chapter 6 news 07

8/4/2019 Chapter 6 News 07

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Chapter 6:

Consumer Choicesand Economic

Behavior


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Key Topics

1. The budget constraint

a. Definition, equation, graph, opportunity cost

b. Impact ofI,Px,Py

2. Utility

a. Total and marginalb. Indifference curve: definition, slope

c. Utility maximization


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Key Topics

3. Downward-sloping demand factors

a. Diminishing marginal utility

b. Income effect

c. Substitution effect

4. Other consumer decisionsa. Work or leisure

b. Save or borrow


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Questions

1. What does it mean if you have a budgetconstraint?

2. How can your attainable consumptionchoices be shown mathematically andgraphically?


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Budget Constraint

The maximum Qcombinations of goods

that can be purchased

given ones income andthe prices of the goods.


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Budget Constraint Variables

I (or M) = the amount of income or moneythat a consumer has to spend on

specified goods and services.

X = the quantity of one specific good or one specific bundle ofgoods

Y = the quantity of a second specific good or

second specific bundle of goods

Px = the price or per unit cost of X

PY = the price or per unit cost of Y


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Budget Line Equation

Income = expensesI = PxX+PYY

Y = l/PY (Px/PY)X

straight line equation


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The Opportunity Set

Y

I/PYI/PY

Budget Line

PX

PY

I/PX X


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Budget Line: Axis Intercepts &

Slope

Vertical Axis Intercept

= I/PY

= max Y (X = 0)

Horizontal Axis Intercept

= I/PX= max X (Y = 0)

- Slope= PX/PY= inverse P ratio

= X axis good P/Y axis good P

= Y/X


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Changes in the Budget Line

Changes in Income

- Increases lead to a parallel,

outward shift in the budget line.

- Decreases lead to a parallel,

downward shift. Y

X


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Changes in the Budget Line

Changes in Price

- A decrease in the price of good X rotates the

budget line counter-clockwise.

- An increase rotates the budget line clockwise.

I Px

/1

New budget line fora price decrease

X

Y

I Px

/2


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Q. What Are Your Preferences?

LunchA: 1 drink, 1 pizza slice

B: 1 drink, 2 pizza slicesC: 2 drinks, 1 pizza slice

EntertainmentA: 1 movie, 1 dinner

B: 1 movie, 2 dinnersC: 2 movies, 1 dinnerFor each, indicate which of the following you prefer:

A vs B, B vs C, or A vs C


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Utility Concepts

Utility:satisfaction received from consuming goods

Cardinal utility:satisfaction levels that can be measured or specifiedwith numbers (units = utils)

Ordinal utility:

satisfaction levels that can be ordered or ranked Marginal utility:

the additional utility received per unit of additionalunit of an item consumed (U/X)


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Utility Assumptions

1. Complete (or continuous) can rank

all bundles of goods2. Consistent (or transitive)

preference orderings are logical and

consistent3. Consumptive (nonsatiation) more

of a normal good is preferred to less


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More of a Good is Preferred to

Less

The shaded area represents those combinations of X and Y that areunambiguously preferred to the combination X*, Y*. Ceteris paribus,individuals prefer more of any good rather than less. Combinations

identified by ? involve ambiguous changes in welfare since they containmore of one good and less of the other.


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Indifference Curve

Indifference Curve

A curve that defines the

combinations of 2 or more

goods that give a consumer

the same level ofsatisfaction.

Curves further from originrepresent higher utility levels


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Assume Bob and Jan are students who actually ENJOYgoing to their classes and learning new things. Each havebeen asked to rank the following combinations of classesin terms of their preferences:

Combination # Econ # Math

A 2 4B 3 3

C 4 2

Preferences: Bob: a > b > cJan: c > b > a

Show and explain graphically with economic concepts.


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c

b

a

Econ (#)

Math (#)

1

2

3

4

5

6

1 2 3 4 5 6


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A bad good, or an economic bad is an item

that a consumer does not like or enjoy, whichmeans their total satisfaction level is lowerthe more of the item they have. This also

means the marginal utility of the item isnegative.


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MRS & MU

MRS

= - slope of indifference curve= -Y/X

= the rate at which a consumer is willing toexchange Y for 1more (or less) unit of X

U = 0 along given indiff curve= MUx(X)+MUY(Y) = 0

= - Y/X = MUx/MUY

= - slope = inverse MU ratio


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Consumer Equilibrium

(U Max)

The equilibrium

consumptionbundle is the

affordable bundle

that yields thehighest level ofsatisfaction.


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Equal Slopes Condition

(for consumer equilibrium)

MUX/MUY = PX/PY

MUX/PX = MUY/PY


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Individual Demand Curve

An individuals

demand curve isderived fromeach newequilibrium point

found on theindifference curveas the price of

good X is varied.


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Diminishing Marginal Utility

The law of diminishing marginalutility:

The more of one good consumed in agiven period, the less satisfaction

(utility) generated by consuming eachadditional (marginal) unit of the samegood.


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Diminishing Marginal Utility and

Downward-Sloping Demand

Diminishing marginal

utility helps toexplain why demandslopes down.

Marginal utility falls

with each additionalunit consumed, sopeople are not willingto pay as much.

40

25

15

0 5 10 25

D

Thai meals per month

Pricepermeal($)


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Income and Substitution Effects of a

Price Change (for normal goods)

Household isbetter off

(higher real income)

Opportunitycost of thegood falls

Household isworse off

(lower real income)

Opportunitycost of the

good rises.

Incomeeffect

Substitutioneffect

Incomeeffect

Substitutioneffect

Householdbuys more

FALLS

RISES

Householdbuys more

Householdbuys less

Householdbuys less

Price of agood orservice


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Household Choices in Labor Markets

As in output markets, households faceconstrained choices in input markets. They

must decide:1. Whether to work

2. How much to work

3. What kind of a job to work at

These decisions are affected by:

1. The availability of jobs

2. Market wage rates

3. The skill possessed by the household


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The Price of Leisure

W = wage rate

= the price (or theopportunity cost or lost

benefits of either unpaidwork or leisure.


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Work vs. Leisure Constraint

24W

24 Leisure (hrs/day)

Income


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The Labor Supply Curve

The labor supply curveis a diagram that showsthe quantity of labor

supplied at different wagerates.


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Saving and Borrowing: Present

Versus Future Consumption

Households can use present income to

finance future spending (i.e., save), or theycan use future funds to finance presentspending (i.e., borrow).

In deciding how much to save and how much

to spend today, interest rates define theopportunity cost of present consumption interms of foregone future consumption.


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borrow

save

Q1(next yr)

I1/P

I0/P

Q0 (this yr)

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