In this chapter, look for the answers to these questions: § How does the budget constraint represent the
C H A P T E R
21 The Theory of The Theory of
Consumer Choice Consumer Choice P R I N C I P L E S O F P R I N C I P L E S O F conomics
E N. Gregory N. Gregory Mankiw Mankiw
Premium PowerPoint Slides © 2009 South-Western, a part of Cengage Learning, all rights reserved by Ron Cronovich In this chapter, In this chapter, look for the answers to these questions: look for the answers to these questions:
§ How does the budget constraint represent the
choices a consumer can afford?
§ How do indifference curves represent the
consumer’s preferences?
§ What determines how a consumer divides her
resources between two goods?
§ How does the theory of consumer choice explain
decisions such as how much a consumer saves, or how much labor she supplies?
1 Introduction
§ Recall one of the Ten Principles from Chapter 1: People face tradeoffs.
§ Buying more of one good leaves less income to buy other goods. § Working more hours means more income and more consumption, but less leisure time. § Reducing saving allows more consumption today but reduces future consumption.
§ This chapter explores how consumers make choices like these.
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W hat the Consumer Can A fford §
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3 The Budget Constraint:
A C T I V E L E A R N I N G A C T I V E L E A R N I N G
C. If Hurley buys 100 fish, how many mangos can
Quantity of Mangos
Answers Quantity of Fish
1
4 A C T I V E L E A R N I N G A C T I V E L E A R N I N G
1 Budget Constraint Budget Constraint
1
he buy? D. Plot each of the bundles from parts A – C on a graph that measures fish on the horizontal axis and mangos on the vertical, connect the dots.
Example: Hurley divides his income between two goods: fish and mangos.
If Hurley spends all his income on mangos, how many mangos does he buy?
B.
= $1 per mango A. If Hurley spends all his income on fish, how many fish does he buy?
M
= $4 per fish, P
F
Hurley’s income: $1200 Prices: P
§ Budget constraint :
§ A “consumption bundle” is
1 Answers
Quantity of Fish Quantity of Mangos
D
THE THEORY OF CONSUMER CHOICE
6 The Slope of the Budget Constraint
THE THEORY OF CONSUMER CHOICE
7 The Slope of the Budget Constraint
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Budget constraint, continued. continued.
2
A C T I V E L E A R N I N G A C T I V E L E A R N I N G
= $2 per mango
P M
His income falls to $800.
Show what happens to Hurley’s budget constraint if: A.
The slope of the budget constraint equals price of fish price of mangos
C
Hurley must give up
From C to D, “rise” = “run” = Slope =
2 Budget constraint,
B. The price of mangos rises to
2 A C T I V E L E A R N I N G A C T I V E L E A R N I N G Answers, Answers, part A part A
2
Quantity of Mangos Quantity of Fish
2 A C T I V E L E A R N I N G A C T I V E L E A R N I N G part B Answers, Answers, part B
2
Quantity of Mangos Quantity of Fish
Preferences: W hat the Consumer Wants One of Hurley’s
Indifference curve : Quantity of Mangos indifference curves
B
A, B, and all other
bundles on I 1 A
I 1
he is indifferent
Quantity of Fish
between them.
THE THEORY OF CONSUMER CHOICE
11
THE THEORY OF CONSUMER CHOICE
12 Four Properties of Indifference Curves Quantity of Fish
C A
I 4 A
B C
3. Indifference curves cannot cross.
I 1
Hurley’s indifference curves
Quantity of Mangos Suppose they did.
14 Four Properties of Indifference Curves Quantity of Fish
He prefers every bundle on I 1 (like A) to every bundle on I (like D).
Quantity of Mangos
I 1 I 2 I D
A few of Hurley’s indifference curves
Hurley prefers every bundle on I 2 (like C) to every bundle on I 1 (like A).
Quantity of Mangos
13 Four Properties of Indifference Curves Quantity of Fish
I 1 THE THEORY OF CONSUMER CHOICE
A One of Hurley’s indifference curves
If the quantity of fish is reduced, the quantity of mangos must be increased to keep Hurley equally happy.
THE THEORY OF CONSUMER CHOICE
15 Four Properties of Indifference Curves Quantity of Fish
Quantity of Mangos
THE THEORY OF CONSUMER CHOICE
Consumer is always willing to trade two nickels for one dime.
: Example: nickels & dimes
Perfect substitutes
: MRS falls as you move down along an indifference curve.
2 A B Marginal rate of substitution (MRS)
6
1
1
I 1
Hurley’s MRS is
Quantity of Mangos
16 The M arginal Rate of Substitution Quantity of Fish
1 A B THE THEORY OF CONSUMER CHOICE
1
I 1
Indifference curves are bowed inward.
Hurley is willing to give up more mangos for a fish if 4.
THE THEORY OF CONSUMER CHOICE
17 One Extreme Case: Perfect Substitutes
Another Extreme Case: Perfect Complements Perfect complements
: Example: Left shoes, right shoes
{7 left shoes, 5 right shoes}
is just as good as
{5 left shoes, 5 right shoes}
18 THE THEORY OF CONSUMER CHOICE
Less Extreme Cases: Close Substitutes and Close Complements Indifference Quantity Indifference
Quantity of hot curves for of Pepsi curves for close dog buns close substitutes complements
Quantity Quantity of Coke of hot dogs Optimization: W hat the Consumer Chooses
A is the optimum: Quantity of Mangos
1200 B
Hurley prefers B to A, A but he cannot afford B.
600 C
Hurley can afford C and D, D but A is on a higher indifference curve.
