1. S PP 2 T OPIC 1 I SSUE 2: C HANGE IN PRICES AFFECT CONSUMER ’ S CHOICES T HE THEORY OF CONSUMER CHOICE Xiaozhen Chen Hai Tran

2. T HE T HEORY OF C ONSUMER C HOICE Do you know….? The Budget Constraint: What the consumer can afford Preferences: What the consumer wants Optimization: What the consumer chooses How changes in prices affect the consumer’s choices

3. T HE B UDGET C ONSTRAINT : W HAT THE CONSUMER CAN AFFORD We begin our study of consumer choice by examining the link between income and spending. Although most people would like to increase the quantity or quality of the goods they consume, people consume less than they desire because their spending is constrained, or limited by their income.

4. T HE B UDGET C ONSTRAINT C ON ’ T Here, we give a simple example to examine the decision facing a consumer who buys two goods : soda and salad with their limited income. We are given that the consumer has an income of $1,000 per month and he spends his entire income on soda and salad. The price for a dish of salad is $25. The price for a can of soda is $5.

5. T HE B UDGET C ONSTRAINT C ON ’ T The below table shows some of the many combinations of salad and soda the consumer can buy. Dishes of Salad Cans of Soda Spending on Salad Spending on Soda Total Spending 400$1,000$ 0$1,000 3050 750 250 1,000 20100 500 1,000 10150 250 750 1,000 0200 01,000

6. T HE B UDGET C ONSTRAINT C ON ’ T The first row in the table shows that if the consumer spends all his income on salad, he can eat 40 dishes during the month, but he would not be able to buy any soda at all. The second row in the table shows another possible consumption bundle : 30 dishes of salad and 50 cans of soda. The next row shows another possible consumption bundle and so on. Each consumption bundle in the table costs exactly $1,000

7. T HE B UDGET C ONSTRAINT C ON ’ T Here, we draw a graph to illustrates the consumption bundles that the consumer can choose and the important concept: The Consumer’s Budget Constraint.

8. T HE B UDGET C ONSTRAINT C ON ’ T At point A, the consumer buys no soda and consumes 40 dishes of salad. At point B, the consumer buys 200 cans of soda and consumes no salad. At point C, the consumer buys 100 cans of soda and consumes 20 dishes of salad. Point C, which is exactly at the middle of the line from A to B, is the point at which the consumer sends an equal amount ($500) on Salad and Soda. The line in the graph is called the budget constraint. It shows the consumption bundles that the consumer can afford. In this case, it shows the trade-off between salad and soda that the consumer faces.

9. T HE B UDGET C ONSTRAINT C ON ’ T The slope of the budget constraint measures the rate at which the consumer can trade one good for the other. In our example, We calculated the slope as the change in the vertical distance of 200 cans of soda divided by the change in the horizontal distance of 40 dishes of salad. Which gives us a result of The slope is 5 cans of soda per salad.

10. T HE BUDGET C ONSTRAINT C ON ’ T The slope of the budget constraint equals the relative price of the two goods—The price of one good compared to the price of the other. For our example, A dish of salad costs 5 times as much as a can of soda, so the opportunity cost of a dish of salad is 5 cans of soda. The budget constraint’s slope of 5 reflects the trade-off the market is offering the consumer: 1 dishes of salad for 5 cans of soda.

11. P REFERENCES : W HAT THE CONSUMER WANTS We have analysis the budget constraint in the above slides, where it shows the combinations of goods the consumer can afford given his income and the prices of the goods. However, budget constraint is just one piece of the analysis, consumer’s choices depends not only on his budget constraint but also on his preferences regarding the two goods. Therefore, we are going to analysis the consumer’s preferences in the next slides.

12. P REFERENCES : W HAT THE CONSUMER WANTS Here, we still use salad and soda as an example to do our analysis. The consumer’s preferences allow him to choose among different bundles of salad and soda. If one offer the consumer two different bundles, he chooses the bundle that best units his tastes. If the two bundles suit his tastes equally well, we say that the consumer is indifferent between the two bundles.

