Possibilities, Preferences, and Choices

• The household's budget line.
• Changes in the budget line caused by changes in price or income.
• Indifference curves and preferences.
• Household choices.
• Effects of price and income changes on consumption choices.

Subterranean Movements

• Spending patterns are constantly changing.
• New goods (VCR's, microwave popcorn) are constantly appearing.
• Other goods (vinyl record albums) are disappearing.
• Why?

Consumption Possibilities

• Consumption choices are limited by income and prices.
  • Income is limited.
  • Prices are taken as given by the household.
• This constraint can be described by a budget line.

Lisa's Budget Line

• Lisa's income: $30 a month.
• Movies cost $6 each. If Lisa consumes only movies, she can afford $30/$6 or 5 per month.
• Soda costs $3 per six-pack. If Lisa buys only soda, she can afford $30/$3 or 10 six-packs per month.

Consumption Possibilities

Consumption Movies Soda

possibility (per month) (six-packs per month)

a 0 10

b 1 8

c 2 6

d 3 4

e 4 2

f 5 0

Divisible and
Indivisible Goods

• Goods such as gasoline and electricity can be bought in any quantity because they are divisible.
• We will assume all goods and services consumed are divisible.
• Lisa's budget line is a constraint on her choices. It marks the boundary between affordable and unaffordable.

The Budget Equation

PsQs + PmQm = y

• Ps is the price per six pack of soda;
• Qs is the quantity of soda bought;
• Pm is the price of a movie;
• Qm is the number of movies bought;
• y is total income.

The Budget Equation

PsQs + PmQm = y

• Divide both sides of equation by Ps

Qs + (Pm/Ps)Qm = y/Ps

• Subtract (Pm/Ps)Qm from both sides of equation

Qs = y/Ps- (Pm/Ps)Qm

Lisa's Budget Equation

Using current prices and income,

$3Qs + $6Qm = $30

Solving,

Qs = ($30/$3) - ($6/$3) Qm

or Qs = 10 - 2Qm

• This is the equation of the budget line.

Choices and Constraints

• Lisa can choose Qs and Qm.
• She takes the prices and her income as given.
• In effect, there are two variables in the budget equation Lisa takes as given: (y/Ps) and (Pm/Ps).

Real Income

• A household's real income is the maximum quantity of a good that the household can afford to buy.

For Lisa, real income is measured in terms of the maximum number of six-packs of soda she can afford, equal to her income divided by the price of soda.

Relative Price

• A relative price is the price of one good divided by the price of another good.
• For Lisa, relative price is the price of a movie in terms of the price of soda, (Pm/Ps) or $6/$3 = 2.
• The opportunity cost of a movie is 2 six-packs. This is also the magnitude of the slope of the budget line.

A Change in Price

• When prices change, so does the budget line.

The lower the price of the good measured on the horizontal axis, the flatter the budget line, as long as no other factor that affects the budget line changes.

A Change in Income

• A change in money income changes real income but does not change relative prices.
• The budget line shifts but its slope does not change.

• Preferences are a person's likes and dislikes.
• Assume that preferences do not depend on prices or income.
• We represent preferences as the way a person or household chooses between combinations of goods.

Assumptions About Preferences

• Preferences do not depend on prices
• Preferences do not depend on income
• More of any good is preferred to less
• The more of good A and the less of good B is consumed, the less willing is a consumer to give up B in exchange for A

Indifference Curves

• An indifference curve is a line that shows combinations of goods among which a consumer is indifferent.
• An indifference curve shows all combinations of the two goods that lead to equal degrees of satisfaction for the consumer.

Indifference Curves and Increasing Satisfaction

• Indifference curves further from the origin represent higher degrees of satisfaction and are thus more desirable.
• A preference map consists of a series of indifference curves.

The marginal rate of substitution (MRS) is the rate at which a person will give up good y to get more of good x, remaining on the same indifference curve.

MRS and Slope

• The marginal rate of substitution is measured from the slope of an indifference curve.

If the indifference curve is steep, the MRS is high and the person is willing to give up a large quantity of good y in exchange for a small quantity of good x while remaining indifferent.