300 150 Quantity of Fish
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Optimization: W hat the Consumer Chooses Quantity
Consumer At the optimum, Consumer of Mangos optimization is optimization is another example another example of “thinking at the
1200 of “thinking at the margin.” margin.”
MRS = P /P F M A
600 150 300 Quantity of Fish
21 THE THEORY OF CONSUMER CHOICE The Effects of an Increase in Income
Quantity of Mangos An increase in income If both goods are
A “normal,” Hurley
Quantity of Fish
22 THE THEORY OF CONSUMER CHOICE
3 A C T I V E L E A R N I N G A C T I V E L E A R N I N G
3
Inferior vs. normal goods Inferior vs. normal goods § An increase in income increases the quantity demanded of normal goods and reduces the quantity demanded of . inferior goods
Suppose fish is a normal good § but mangos are an inferior good.
Use a diagram to show the effects of § an increase in income on Hurley’s optimal bundle of fish and mangos.
23
3 A C T I V E L E A R N I N G
3 A C T I V E L E A R N I N G Answers Answers
Quantity of Mangos Quantity of Fish
24 The Effects of a Price Change Quantity
Initially, of Mangos
P = $4 F
1200 initial
P = $1 M optimum falls to $2
P F 600 150 300 Quantity of Fish
25 THE THEORY OF CONSUMER CHOICE The Income and Substitution Effects
A fall in the price of fish has two effects on Hurley’s optimal consumption of both goods.
§ Income effect § Substitution effect
Notice:
THE THEORY OF CONSUMER CHOICE
26
The Income and Substitution Effects Initial Quantity of Mangos optimum at A.
P falls.
F Substitution effect: from A to B,
A buy more fish and fewer mangos.
Income effect: from B to C, buy more of both
Quantity goods. of Fish
27 THE THEORY OF CONSUMER CHOICE
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4 A C T I V E L E A R N I N G A C T I V E L E A R N I N G The substitution effect in two cases The substitution effect in two cases
Do you think the substitution effect would be bigger for substitutes or complements? § Draw an indifference curve for Coke and Pepsi,
and, on a separate graph, one for hot dogs and hot dog buns.
§ On each graph, show the effects of a relative
price change (keeping the consumer on the initial indifference curve).
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4 A C T I V E L E A R N I N G A C T I V E L E A R N I N G Answers Answers
4
Quantity Quantity of of Pepsi hot dog buns
Quantity Quantity of Coke of hot dogs
Deriving Hurley’s Demand Curve for Fish Quantity Price of of Mangos Fish
A $4
A 150 150 Quantity Quantity of Fish of Fish
30 A pplication 1: Giffen Goods § Do all goods obey the Law of Demand?
Suppose the goods are potatoes and meat, § and potatoes are an inferior good.
If price of potatoes rises, § substitution effect:
§ § income effect: If
§ then potatoes are a Giffen good ,
31 THE THEORY OF CONSUMER CHOICE A pplication 1: Giffen Goods
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A pplication 2: W ages and Labor Supply Budget constraint
§ The relative price of an hour of leisure Indifference curve
Shows “bundles” of
§
33 THE THEORY OF CONSUMER CHOICE A pplication 2: W ages and Labor Supply
34 THE THEORY OF CONSUMER CHOICE A pplication 2: W ages and Labor Supply
An increase in the wage has two effects on the optimal quantity of labor supplied.
§ Substitution effect (SE): § Income effect (IE):
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A pplication 2: W ages and Labor Supply
For this person, So her labor supply
For this person, So her labor supply SE > IE
increases with the wage
SE > IE increases with the wage 24729_2114
36 THE THEORY OF CONSUMER CHOICE A pplication 2: W ages and Labor Supply
For this person, So his labor supply falls
For this person, So his labor supply falls SE < IE
when the wage rises
SE < IE 24729_2114 when the wage rises
37 THE THEORY OF CONSUMER CHOICE Could This Happen in the Real W orld???
Cases where the income effect on labor supply is very strong:
§ Over last 100 years, technological progress has increased labor demand and real wages.
The average workweek fell from 6 to 5 days.
§ When a person wins the lottery or receives an
inheritance, his wage is unchanged – hence no substitution effect. But such persons are more likely to work fewer hours, indicating a strong income effect.
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§ Period 1: young, works, earns $100,000
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39 A pplication 3: Interest Rates and Saving § A person lives for two periods.
THE THEORY OF CONSUMER CHOICE
40 A pplication 3: Interest Rates and Saving
5
41
Ef fects of a change in the interest rate fects of a change in the interest rate
A C T I V E L E A R N I N G A C T I V E L E A R N I N G
consumption = $100,000 minus amount saved
§ Suppose the interest rate rises. § Describe the income and substitution effects on current and future consumption, and on saving.
At the optimum, Budget constraint shown is for 10% interest rate.
The interest rate determines
§
consumption = saving from Period 1 plus interest earned on saving
§ Period 2: old, retired
5 Ef
A pplication 3: Interest Rates and Saving
In this case,
In this case, SE > IE and
SE > IE and
saving rises
saving rises
43 THE THEORY OF CONSUMER CHOICE A pplication 3: Interest Rates and Saving
In this case,
In this case, SE < IE and
SE < IE and
saving falls
saving falls
44
44 THE THEORY OF CONSUMER CHOICE CONCLUSION:
Do People Really Think This W ay? § People do not make spending decisions
by writing down their budget constraints and indifference curves.
§ Yet, they try to make the choices that maximize their satisfaction given their limited resources. § The theory in this chapter is only intended as a metaphor for how consumers make decisions.
It explains consumer behavior fairly well in many
§
situations and provides the basis for more advanced economic analysis.
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