1. Chapter 9: Going from Possibilities (Budget Constraint) and Preferences (Preference Function) to understanding Price and Income Effects

2. 9 Possibilities, Preferences, and Choices

3. After studying this chapter you will be able to  Describe a household’s (consumer unit’s) budget line and show how budget line changes when prices or income change, and derive a demand curve  Use indifference curves to map preferences, the principle of diminishing marginal rate of substitution, and re-discover Adam Smith’s “Invisible Hand” proposition.  Deconstructing a price effect into its “Substitution Effect” and “Income Effect” components. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

4. You buy your music online and play it on an iPod. The prices of a music download and an iPod have tumbled, the volume of downloads and sales of iPods have skyrocketed. (both Quantities of complements rise based on falls in prices) The price of a DVD has fallen and we’re buying ever more of them. (actually we are not, why not? ANS: because of downloads. ) Why are we going to movie theaters in ever-greater numbers even though it is cheaper to buy a DVD? This chapter studies a model of choice that provides tools to explore these questions. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

5. Consumption Possibilities Household consumption choices are constrained by its income and the prices of the goods and services available. The budget line describes the limits to the household’s consumption choices. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

6. Consumption Possibilities Lisa has $40 to spend, the price of a movie is $8 and the price of pop is $4 a case. The rows of the table show combinations of pop and movies that Lisa can buy with her $40. The graph plots these seven possible combinations. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

7. Consumption Possibilities The budget line is a constraint on Lisa’s consumption choices. Lisa can afford any point on her budget line or inside it. Lisa cannot afford any point outside her budget line. Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

8. The Budget Equation We can describe the budget line by using a budget equation. The budget equation states that Expenditure = Income The price of pop P P, the quantity of pop Q P, the price of a movie P M, the quantity of movies Q M, and income Y. Lisa’s budget equation is: P P Q P + P M Q M = Y. Consumption Possibilities Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

9. P P Q P + P M Q M = Y Divide both sides of this equation by P P, to give: Q P + (P M /P P )Q M = Y/P P Then subtract (P M /P P )Q M from both sides of the equation to give: Q P = Y/P P – (P M /P P )Q M Y/P P is Lisa’s real income in terms of pop. P M /P P is the relative price of a movie in terms of pop. Consumption Possibilities Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

10. A household’s real income is the income expressed as a quantity of goods the household can afford to buy. Lisa’s real income in terms of pop is the point on her budget line where it meets the y-axis, in terms of movies the point where it meets the x-axis. A relative price is the price of one good divided by the price of another good. Relative price is the magnitude of the slope of the budget line. The relative price shows how many cases of pop must be forgone to see an additional movie. Consumption Possibilities Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

11. A Change in Prices A change in the price of the good on the x-axis changes the affordable quantity of that good and changes the slope of the budget line. (P M up – slope steeper; P M down – reverse) Figure 9.2(a) shows the rotation of a budget line after a change (up to $16; down to $4) in the relative price of movies. Consumption Possibilities Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

12. A Change in Income An change in money income brings a parallel shift of the budget line. The slope of the budget line doesn’t change because the relative price doesn’t change. Figure 9.2(b) shows the effect of a fall in income. Consumption Possibilities Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

13. An indifference curve is a line that shows/maps combinations of goods among which a consumer is indifferent. Figure 9.3(a) illustrates a consumer’s indifference curve. Let’s start with Lisa seeing 2 movies and drinking 6 cases of pop a month. Preferences and Indifference Curves Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

14. Preferences and Indifference Curves Lisa can sort all possible combinations of goods into three groups: preferred, not preferred, and just as good as point C. An indifference curve joins all those points that Lisa says are just as good as C. G is such a point. Lisa is indifferent between point C and point G, and all points on I o Copyright © 2013 Pearson Canada Inc., Toronto, Ontario Indifference curves are always concave from above IOIO IOIO

15. All the points on the indifference curve are preferred to all the points below the indifference curve And all the points above the indifference curve are preferred to all the points on the indifference curve. Think of Indifference Curves as projections down from a third axis measuring satisfaction, where more means happier. Preferences and Indifference Curves (everywhere dense like topographic maps,) Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

16. A preference mapping is a depiction of the whole family of indifference curves. I 2 is an indifference curve above I 1, and I 0 is below I 1 Lisa prefers any point on I 2 to any point on I 1. For example, Lisa prefers point J to either point C or point G. Preferences and Indifference Curves Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

17. Marginal Rate of Substitution: Slope of Indifference Curve 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). The magnitude of the slope of the indifference curve measures the marginal rate of substitution. Preferences and Indifference Curves Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

18.  If the indifference curve is relatively steep, the MRS is high. (Give up a lot of “vertical” for a bit of “horizontal”) In this case, the person is willing to give up a large quantity of y to get a bit more x.  If the indifference curve is relatively flat, the MRS is low. (Give up only a bit of “vertical” for a lot of “horizontal”) In this case, the person is willing to give up a small quantity of y to get more x. Preferences and Indifference Curves Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

19. A diminishing marginal rate of substitution is the key assumption of consumer theory, and is similar to the Principle of diminishing marginal utility. (either implies the other) 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. Preferences and Indifference Curves Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

20. Figure 9.4 shows the diminishing MRS of movies for pop. At point C, Lisa is willing to give up 2 cases of pop to see one more movie— her MRS is 2. At point G, Lisa is willing to give up 1/2 case of pop to see one more movie— her MRS is 1/2. Preferences and Indifference Curves Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

