theory of economics

7/25/2019 Theory of economics

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7TOPICS FOR FURTHER STUDY


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Copyright2004 South-Weter!

2"2"The Theory o#Co!u$er Choi%e


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The theory of consumer choice addresses the

following questions:

Do all demand curves slope downward?

How do wages affect labor supply?

How do interest rates affect household saving?


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THE BUDGET CONSTRAINT: WHATTHE CONSUMER CAN AFFORD

The budget constraint depicts the limit on the

consumption bundles that a consumer can

afford

!eople consume less than they desire because theirspending is constrained" or limited" by their income


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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


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The Consumers Budget Constr!nt


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The #onsumer$s %udget #onstraint

&ny point on the budget constraint line indicates the

consumer$s combination or tradeoff between two

goods 'or e(ample" if the consumer buys no pi))as" he can

afford *++ pints of !epsi ,point %- .f he buys no

!epsi" he can afford /++ pi))as ,point &-


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F!gure " The Consumers Budget Constr!nt

&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

Consumers$udget %onstr!nt

#B

"##

A





The #onsumer$s %udget #onstraint

&lternately" the consumer can buy *+ pi))as and

0*+ pints of !epsi


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F!gure " The Consumers Budget Constr!nt

&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

Consumers$udget %onstr!nt

#B

'

C

"##

A





Theslopeof the budget constraint line equals

the relative price of the two goods" that is" the

price of one good compared to the price of the

other .t measures the rate at which the consumer can

trade one good for the other



(REFERENCES: WHAT THECONSUMER WANTS

& consumer$s preference among consumption

bundles may be illustrated with indifference

curves



Re)resent!ng (re*eren%es +!th Ind!**eren%eCur,es

&n indifference curve is a curve that shows

consumption bundles that give the consumer

the same level of satisfaction


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F!gure ' The Consumers (re*eren%es

&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

Ind!**eren%e

%ur,e- I"

I'

C

B

A

D




Re)resent!ng (re*eren%es +!th Ind!**eren%eCur,es

The #onsumer$s !references

The consumer is indifferent" or equally happy" with

the combinations shown at points &" %" and #

because they are all on the same curve The 1arginal 2ate of 3ubstitution

The slope at any point on an indifference curve is

the marginal rate of substitution .t is the rate at which a consumer is willing to trade one

good for another

.t is the amount of one good that a consumer requires as

compensation to give up one unit of the other good


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&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

Ind!**eren%e

%ur,e- I"

I'

"

MRS

C

B

A

D




Four (ro)ert!es o* Ind!**eren%e Cur,es

Higher indifference curves are preferred to

lower ones

.ndifference curves are downward sloping

.ndifference curves do not cross

.ndifference curves are bowed inward




!roperty /: Higher indifference curves are

preferred to lower ones

#onsumers usually prefer more of something to less

of it Higher indifference curves represent larger

quantities of goods than do lower indifference

curves


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&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

Ind!**eren%e

%ur,e- I"

I'

C

B

A

D





!roperty 0: .ndifference curves are downward

sloping

& consumer is willing to give up one good only if

he or she gets more of the other good in order toremain equally happy

.f the quantity of one good is reduced" the quantity

of the other good must increase

'or this reason" most indifference curves slope

downward


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&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

Ind!**eren%e

%ur,e- I"





!roperty 4: .ndifference curves do not cross

!oints & and % should ma5e the consumer equally

happy

!oints % and # should ma5e the consumer equallyhappy

This implies that & and # would ma5e the consumer

equally happy

%ut # has more of both goods compared to &


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F!gure . The Im)oss!$!/!t0 o* Interse%t!ng Ind!**eren%eCur,es

&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

C

A

B





!roperty 6: .ndifference curves are bowedinward

!eople are more willing to trade away goods that

they have in abundance and less willing to tradeaway goods of which they have little

These differences in a consumer$s marginal

substitution rates cause his or her indifference curve

to bow inward


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F!gure 1 Bo+ed Ind!**eren%e Cur,es

&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

Ind!**eren%e%ur,e

2

.

A

.

3

B

"

MRS4 5

"

MRS4 "1

5

"1

'



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T+o E6treme E6m)/es o* Ind!**eren%eCur,es

!erfect substitutes

!erfect complements


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Perfect Substitutes

Two goods with straight7line indifference curves are

perfect substitutes

The marginal rate of substitution is a fi(ed number


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F!gure & (er*e%t Su$st!tutes nd (er*e%t Com)/ements

Di$e#

)i%*e+

,' Per#e%t Su.titute

I" I' I.

.

