Chapter 21

1. Chapter 21 Theory of Consumer Choice Ratna K. Shrestha

2. Theory of Consumer Choice ... addresses the following questions and links them in understanding: • How do wages affect labor supply? • How do interest rates affect household saving? • Do the poor prefer to receive cash or in-kind transfers?

3. The Budget Constraint • Shows what combination of goods the consumer can afford given his income and the prices of the two goods. • Assume I = $ 1000 Ppizza = $10 Ppepsi = $2

4. The Budget Constraint Pepsi ($2) • I = $ 1000; • Ppizza = $10; Ppepsi = $2 I = Ppizza*Pizza + Ppepsi*Pepsi Assume Pizza =X and Pepsi =Y, then rewriting: Y = I/PY +PX/PY X B 500 A Pizza ($10) 100

5. The Budget Constraint Pepsi ($2) Any point on the budget constraint line equals $1,000, the income available to spend on the two products. B 500 Slope = Ppizza /Ppepsi = 10/2 = 5 C 250 A Pizza ($10) 50 100

6. Preferences • Indifference curves illustrate consumer’s preference between different bundles of goods and services. • An indifference curve depicts bundles of goods that make the consumer equally well-off. It shows the combinations of goods that give the consumer the same level of utility. • In the next slide, the levels of utility that the consumer can derive from three bundles A or B or C, which are on the same curve, are equal. • The bundle D provides higher utility than bundle A, B or C.

7. Indifference Curves Pepsi . Utility I2 > Utility I1 C . . . B D I2 I1 A Pizza

8. Indifference Curves Pepsi . Slope between points A and B (MRS). Tradeoff between the two bundles. C . . . B D I2 I1 A Pizza

9. Marginal Rate of Substitution • The rate at which consumers are willing to trade one good for another is called the marginal rate of substitution (MRS). • MRS measures how many Pepsi you have to sacrifice to get one more Pizza and be equally well off as before. • MRS = Pepsi / Pizza

10. Properties of Indifference Curves • Higher indifference curves are preferred to lower ones. • Indifference curves are downward sloping. • Indifference curves do notcross. • Indifference curves are bowed inward.

11. (1) Higher indifference curves are preferred to lower ones Properties of Indifference Curves • Because consumers prefer more consumption to less, higher indifference curves are preferred to lower ones. • Indifference curves farther from the origin represent higher levels of well-being or utility.

12. Indifference Curves Pepsi At both B and D, you have equal Pepsi. But at D you have more Pizza  I2 > I1 . C . . D . B I2 > I1 I1 A Pizza

13. Properties of Indifference Curves (2) Indifference curves are downward sloping • The fact that the consumer is willing to give up one of the goods only if he/she is given some more of the other good results in the indifference curve being downward sloping. (3) Indifference curves do not cross • In order for preference rankings to be consistent, indifference curves cannot intersect or cross. • If indifference curves were to cross the assumption that “more is preferred to less” would be violated.

14. Quantity of Pepsi Quantity of Pizza Indifference curves do not cross. Properties of Indifference Curves C A B 0

15. Quantity of Pepsi 14 MRS = 6 A 8 1 4 B MRS = 1 3 Indifference 1 curve 2 3 6 7 Quantity of Pizza (4) Indifference curves are bowed inward. Properties of Indifference Curves When Pizza = 2, you give up 6 Pepsi to have one more pizza. But when Pizza = 6, you give up only 1 Pepsi to have one more pizza. 0

16. Perfect Substitutes Nickels 6 Nickel and dimes are perfect substitutes; 2 Nickel = 1 dime all the time. 4 2 I3 I2 I1 Dimes 1 2 3

17. Perfect Complements Left Shoes I2 1 I1 Right Shoes 1

18. Consumer’s Optimal Choice Pepsi Consumer’s indifference curves, based on personal preferences. I3 I2 I1 Pizza

19. Consumer’s Optimal Choice Pepsi Budget constraint. B At both A and B you spend the same income. Which point will you choose? A I3 I2 > I1 I1 Pizza

20. Consumer’s Optimal Choice Pepsi . Optimal Choice QPepsi I3 I2 I1 Pizza QPizza

21. Consumer’s Optimal Choice • The point at which the indifference curve and the budget constraint touch (i.e. are tangent) maximizes consumer’s utility for the given income. • That is, consumer chooses the two goods so that the marginal rate of substitution equals the relative price (or Price Ratio).

