Consumer Theory. Preferences, Utility, Budget Line and Consumer Equilibrium

Transcription

1 Consumer Theory Preferences, Utility, Budget Line and Consumer Equilibrium

2 The Household s Budget Consumption Possibilities A household s consumption possibilities are constrained by its income and the prices of the goods and services it buys. A household has a given amount of income to spend and cannot influence the prices of the goods and services it buys. A household s budget line describes the limits to a household s consumption choices.

3 The Household s Budget Figure 7.1 shows a budget line for movies and soda. The household can afford all the points on or below the budget line. The household cannot afford the points beyond the budget line.

4 The Household s Budget Relative Price A relative price is the price of one good divided by the price of another good. The price of a movie is $6 and the price of soda is $3 a six-pack. So the relative price of a movie is $6 per movie divided by $3 per six-pack, which equals 2 six-packs per movie.

5 The Household s Budget A Price Change 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. Figure 7.2(a) shows the rotation of a budget line after a change in the relative price of movies.

6 The Household s Budget Real Income A household s real income is the household s income expressed as the quantity of goods that the household can afford to buy. Expressed in terms of soda, Lisa s real income is 10 sixpacks the maximum quantity of six-packs that she can buy. Lisa s real income equals her money income ($30) divided by the price of a six-pack ($3).

7 The Household s Budget A Change in Income An change in the 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 7.2(b) shows how the budget line shifts when income changes.

8 Preferences and Utility Preferences A household s preferences determine the benefits or satisfaction a person receives consuming a good or service. The benefit or satisfaction from consuming a good or service is called utility. Total Utility Total utility is the total benefit a person gets from the consumption of goods. Generally, more consumption gives more utility.

9 Preferences and Utility Table 7.1 on page 157 provides an example of total utility schedule. Figure 7.2(a) shows a total utility curve. Total utility increases with the consumption of a good.

10 Preferences and Utility Marginal Utility Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed. As the quantity consumed of a good increases, the marginal utility from consuming it decreases. We call this decrease in marginal utility as the quantity of the good consumed increases the principle of diminishing marginal utility.

11 Preferences and Utility Figure 7.2(b) illustrates diminishing marginal utility. Utility is analogous to temperature. Both are abstract concepts and both are measured in arbitrary units.

12 Maximizing Utility The key assumption of marginal utility theory is that the household chooses the consumption possibility that maximizes total utility. The Utility-Maximizing Choice We can find the utility-maximizing choice by looking at the total utility that arises from each affordable combination. Table 7.2 (page 158) shows an example of the utilitymaximizing combination, which is called a consumer equilibrium.

13 Maximizing Utility Equalizing Marginal Utility per Dollar Using marginal analysis, a consumer s total utility is maximized by following the rule: Spend all available income and equalize the marginal utility per dollar for all goods. The marginal utility per dollar is the marginal utility from a good divided by its price.

14 Maximizing Utility The Utility-Maximizing Rule: Call the marginal utility of movies MU M. Call the marginal utility of soda MU S. Call the price of movies P M. Call the price of soda P S. The marginal utility per dollar from seeing movies is MU M /P M. The marginal utility per dollar from soda is MU S /P S.

15 Maximizing Utility Total utility is maximized when: MU M /P M = MU S /P S Table 7.3 (page 159) and Figure 7.4 on the next slide show why the utility maximizing rule works.

16 Maximizing Utility If MU M /P M > MU S /P S, then moving a dollar from soda to movies increases the total utility from movies by more than it decreases the total utility from soda, so total utility increases. Only when MU M /P M = MU S /P S, is it not possible to reallocate the budget and increase total utility.

17 Maximizing Utility If MU S /P S > MU M /P M, then moving a dollar from movies to soda increases the total utility from soda by more than it decreases the total utility from movies, so total utility increases. Only when MU M /P M = MU S /P S, is it not possible to reallocate the budget and increase total utility.

18 Predictions of Marginal Utility Theory A Fall in the Price of a Movie When the price of a good falls the quantity demanded of that good increases the demand curve slopes downward. For example, if the price of a movie falls, we know that MU M /P M rises, so before the consumer changes the quantities consumed, MU M /P M > MU S /P S. To restore consumer equilibrium (maximum total utility) the consumer increases the quantity of movies consumed to drive down the MU M and restore MU M /P M = MU S /P S.

19 Predictions of Marginal Utility Theory A change in the price of one good changes the demand for another good. You ve seen that if the price of a movie falls, MU M /P M rises, so before the consumer changes the quantities consumed, MU M /P M > MU S /P S. To restore consumer equilibrium (maximum total utility) the consumer decreases the quantity of soda consumed to drive up the MU S and restore MU M /P M = MU S /P S.

20 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.

21 Consumption Possibilities Figure 8.1 shows Lisa s budget line. Divisible goods can be bought in any quantity along the budget line (gasoline, for example). Indivisible goods must be bought in whole units at the points marked (movies, for example). Lisa can afford any point on the budget line or inside it.

22 Consumption Possibilities The budget line is a constraint on Lisa s choices. Lisa can afford any point on her budget line or inside it. Lisa cannot afford any point outside her budget line.

23 Consumption Possibilities The Budget Equation We can describe the budget line by using a budget equation. The budget equation states that Expenditure = Income Call the price of soda P S, the quantity of soda Q S, the price of a movie P M, the quantity of movies Q M, and income Y. Lisa s budget equation is: P S Q S + P M Q M = Y.