5

'

1

"

'



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Perfect Complements

Two goods with right7angle indifference curves are

perfect complements


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F!gure & (er*e%t Su$st!tutes nd (er*e%t Com)/ements

Right Shoe#

/e#t

Shoe

,. Per#e%t Co$p+e$e!t

I"

I'

3

3

&

&



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O(TIMI7ATION: WHAT THECONSUMER CHOOSES

#onsumers want to get the combination ofgoods on the highest possible indifference

curve

However" the consumer must also end up on orbelow his budget constraint


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The Consumers O)t!m/ Cho!%es

#ombining the indifference curve and thebudget constraint determines the consumer$s

optimal choice

#onsumer optimum occurs at the point wherethe highestindifference curve and the budget

constraint are tangent


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The Consumers O)t!m/ Cho!%e

The consumer chooses consumption of the twogoods so that the marginal rate of substitution

equals the relative price


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The Consumers O)t!m/ Cho!%e

&t the consumer$s optimum" the consumer$svaluation of the two goods equals the mar5et$s

valuation


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F!gure 5 The Consumers O)t!mum

&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

Budget %onstr!nt

I"

I'

I.

O)t!mum

AB



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Ho+ Chnges !n In%ome A**e%t theConsumers Cho!%es

&n increase in income shifts the budgetconstraint outward

The consumer is able to choose a better

combination of goods on a higherindifference curve


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F!gure 3 An In%rese !n In%ome

&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

Ne+ $udget %onstr!nt

I"

I'

'8 8 8 8 r!s!ng )!99 %onsum)t!on 8 8 8

.8 8 8 8 nd(e)s!%onsum)t!on8

In!t!/$udget%onstr!nt

"8 An !n%rese !n !n%ome sh!*ts the$udget %onstr!nt out+rd 8 8 8

In!t!/o)t!mum

Ne+ o)t!mum



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Ho+ Chnges !n In%ome A**e%t theConsumers Cho!%es

8ormal versus .nferior 9oods .f a consumer buys more of a good when his or her

income rises" the good is called a normal good

.f a consumer buys less of a good when his or herincome rises" the good is called an inferior good

F! 2 A I * ! G d


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F!gure 2 An In*er!or Good

&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

In!t!/

$udget%onstr!nt


I" I'

"8 When n !n%rese !n !n%ome sh!*ts the$udget %onstr!nt out+rd 8 8 8.8 8 8 8 $ut

(e)s!%onsum)t!on*//s- m!ng(e)s! n!n*er!or good8

'8 8 8 8 )!99 %onsum)t!on r!ses- m!ng )!99 norm/ good 8 8 8

In!t!/o)t!mum

Ne+ o)t!mum



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Ho+ Chnges !n (r!%es A**e%t ConsumersCho!%es

& fall in the price of any good rotates thebudget constraint outward and changes the

slope of the budget constraint

F! ; A Ch ! ( !


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F!gure ; A Chnge !n (r!%e

&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

"-### D

# B

"##

A

I"

I'

In!t!/ o)t!mum


In!t!/$udget%onstr!nt

"8 A *// !n the )r!%e o* (e)s! rottesthe $udget %onstr!nt out+rd 8 8 8

.8 8 8 8 ndr!s!ng (e)s!%onsum)t!on8

'8 8 8 8 redu%!ng )!99 %onsum)t!on 8 8 8

Ne+ o)t!mum



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In%ome nd Su$st!tut!on E**e%ts

& price change has two effects on consumption &n income effect

& substitution effect


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The .ncome ffect 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 3ubstitution ffect

Thesubstitution effect is the change in consumption

that results when a price change moves theconsumer along an indifference curve to a point

with a different marginal rate of substitution


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& #hange in !rice: 3ubstitution ffect & price change first causes the consumer to move

from one point on an indifference curve to another

on the same curve .llustrated by movement from point & to point %

& #hange in !rice: .ncome ffect

&fter moving from one point to another on the samecurve" the consumer will move to another

indifference curve

.llustrated by movement from point % to point #

F!gure "# In%ome nd Su$st!tut!on E**e%ts


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F!gure "# In%ome nd Su$st!tut!on E**e%ts

&u'!tity

o# Pi(('

&u'!tity

o# Pepi

#

I"

I'A

In!t!/ o)t!mum


In!t!/$udget

%onstr!nt

Su$st!tut!one**e%t

Su$st!tut!on e**e%t

In%omee**e%t

In%ome e**e%t

B

C Ne+ o)t!mum


T$/e " In%ome nd Su$st!tut!on E**e%ts When the


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$ e %o e d Su$s u o e% s e e(r!%e o* (e)s! F//s



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Der!,!ng the Demnd Cur,e

& consumer$s demand curve can be viewed as asummary of the optimal decisions that arise

from his or her budget constraint and

indifference curves

F!gure "" Der!,!ng the Demnd Cur,e


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F!gure "" Der!,!ng the Demnd Cur,e

&u'!tity

o# Pi(('

#

Demnd

,' The Co!u$er Opti$u$

&u'!tity

o# Pepi

#

Pri%e o#

Pepi

,. The De$'!1 Cure #or Pepi

&u'!tity

o# Pepi

'