22. Quantity New budget constraint of Pepsi 1. An increase in income shifts the budget constraint outward New optimum 3. and Pepsi consumption. I2 Quantity of Pizza 2. raising pizza consumption An Increase in Income... Initial optimum Initial budget constraint I1 0

23. New budget constraint 1. When an increase in income shifts the budget constraint outward. 3. ... but Pepsi consumption falls, making Pepsi an inferior good. New optimum I2 2. ... pizza consumption rises, making pizza a normal good. An Inferior Good... Quantity of Pepsi Initial optimum Initial budget constraint I1 0 Quantity of Pizza

24. New budget constraint New optimum 1. A fall in the price of Pepsi rotates the budget constraint outward… 3. …and raising Pepsi consumption. I2 I1 2. …reducing pizza consumption… A Change in Price... I = $1000 PPepsi = $2 to $1 PPizza =$10 Quantity of Pepsi 1,000 B 500 A Initial budget constraint Quantity of Pizza 100 0

25. Income and Substitution Effects • The price effect can be divided into: • an income effect • a substitution effect

26. Quantity of Pepsi New budget constraint C New optimum Income effect B Substitution effect I2 Substitution effect Income effect Income and Substitution Effects... Initial optimum A I1 Initial budget constraint 0 Quantity of Pizza

27. Deriving demand curve: The Consumer’s Optimal choices when Ppepsi falls from $2 to $1 (say I = $200) Quantity of Pepsi Price of Pepsi A B $2 150 I2 New budget constraint B $1 A 50 I1 0 0 Quantity of Pizza 50 150 Quantity of Pepsi Initial budget constraint

28. Applications:(1) How do increase in wages affect labor supply?

29. Work-Leisure Decision... Consumption Available hour = 100; w = $50 The optimum work-leisure choice is where BL is tangent to ID curve. $5,000 Optimum 3,000 I3 2,000 I2 I1 Hours of Leisure 0 100 40 60

30. 1. When the wage rises 2. …hours of leisure decrease… 3. ...and hours of labor increase. An Increase in the Wage... (a) Stronger preferences for consumption (substitution effect> Income effect) …the labor supply curve slopes upward. Wage Consumption S B B I2 A BC1 A BC2 I1 0 0 Hours of Leisure Hours of Labor Supplied

31. 1. When the wage rises… 2. …hours of leisure increase… 3. ...and hours of labor decrease. An Increase in the Wage... (b) Stronger preferences for leisure (Income effect>Substitution effect) Wage . .the labor supply curve slopes backward. Consumption BC2 B B A A I2 BC1 I1 0 0 Hours of Leisure Hours of Labor Supplied

32. (2) How do interest rates affect household saving? • An increase in the interest rate could either encourage or discourage saving.

33. Consumption-Saving Decision... Consumption Budget constraint when Old $110,000 Optimum 55,000 I3 I2 I1 Consumption 0 $50,000 100,000 when Young

34. 1. A higher interest rate rotates the budget constraint outward... 1. A higher interest rate rotates the budget constraint outward... 2. …resulting in lower consumption when young and, thus, higher saving. 2. …resulting in higher consumption when young and, thus, lower saving. An Increase in the Interest Rate... (a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving Consumption when Old Consumption when Old BC2 BC2 B B BC1 I2 A I2 BC1 A I1 I1 Consumption when young 0 0 Consumption when Young

35. (3) Cash Vs. In Kind Transfer

36. Cash versus In-Kind Transfers... (a) The Constraint Is Not Binding Cash Transfer In-Kind Transfer Food Food (with $1,000 cash) BC2 BC2 (with $1,000 food stamps) BC1 BC1 B B I2 I2 $1,000 $1,000 A A I1 I1 0 0 Nonfood Nonfood Consumption Consumption

37. Cash versus In-Kind Transfers... (b) The Constraint Is Binding Cash Transfer In-Kind Transfer Food Food BC2 (with $1,000 cash) BC2 (with $1,000 food stamps) BC1 BC1 I3 I2 I1 $1,000 $1,000 C B B A A I2 I1 0 0 Nonfood Nonfood Consumption Consumption