher indifference curve Inferior Good - Buy less of inferior goods Income effect

Price Effect Total Price Effect = Substitution effect + Income Effect

A Change in Price- Price of Pepsi decreases from $2 to $1 Quantity of Pepsi I2 I1 New budget constraint Total effect Income effect Substitution effect C New optimum B A Initial optimum Initial budget constraint Quantity of Pizza

Total effect of Price decrease of Good X on Quantity demanded of Good X = Substitution effect + Income effect 9 5 4 Total effect of price decrease = Substitution effect + Income effect 3 5 (-2)

Generalization: Income and Substitution Effects The Income Effect The income effect is the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve The Substitution Effect The substitution effect is the change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution.

THREE APPLICATIONS Do all demand curves slope downward? How do wages affect labour supply? How do interest rates affect household savings?

THREE APPLICATIONS Do all demand curves slope downward? Demand curves can sometimes slope upward. This happens when a consumer buys more of a good when its price rises. Giffen goods Economists use the term Giffen good to describe a good that violates the law of demand. Giffen goods are goods for which an increase in the price raises the quantity demanded. The income effect dominates the substitution effect. They have demand curves that slope upwards.

Application I: A Giffen Good Reasons: Potatoes are a strongly inferior good. When the price of potatoes rises, the consumer is poorer. The income effect makes the consumer want to buy less meat and more potatoes Because potatoes are more expensive, substitution effect makes the consumer want to buy more meat but income effect is so strong that it exceeds the substitution effects Quantity of Potatoes Initial budget constraint A B I1 Optimum with high price of potatoes I2 Optimum with low price of potatoes D E 2. . . . which increases potato consumption if potatoes are a Giffen good. 1. An increase in the price of potatoes rotates the budget constraint inward . . . C New budget constraint Quantity of Meat

What happens when the wage rate increases? When wage rate increases, a) If people find that spending more time on leisure activity incur higher opportunity costs, the substitution effect is greater than the income effect for them and they work more. b) If people find that increase in wage rate is an increase in their income level, income effect is greater than the substitution effect for them and they spend more time on leisure and works less or the same amount.

Application II: The Work-Leisure Decision Consumption I3 What happens when the wage increases? I2 $5,000 100 I1 Optimum 2,000 60 Hours of Leisure

An Increase in the Wage: Substitution effect-Income effect (a) For a person with substitution effect . . . Hours of work (b) For a person with Income effect . . . Hours of work I2 I1 BC2 1. When the wage rises . . . I2 I1 1. When the wage rises . . . BC1 BC1 BC2 Hours of 2. . . . hours of leisure decrease . . . Hours of Leisure 2. . . . hours of leisure increase . . . Leisure

How do interest rates affect household saving? If the substitution effect of a higher interest rate is greater than the income effect, households save more. If the income effect of a higher interest rate is greater than the substitution effect, households spend more and save less or remain constant.

Application III: The Consumption-Saving Decision Budget constraint when Old I3 What happens when the bank interest rate increases? $110,000 100,000 I2 I1 55,000 $50,000 Optimum Consumption when Young

An Increase in the Interest Rate-Substitution and Income Effect (a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving Consumption Consumption when Old when Old BC2 BC2 1. A higher interest rate rotates the budget constraint outward . . . 1. A higher interest rate rotates the budget constraint outward . . . I2 I1 I1 I2 BC1 BC1 Consumption Consumption 2. . . . resulting in lower consumption when young and, thus, higher saving. 2. . . . resulting in higher consumption when young and, thus, lower saving. when Young when Young Thus, an increase in the interest rate could either encourage or discourage saving.

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