13. P REFERENCES : W HAT THE CONSUMER WANTS We try to use graph to represent the consumer’s preferences here. We do this with indifference curves. An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction. In our case, the indifference curves show the combinations of salad and soda with which the consumer is equally satisfied.

14. P REFERENCES : W HAT THE CONSUMER WANTS

15. The above graph shows two of the consumer’s many indifference curves. The consumer is indifferent among combinations A, B, and C because they are all on the same curve. If the consumer’s consumption of salad is reduced, say, from point A to point B, consumption of soda must increase to keep him equally happy. If consumption of salad is reduced again, from point B to point C, the amount of soda consumed must increase yet again.

16. P REFERENCES : W HAT THE CONSUMER WANTS The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other. This rate is called the marginal rate of substitution (MRS). For our example, the marginal rate of substitution measures how much soda the consumer requires to be compensated for a dish reduction in salad consumption. The marginal rate of substitution is not the same at all points on a given difference curve because the indifference curves are not straight lines.

17. P REFERENCES : W HAT THE CONSUMER WANTS The rate at which a consumer is willing to trade one good for the other depends on the amounts of the goods he is already consuming. In our case, the rate at which a consumer is willing to trade salad for soda depends on whether he is hungrier or thirstier, which in turn depends on how much salad and soda he is consuming.

18. P REFERENCES : W HAT THE CONSUMER WANTS The consumer is equally happy at all points on any given difference curve, but he prefers some indifference curves to others. Because he prefers more consumption to less, higher indifference curves are preferred to lower ones. In our graph, any point on curve I ₂ is preferred to any point on curve I₁.

19. P REFERENCES : W HAT THE CONSUMER WANTS A consumer’s set of indifference curves gives a complete ranking of the consumer’s preferences. In our example, the indifference curves tell us that point D is preferred to point A because point D is on a higher indifference curve than point A.  Point D offers the consumer both more salad and more soda than Point A. The indifference curves also tell us that point D is preferred to point C because point D is on a higher indifference curve.  Even thought point D has less soda than point C, it has more than enough extra salad to make the consumer prefer it. To see which point is on the higher indifference curve, we can use the set of indifference curves to rank any combination of Salad and Soda.

20. P REFERENCES : W HAT THE CONSUMER WANTS Below are four properties that describe most indifference curves: Property1: Higher indifference curves are preferred to lower ones.  Higher indifference curves represent larger quantities of goods than lower indifference curves. Thus, the consumer prefers being on higher indifference curves. o Property 2: Indifference curves are downward sloping.  The slope of an indifference curve is the rate at which the consumer give up one good to substitute for the other. In most case, consumer wants both good, therefore, if the quantity of one good is reduced, the quantity of the other good must increase for the consumer to be equally happy. For this reason, most indifference curves slope downward.

21. P REFERENCES : W HAT THE CONSUMER WANTS Property 3: Indifference curves do not cross.  As the below graph show, point A and point B are on the same indifference curve, therefore the two points would make the consumer equally happy. Also, point B and point C are on the same indifference curve, they will make the consumer equally happy as well. This imply that point A and point C would make the consumer equally happy, Even though point C has more of both goods. This contradicts our assumption that the consumer always prefers more of both goods to less. Thus, the indifference curve cannot cross.

22. P REFERENCES : W HAT THE CONSUMER WANTS

23. Property 4: Indifference curves are bowed inward.  The slope of an indifference curve is the marginal rate at which consumer is willing to trade off one good for the other.  People are willing to trade off goods that they have a lot and less willing to trade away goods that they have little. Therefore, the indifference curve are bowed inward.  As the below graph shown, At point A, the consumer is very hungry but not very thirsty because he has a lot of soda but a little salad.  He need to give up 1 dish of salad to has 6 cans of soda. MRS is 6 cans per dish.

24. P REFERENCES : W HAT THE CONSUMER WANTS  At point B, He is very thirsty but not very hungry because he has a lot of salad but a little soda.  He is willing to give up 1 dish of salad to get 1 can of soda. MRS is 1 can per dish.  Thus, the bowed shape of the indifference curve reflects the consumer’s greater willingness to give up a good that he already has in large quantity.