Calculating the Marginal Rate of Substitution

• The MRS is the magnitude of the slope of the indifference curve at a point.
• The slope of the indifference curve is equal to the slope of a line tangent to the curve at that point.

The assumption of diminishing marginal rate of substitution is a general tendency for the MRS to diminish as the consumer moves along an indifference curve.

• The slope of the curve tells us how willing a person is to substitute one good for another (remaining indifferent).

Degree of Substitutability

• Perfect substitutes have linear indifference curves. Any combination of the two goods is fine with us.
• Perfect complements have right-angled indifference curves. No substitution is possible.
• Most goods are substitutes and have ordinary indifference curves.

• Lisa wants to choose the best affordable combination of movies and soda.
• She will not choose any point under the budget line.
• The best affordable point is where the budget line is just tangent to an indifference curve.

• It is on the budget line. All income is spent on goods that increase satisfaction.
• It is on the highest attainable indifference curve.
• At this point, the indifference curve has the same slope as the budget line.

The Slope of the MRS and the Slope of the Budget Line

• At the best attainable point, the two slopes are equal.
• This means the magnitude of the marginal rate of substitution is equal to the relative price of the two goods.

MRS = Pm/Ps

Predicting Consumer Behavior

• How do consumers respond to:
  • changes in the price of a good?
  • changes in their income?
• Remember that a change in the price of a good causes a change in quantity demanded.

A Change in Price

• The effect of a change in price on the quantity of a good consumed is called the price effect.
• A decrease in the price of movies from $6 to $3 will induce Lisa to substitute movies for soda.

The Demand Curve

• A demand curve shows the relationship between the quantity demanded of a good and its price, holding everything else constant.
• The demand curve is derived from the budget line and indifference curves.

• The effect of a change in income on consumption is called the income effect.
• When income increases, the budget line shifts out.
• This allows the individual to consume more of both goods.
• The demand curve shifts.

• When Lisa's income increases, she increases her consumption of all normal goods.
• A decrease in the price of a normal good will also cause an increase in consumption of that good.

Substitution Effect

• The substitution effect is the effect of a change in price on the quantities consumed.
  • The consumer must remain on the same indifference curve.
• This effectively keeps real income constant.

Income Effect

• A decrease in the price of movies also increases Lisa's real income since more of both goods can be purchased.
• The effect of a change in the price of a good on real income is called the income effect.

Price Effect

• The price effect is the sum of the substitution effect and income effect.
• The substitution effect always causes the consumer to buy less of the good whose relative price has risen.
• The income effect can be either positive or negative.

• When real income increases, demand for normal goods increases.
• A decrease in the price of movies causes Lisa's real income to increase.

Since movies are a normal good, the substitution and income effects work together to cause Lisa's demand for movies to increase.

Inferior Goods

• When real income increases, demand for inferior goods decreases; the income effect is negative.
• The substitution and income effects work in opposite directions; the income effect partially offsets the substitution effect.

Back to the Facts

Spending patterns are interpreted as revealing the best choices households can make, given their preferences, income, and the prices of the goods they consume.

• Changes in prices and incomes lead to changes in the best affordable choice and changes in consumption patterns.

Other Household Choices

• How much labor to supply.
• How much to save.

Labor Supply

• We must choose how much time to allocate to working (labor) and all other activities (leisure).
• The opportunity cost of an additional hour of leisure is the foregone income: the hourly wage rate.
• Lisa buys leisure by not supplying labor and foregoing income.

A Higher Wage Rate

• Like any other price, a change in the wage rate will have substitution and income effects.
• A higher wage rate increases the opportunity cost of leisure, causing a substitution effect away from leisure.
• A higher wage rate increases income, causing an income effect toward more leisure.

Saving

• Saving decreases current consumption and increases future consumption.
• Saving and consumption are two choices we have for allocating our income.
• The interest rate is the opportunity cost of consumption since interest is foregone by not saving.

A Higher Interest Rate

When the interest rate increases, the opportunity cost of consumption increases. The substitution effect will act to increase saving.

• The higher interest increases income on existing wealth which may act to reduce current saving.
• The net effect is ambiguous.