21. Degree of Substitutability The shape of the indifference curves reveals the degree of substitutability between two goods. Figure 9.5 shows the indifference curves for ordinary goods, perfects substitutes, and perfect complements. Preferences and Indifference Curves Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

22. Predicting Consumer Choices Best Affordable Choice The consumer’s best affordable choice is  On the budget line  On the highest attainable indifference curve  Has a marginal rate of substitution between the two goods equal to the relative price of the two goods Q Y = Inc/ P Y – (P X / P Y ) Q X Copyright © 2013 Pearson Canada Inc., Toronto, Ontario Slope

23. Here, the best affordable point is C. Lisa can afford to consume more pop and see fewer movies at point F. And she can afford to see more movies and consume less pop at point H. But she is indifferent between F, I, and H and she prefers C to I. Predicting Consumer Choices Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

24. At point F, Lisa’s MRS is greater than the relative price, and at point H, Lisa’s MRS is less than the relative price. At point C, Lisa’s MRS is equal to the relative price. At C Lisa’s MRS of pop for movies = (P m /P p ) so her subjective MRS is the same as the objective rate at which they substitute in the market Predicting Consumer Choices Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

25. At C: Lisa’s MRS of pop for movies = (P m /P p ). Her subjective MRS is the same as the objective rate at which they substitute in the market. If all face similar prices: MRS Lisa = MRS everybody is same as Lisa’s MU X /MU y = MU X /MUy for everybody. (utility theory) Predicting Consumer Choices Copyright © 2013 Pearson Canada Inc., Toronto, Ontario Adam Smith’s “Invisible Hand” at work

26. Predicting & Deconstructing A Change in Price Effect of a change in the price of a good on the quantity consumed is called the price effect (sliding along demand curve). Figure 9.7: The price effect reflects how the consumer’s demand curve is generated. The price of a movie is $8 and Lisa consumes at point C in part (a) and at point A in part (b). Then drop Price and follow changes in Quantity Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

27. The price of a movie then falls to $4. The budget line rotates outward. Lisa’s best affordable point is now J in part (a). In part (b), Lisa moves to point B, which is a movement along her demand curve for movies. Generating the Demand Curve Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

28. First look at a Change in Income The effect of a change in income on the quantity of a good consumed is called the income effect. Figure 9.8 illustrates the effect of a decrease in Lisa’s income. Initially, Lisa consumes at point J in part (a) and at point B on demand curve D 0 in part (b). Deconstructing the price effect Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

29. Lisa’s income decreases and her budget line shifts leftward in part (a). Her new best affordable point is K in part (a). Her demand for movies decreases, shown by a leftward shift of her demand curve for movies in part (b). Price has not changed in either part (a) or part (b) Predicting … Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

30. Deconstructing the Price Effect Substitution Effect and Income Effect For a normal good, a fall in price always increases the quantity consumed. We can prove this assertion by dividing the price effect in two parts:  Substitution effect  Income effect Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

31. Initially, Lisa has an income of $40, the price of a movie is $8, and she consumes at point C. Lisa’s best affordable point is now J. The move from point C to point J is the price effect. The price of a movie falls from $8 to $4 and her budget line rotates outward. Deconstructing the Price Effect Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

32. We’re going to break the move from point C to point J into two parts. The first part is the substitution effect and the second is the income effect. Thought experiment: Change price of movies but leave Lisa just as well off (on I 1 ) Deconstructing the Price Effect Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

33. Substitution Effect The substitution effect is the effect of a change in price on the quantity bought when the consumer remains on the same indifferent curve. Deconstructing the Price Effect Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

34. C to K, substitution effect K to J, income effect

35. To isolate the substitution effect, we give Lisa a hypothetical pay cut. Lisa is now back on her original indifference curve but with a lower price of movies and her best affordable point is K. The move from C to K is the substitution effect. Deconstructing the Price Effect Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

36. The direction of the substitution effect never varies: When the relative price falls, the consumer always substitutes more of that good for other goods. The substitution effect is the first reason why the demand curve slopes downward. Deconstructing the Price Effect Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

37. Income Effect To isolate the income effect, we reverse the hypothetical pay cut and restore Lisa’s income to its original level (its actual level). Lisa is now back on indifference curve I 2 and her best affordable point is J. The move from K to J is the income effect. Deconstructing the Price Effect Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

38. For Lisa, movies are a normal good. With more income to spend, she sees more movies—the income effect is positive. For a normal good, the income effect reinforces the substitution effect and is the second reason why the demand curve slopes downward. (Bare Naked Ladies, “If I had a million dollars”) Deconstructing the Price Effect Copyright © 2013 Pearson Canada Inc., Toronto, Ontario M

39. Inferior Goods For an inferior good, when income increases, the quantity bought decreases. The income effect is negative and works against the substitution effect. So long as the substitution effect dominates, the demand curve still slopes downward. (If movies were an inferior good Lisa would go somewhere like M) Deconstructing the Price Effect Copyright © 2013 Pearson Canada Inc., Toronto, Ontario

40. 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! (or curves back) This case does not appear to occur often in the real world. Deconstructing the Price Effect Copyright © 2013 Pearson Canada Inc., Toronto, Ontario P Q D D Inferior good Range: macaroni and cheese so cheap we can buy more meat