25. P REFERENCES : W HAT THE CONSUMER WANTS

26. P REFERENCES : WHAT THE CONSUME WANTS The shape of an indifference curve tells us about the consumer’s willingness to trade one good for the other. When the goods are easy to substitute for each other, the indifference curves are less bowed; when the goods are hard to substitute, the indifference curves are very bowed. Here is two examples to explain the above situation.

27. P REFERENCES : W HAT THE CONSUMES WANTS Two Extreme examples of indifference Curves. Perfect Substitutes: Two goods with straight-line indifference curve.

28. P REFERENCES : W HAT THE CONSUMES WANTS We use $1 bill and $5 bill as our example to analysis. Since we all care about the money value, we only willing to trade 5 one dollar bill for 1 five dollar bill. Therefore, the MRS is a fixed number of 5. Since the MRS is a fixed number, the indifference curves are straight lines. Thus $1 bill and $5 bill are perfect substitutes.

29. P REFERENCES : W HAT THE C ONSUMNES WANTS Perfect Complements: two goods with right-angle indifference curve.

30. P REFERENCES : W HAT THE C ONSUMES WANTS Here we use the left sock and right sock to analysis. Suppose we have 3 left socks and 5 right socks, It only give us 3 pair of socks. Getting 2 more right socks have no value because there is no left socks to make it a pair. Therefore, a bundle with 3 left socks and 3 right socks is just as good as a bundle with 3 left socks and 5 right socks. Therefore, the indifference curve are right angles. Thus, left sock and right sock are perfect complements.

31. O PTIMIZATION : W HAT THE CONSUMER CHOOSES Here, we are putting the two pieces consumer’s budget constraint and consumer’s preferences together and consider the consumer’s decision about what to buy. Lets use the salad and soda as our example. The consumer would like to end up with the best possible combination of salad and soda for him— that is, he want the combination of the highest possible indifference curve. However, the consumer must also end up on or below his budget constraint, which measures the total resources available to him.

32. O PTIMIZATION : W HAT THE CONSUMER CHOOSES

33. In the above graph, we could see that the highest indifference curve the consumer can reach is I ₂ because I₂ is the curve barely touches the budget constraint. The point where the indifference curve and the budget constraint touch is called the optimum. The optimum represents the best combination of salad and soda available to the consumer. Of course the consumer would prefer point A, but he cannot afford the point because it lies above the budget constraint. On the other hand, although consumer can afford point B, but that point is on a lower indifference curve which gives him less satisfaction.

34. O PTIMIZATION : W HAT THE CONSUMER CHOOSES At optimum, the slope of the indifference curve equals the slope of the budget constraint. We say that the indifference curve is tangent to the budget constraint. The slope of the indifference curve is the MRS between salad and soda, and the slope of the budget constraint is the relative price of salad and soda. Thus, the consumer chooses consumption of the two goods so that marginal rate of substitution equals the relative price.

35. O PTIMIZATION : W HAT THE CONSUMER CHOOSES The relative price is the rate at which the market is willing to trade one good for the other, whereas the marginal rate of substitution is the rate at which the consumer is willing to trade one good for the other. At the consumer’s optimum, the consumer’s valuation of the two goods (as measured by the marginal rate of substitution) equals the market’s valuation(as measured by the relative price). As a result of this consumer optimization, market prices of different goods reflect the value that consumers place on those goods.

36. H OW CHANGES IN P RICES A FFECT THE CONSUMER ’ S CHOICES Let’s suppose that in our example, the price of soda falls from $5 to $4 per can. The lower price expands the consumer’s set of buying opportunities and shifts the budget constraint outward. Lets suppose that the consumer will spends all of his income $1,000 on salad, then the price of salad is irrelevant. Thus, point A in the graph below stays the same. Since the price of the soda drops, the consumer could buy 250 cans of soda rather than 200 cans with his income $1,000 while the price of salad remained the same. This change bring us a new budget constraint, which has steeper slope. The consumer buys more soda and less salad.

37. H OW CHANGES IN PRICES AFFECT THE CONSUMER ’ S CHOICES

38. W ORK C ITED N. Gregory Mankiw. Principles of Microeconomics 2009

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