Economic Analysis for Business Session XV: Theory of Consumer Choice (Chapter 21)

1. Economic Analysis for BusinessSession XV: Theory of Consumer Choice (Chapter 21) InstructorSandeep Basnyat 9841892281 Sandeep_basnyat@yahoo.com

2. ACTIVE LEARNING 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

3. B C A ACTIVE LEARNING 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 Pizzas 3

4. C D 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. Pizzas CHAPTER 21 THE THEORY OF CONSUMER CHOICE

5. 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

6. ACTIVE LEARNING 2: Exercise Pepsis What happens to the budget constraint if: A. Income falls to $800 Pizzas 6

7. ACTIVE LEARNING 2A: Answers A fall in income shifts the budget constraint inward. Pepsis Consumer can buy $800/$10 = 80 pizzas or $800/$2 = 400 Pepsis or any combination in between. Pizzas 7

8. ACTIVE LEARNING 2: Exercise Pepsis What happens to the budget constraint if: B. The price of Pepsi rises to $4/pint. Pizzas 8

9. ACTIVE LEARNING 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

10. 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.

11. C B Indifference A curve, I1 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 of Pepsi Quantity 0 If the consumption of pizza is reduced, consumption of Pepsi must increase to keep him equally happy. of Pizza

12. C B MRS 5 Indifference A curve, I1 The Consumer’s Preferences-MRS The slope at any point on an indifference curve is the Marginal Rate of Substitution MRS Quantity • 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. of Pepsi 200 100 30 50 Quantity 0 MRS tells how much Pepsi the consumer requires to be compensated for a one unit increase in pizza consumption of Pizza

13. C B D E I3 MRS I2 5 Indifference A curve, I1 Higher and Lower Indifference Curves: Indifference Map • Higher indifference curves represent higher level of satisfaction Quantity of Pepsi Quantity 0 of Pizza

14. 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.

15. 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.

16. C B D I2 Indifference A curve, I1 The Consumer’s Preferences Quantity of Pepsi Quantity 0 of Pizza

17. 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.

18. Indifference curve, I1 The Consumer’s Preferences Quantity of Pepsi Quantity 0 of Pizza

19. 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.

20. C A B The Impossibility of Intersecting Indifference Curves Quantity of Pepsi Quantity 0 of Pizza

21. 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.

22. 14 MRS = 6 A 8 1 4 B MRS = 1 3 1 Indifference curve 2 3 6 7 Bowed Indifference Curves Quantity of Pepsi Quantity 0 of Pizza

23. 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

24. 6 4 2 I1 I2 I3 1 2 3 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. $ amount 0

25. I2 7 9 5 I1 5 7 9 Perfect Substitutes and Perfect Complements (b) Perfect Complements • Perfect Complements • Two goods with right-angle indifference curves are perfect complements. Left Shoes Right Shoes 0

26. 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.

27. Optimum B A I3 I2 I1 Budget constraint 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 of Pepsi Note: Slop of ID curve: MRS Slop of BC: Relative price of Pepsi and Pizza Quantity 0 of Pizza

28. 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.

29. 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

30. New budget constraint I2 I3 I4 Initial optimum Initial budget I1 constraint An Increase in Income-Normal goods: Pepsi and Pizza Quantity of Pepsi Which Indifference curve would the consumer chose? Quantity 0 of Pizza

31. New budget constraint New optimum Initial optimum I3 Initial budget I1 constraint An Increase in Income-Normal goods case Quantity of Pepsi Quantity 0 of Pizza

32. New budget constraint Initial optimum New optimum Initial budget I2 I1 constraint Increase in Income- An Inferior Good case (Pepsi) Quantity of Pepsi Quantity 0 of Pizza

33. 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.

34. Price 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

35. Price 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

36. Price Effect • Total Price Effect = Substitution effect + Income Effect

37. New budget constraint C New optimum B Initial optimum Initial budget constraint A I2 I1 A Change in Price- Price of Pepsi decreases from $2 to $1 Quantity of Pepsi Total effect Income effect Substitution effect Quantity 0 of Pizza

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

39. 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.

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

41. 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.

42. 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 Initial budget constraint B Optimum with high price of potatoes Optimum with low D price of potatoes E 2. . . . which 1. An increase in the price of increases C potatoes rotates the budget potato constraint inward . . . consumption if potatoes I1 New budget I2 are a Giffen constraint good. A Application I: A Giffen Good Quantity of Potatoes Quantity 0 of Meat

43. 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.

44. $5,000 Optimum I3 2,000 I2 I1 60 100 Application II: The Work-Leisure Decision Consumption What happens when the wage increases? Hours of Leisure 0

45. BC2 1. When the wage rises . . . 1. When the wage rises . . . BC1 BC1 I2 BC2 I2 I1 I1 2. . . . hours of leisure decrease . . . 2. . . . hours of leisure increase . . . An Increase in the Wage: Substitution effect-Income effect (a) For a person with substitution effect . . . (b) For a person with Income effect . . . Hours of work Hours of work Hours of 0 Hours of 0 Leisure Leisure

46. 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.

47. Budget constraint $110,000 Optimum 55,000 I3 I2 I1 $50,000 100,000 Application III: The Consumption-Saving Decision Consumption when Old What happens when the bank interest rate increases? Consumption 0 when Young

48. BC2 BC2 1. A higher interest rate rotates the budget constraint outward . . . 1. A higher interest rate rotates the budget constraint outward . . . BC1 BC1 I2 I2 I1 I1 2. . . . resulting in lower 2. . . . resulting in higher consumption when young consumption when young and, thus, higher saving. and, thus, lower saving. 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 Consumption Consumption 0 0 when Young when Young Thus, an increase in the interest rate could either encourage or discourage saving.

49. Thank you