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THREE A((=ICATIONS

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

conomists use the term 9iffen good to describe a good

that violates the law of demand

9iffen 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

F!gure "' A G!**en Good


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F!gure "' A G!**en Good

&u'!tity

o# 3e't

&u'!tity o#

Pot'toe

#

I'I"

In!t!/ $udget %onstr!nt

Ne+ $udget

%onstr!nt

D

A

B

'8 8 8 8 +h!%h

!n%reses

)otto%onsum)t!on

!* )ottoes

re G!**en

good8

O)t!mum +!th /o+

)r!%e o* )ottoes

O)t!mum +!th h!gh

)r!%e o* )ottoes

E

C"8 An !n%rese !n the )r!%e o*

)ottoes rottes the $udget

%onstr!nt !n+rd 8 8 8



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THREE A((=ICATIONS

How do wages affect labor supply? .f the substitution effect is greater than the income

effect for the wor5er" he or she wor5s more

.f income effect is greater than the substitutioneffect" he or she wor5s less

F!gure ". The Wor>=e!sure De%!s!on


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F!gure ". The Wor>=e!sure De%!s!on

Hour o# /eiure#

Co!u$ptio!


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F!gure "1 An In%rese !n the Wge

Hour o#

/eiure

#

Co!u$ptio!

,' For ' pero! ith thee pre#ere!%e5 5 5

Hour o# /'.or

Supp+ie1

#

W'ge

5 5 5 the +'.or upp+y %ure +ope up'r15

I"

I'BC'

BC"

'8 8 8 8 hours o* /e!sure de%rese 8 8 8 .8 8 8 8 nd hours o* /$or !n%rese8

"8 When the +ge r!ses 8 8 8

=$or

su))/0




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Hour o#

/eiure

#

Co!u$ptio!

,. For ' pero! ith thee pre#ere!%e5 5 5

Hour o# /'.or

Supp+ie1

#

W'ge

5 5 5the +'.or upp+y %ure +ope .'%*'r15

I"

I'

BC'

BC"

"8 When the +ge r!ses 8 8 8

'8 8 8 8 hours o* /e!sure !n%rese 8 8 8 .8 8 8 8 nd hours o* /$or de%rese8

=$orsu))/0



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THREE A((=ICATIONS

How do interest rates affect household saving? .f the substitution effect of a higher interest rate is

greater than the income effect" households save

more .f the income effect of a higher interest rate is

greater than the substitution effect" households save

less

F!gure "& The Consum)t!on>S,!ng De%!s!on


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F!gure "& The Consum)t!on S,!ng De%!s!on

Co!u$ptio!

he! You!g#

Co!u$ptio!

he! O+1


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F!gure "5 An In%rese !n the Interest Rte

#

,' Higher I!teret R'te R'ie S'i!g ,. Higher I!teret R'te /oer S'i!g

Co!u$ptio!

he! O+1

I"

I'

BC"

BC'

#

I" I'

BC"

BC'

Co!u$ptio!

he! O+1

Co!u$ptio!

he! You!g

"8 A h!gher !nterest rte rottes

the $udget %onstr!nt out+rd 8 8 8

"8 A h!gher !nterest rte rottes

the $udget %onstr!nt out+rd 8 8 8

'8 8 8 8 resu/t!ng !n /o+er

%onsum)t!on +hen 0oung

nd- thus- h!gher s,!ng8

'8 8 8 8 resu/t!ng !n h!gher

%onsum)t!on +hen 0oung

nd- thus- /o+er s,!ng8

Co!u$ptio!

he! You!g



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THREE A((=ICATIONS

Thus" an increase in the interest rate couldeither encourage or discourage saving


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Summr0

& consumer$s budget constraint shows thepossible combinations of different goods he can

buy given his income and the prices of the

goods The slope of the budget constraint equals the

relative price of the goods

The consumer$s indifference curves representhis preferences


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Summr0

!oints on higher indifference curves arepreferred to points on lower indifference

curves

The slope of an indifference curve at any pointis the consumer$s marginal rate of substitution

The consumer optimi)es by choosing the point

on his budget constraint that lies on the highestindifference curve


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Summr0

;hen the price of a good falls" the impact onthe consumer$s choices can be bro5en down

into an income effect and a substitution effect

The income effect is the change in consumptionthat arises because a lower price ma5es the

consumer better off

The income effect is reflected by the movementfrom a lower to a higher indifference curve


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Summr0

The substitution effect is the change inconsumption that arises because a price change

encourages greater consumption of the good

that has become relatively cheaper The substitution effect is reflected by a

movement along an indifference curve to a

point with a different slope


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Summr0

The theory of consumer choice can e(plain: ;hy demand curves can potentially slope upward

How wages affect labor supply

How interest rates affect household saving

theory of economics

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