24 Consumption Possibilities 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 soda is the point on her budget line where it meets the y-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 sodas must be forgone to see an additional movie.

25 Consumption Possibilities A Change in Prices A rise in the price of the good on the x-axis decreases the affordable quantity of that good and increases the slope of the budget line. Figure 8.2(a) shows the rotation of a budget line after a change in the relative price of movies.

26 Consumption Possibilities 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 8.2(b) shows the effect of a fall in income.

27 Preferences and Indifference Curves An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. Figure 8.3(a) illustrates a consumer s indifference curve. At point C, Lisa consumes 2 movies and 6 six-packs a month.

28 Preferences and Indifference Curves Lisa can sort all possible combinations of goods into three groups: preferred, not preferred, and indifferent. 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 C and G.

29 Preferences and Indifference Curves All the points above the indifference curve are preferred to the points on the curve. And all the points on the indifference curve are preferred to the points below the curve.

30 Preferences and Indifference Curves A preference map is series of indifference curves. Call the indifference curve that we ve just seen I 1. I 0 is an indifference curve below I 1. Lisa prefers any point on I 1 to any point on I 0.

31 Preferences and Indifference Curves I 2 is an indifference curve above 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.

32 Preferences and Indifference Curves Marginal Rate of Substitution The marginal rate of substitution, (MRS) measures the rate at which a person is willing to give up good y, (the good measured on the y-axis) to get an additional unit of good x (the good measured on the x-axis) and 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.

33 Preferences and Indifference Curves If the indifference curve is relatively steep, the MRS is high. 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. In this case, the person is willing to give up a small quantity of y to get more x.

34 Preferences and Indifference Curves A diminishing marginal rate of substitution is the key assumption of consumer theory. 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, and at the same time remain indifferent, as the quantity of good x increases.

35 Preferences and Indifference Curves Figure 8.4 shows the diminishing MRS of movies for soda. At point C, Lisa is willing to give up 2 six-packs to see one more movie her MRS is 2. At point G, Lisa is willing to give up 1/2 a six-pack to see one more movie her MRS is 1/2.

36 Preferences and Indifference Curves Degree of Substitutability The shape of the indifference curves reveals the degree of substitutability between two goods. Figure 8.5 shows the indifference curves for ordinary goods, perfects substitutes, and perfect complements.

37 Predicting Consumer Behavior The consumer s best affordable point 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

38 Predicting Consumer Behavior Here, the best affordable point is C. Lisa can afford to consume more soda and see fewer movies at point F. And she can afford to see more movies and consume less soda at point H. But she is indifferent between F, I, and H and she clearly prefers C to I.

39 Predicting Consumer Behavior At point F, Lisa s MRS is greater than the relative price. At point H, Lisa s MRS is less than the relative price. At point C, Lisa s MRS is equal to the relative price.

40 Predicting A Change in Price The effect of a change in the price of a good on the quantity of the good consumed is called the price effect. Figure 8.7 illustrates the price effect and shows how the consumer s demand curve is generated. Initially, the price of a movie is $6 and Lisa consumes at point C in part (a) and at point A in part (b).

41 Predicting The price of a movie then falls to $3. 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.

42 Predicting A Change in Income The effect of a change in income on the quantity of a good consumed is called the income effect. Figure 8.8 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).

43 Predicting 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).

44 Predicting Consumer Behavior 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

45 Predicting Consumer Behavior Initially, Lisa has an income of $30, the price of a movie is $6, and she consumes at point C. The price of a movie falls from $6 to $3 and her budget line rotates outward. Lisa s best affordable point is then J. The move from point C to point J is the price effect.

46 Predicting Consumer Behavior 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.

47 Predicting Consumer Behavior Substitution Effect The substitution effect is the effect of a change in price on the quantity bought when the consumer remains indifferent between the original situation and the new situation.

48 Predicting Consumer Behavior 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.

49 Predicting Consumer Behavior 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.

50 Predicting Consumer Behavior 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.

51 Predicting Consumer Behavior For Lisa, movies are a normal good. When her income increases, 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.

52 Predicting Consumer Behavior Inferior Good For an inferior good, when income increases, the quantity bought decreases. For an inferior good, the income effect works against the substitution effect. So long as the substitution effect dominates, the demand curve still slopes downward.

53 Predicting Consumer Behavior 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! This case does not appear to occur in the real world.

54 Work-Leisure Choices The model of consumer choice can be used to study the allocation of time between work and leisure. The two goods are leisure and income where income represents all other goods. Lisa buys leisure by not supplying labor and by forgoing income. So the price of leisure is the wage rate forgone.

55 Work-Leisure Choices The Labor Supply Curve By changing the wage rate, we can find a person s labor supply curve. An increase in the wage rate makes leisure relatively more expensive (higher opportunity cost to not working) and has a substitution effect toward less leisure (toward more work).

56 Work-Leisure Choices A higher wage also has a positive income effect on leisure. If the income effect is weaker than the substitution effect, the quantity of work hours increases as the wage rate rises. When the wage rate rises from $5 to $10 an hour, work increases from 20 to 35 hours a week the move from A to B.

57 Work-Leisure Choices But if the income effect is stronger than the substitution effect, the quantity of work hours decreases as the wage rate rises. When the wage rate rises from $10 to $15 an hour, work decreases from 35 to 30 hours a week the move from B to C.

58 Work-Leisure Choices Historical evidence shows that the average workweek has declined over the centuries, implying that people have preferred to seek greater leisure despite its higher opportunity cost.