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Lecture 6

In this chapter, look for the answers to


these questions:
The Theory of What is the law of diminishing marginal utility?
Consumer Choice How does the budget constraint represent the
choices a consumer can afford?
How do indifference curves represent the
consumers 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,
0 or how much labor she supplies? 1

Introduction HOUSEHOLD CHOICE IN OUTPUT MARKETS

Recall one of the Ten Principles: THE DETERMINANTS OF HOUSEHOLD DEMAND


People face tradeoffs.
Several factors influence the quantity of a given good
Buying more of one good leaves or service demanded by a single household:
less income to buy other goods.
Working more hours means more income and The price of the product
more consumption, but less leisure time. The income available to the household
Reducing saving allows more consumption today The households amount of accumulated wealth
but reduces future consumption. The prices of other products available to the household

This chapter explores how consumers make The households tastes and preferences
choices like these. The households expectations about future income,
wealth, and prices

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THE BASIS OF CHOICE: UTILITY THE BASIS OF CHOICE: UTILITY

Utility The satisfaction, or reward, a product yields Total Utility and Marginal Utility of Trips
to the Jazz Club Per Week
relative to its alternatives. The basis of choice. TRIPS TOTAL MARGINAL
TO JAZZ CLUB UTILITY UTILITY
1 12 12
Marginal utility (MU) The additional satisfaction gained 2 22 10
by the consumption or use of one more unit of something. 3 28 6
4 32 4
Total utility The total amount of satisfaction obtained 5 34 2
from consumption of a good or service. 6 34 0

Law of diminishing marginal utility The more of any


one good consumed in a given period, the less satisfaction
(utility) generated by consuming each additional (marginal) Graphs of Total and Marginal Utility

unit of the same good.


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ALLOCATING INCOME TO MAXIMIZE UTILITY
THE BASIS OF CHOICE: UTILITY
Allocation of Fixed Expenditure per Week Between Two Alternatives
(1) (3) (5)
TRIPS
TO JAZZ CLUB
(2)
TOTAL
MARGINAL
UTILITY
(4)
PRICE
MARGINAL UTILITY
PER DOLLAR THE UTILITY-MAXIMIZING RULE
PER WEEK UTILITY (MU) (P) (MU/P)
1 12 12 P3.00 4.0 In general, utility-maximizing consumers spread out their
2 22 10 3.00 3.3 expenditures until the following condition holds:
3 28 6 3.00 2.0
4 32 4 3.00 1.3
MU X MU Y
5 34 2 3.00 0.7
utility - maximizing rule : for all pairs of goods
6 34 0 3.00 0 PX PY
(1) (3) (5)
BASKETBALL (2) MARGINAL (4) MARGINAL UTILITY
GAMES TOTAL UTILITY PRICE PER DOLLAR
PER WEEK UTILITY (MU) (P) (MU/P)
1 21 21 P6.00 3.5
2 33 12 6.00 2.0
3 42 9 6.00 1.5
4 48 6 6.00 1.0
5 51 3 6.00 .5
6 7
6 51 0 6.00 0

THE BASIS OF CHOICE: UTILITY HOUSEHOLD CHOICE IN OUTPUT MARKETS


DIMINISHING MARGINAL UTILITY AND
DOWNWARD-SLOPING DEMAND THE BUDGET CONSTRAINT
Information on household income and wealth,
together with information on product prices, makes
Diminishing Marginal Utility and
it possible to distinguish those combinations of
Downward-Sloping Demand goods and services that are affordable from those
that are not.

budget constraint: the limits imposed on


household choices by income, wealth,
and product prices.

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HOUSEHOLD CHOICE IN OUTPUT MARKETS Preferences, Tastes, Trade-Offs, and


Opportunity Cost
Possible Budget Choices of a Person Earning P10,000 Per Month After Taxes

MONTHLY OTHER Preferences play a key role in


OPTION RENT FOOD EXPENSES TOTAL AVAILABLE? determining demand. Some people
like the blues or jazz, some like
classical, while others love country
A P 4000 P2500 P3500 P10,000 Yes
music.
B 6000 2000 2000 10,000 Yes

C 7000 1500 1500 10,000 Yes

D 10,000 1000 1000 12,000 No

choice set or opportunity set: the set of As long as a household faces a limited budgetand all households
ultimately dothe real cost of any good or service is the value of the other
options that is defined and limited by a budget goods and services that could have been purchased with the same amount
constraint. of money. The real cost of a good or service is its opportunity cost, and
opportunity cost is determined by relative prices.
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The Budget Constraint:
HOUSEHOLD CHOICE IN OUTPUT MARKETS
What the Consumer Can Afford
THE EQUATION OF THE BUDGET CONSTRAINT Two goods: pizza and Pepsi
In general, the budget constraint can be written:
A consumption bundle is a particular combination
of the goods, e.g., 40 pizzas & 300 pints of Pepsi.
PXX + PYY = I, Budget constraint: the limit on the consumption
bundles that a consumer can afford
where
PX = the price of X The budget constraint is defined by income, wealth, and prices.
X = the quantity of X consumed Within those limits, households are free to choose, and the
PY = the price of Y households ultimate choice depends on its own likes and
dislikes.
Y = the quantity of Y consumed
I = household income.

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Budget constraint
D. The consumers
Pepsis
The consumers income: P1000 budget constraint
A. P1000/P10 B shows the bundles
Prices: P10 per pizza, P2 per pint of Pepsi 500
= 100 pizzas that the consumer
A. If the consumer spends all his income on pizza, can afford.
B. P1000/P2 400
how many pizzas does he buy?
B. If the consumer spends all his income on Pepsi, = 500 Pepsis C
300
how many pints of Pepsi does he buy? C. P400/P10
C. If the consumer spends P400 on pizza, = 40 pizzas 200
how many pizzas and Pepsis does he buy? P600/P2
= 300 Pepsis 100
D. Plot each of the bundles from parts A-C on a
diagram that measures the quantity of pizza on A
0
the horizontal axis and quantity of Pepsi on the 0 20 40 60 80 100 Pizzas
vertical axis, then connect the dots.
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The Slope of the Budget Constraint The Slope of the Budget Constraint
From C to D, Pepsis The slope of the budget constraint equals
rise = 100 500 the rate at which the consumer
Pepsis can trade Pepsi for pizza
run = +20
400 the opportunity cost of pizza in terms of Pepsi
pizzas 300 C the relative price of pizza:
Slope = 5 D price of pizza $10
200 5 Pepsis per pizza
Consumer must price of Pepsi $2
give up 5 Pepsis 100
to get another
pizza. 0
0 20 40 60 80 100 Pizzas
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Exercise
Pepsis Pepsis A fall in income
Consumer shifts the budget
Show what 500 500
can buy constraint inward.
happens to the
P800/P10
budget constraint 400 400
= 80 pizzas
if:
300 or P800/P2 300
A. Income falls to
P800 = 400 Pepsis
200 200
B. The price of or any
Pepsi rises to 100 combination 100
P4/pint. in between.
0 0
0 20 40 60 80 100 Pizzas 0 20 40 60 80 100 Pizzas
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DERIVING INDIFFERENCE CURVES


Pepsis An increase in the price
Consumer of one good pivots the
can still buy 500 budget constraint inward. An indifference
100 pizzas. curve is a set of
400 points, each point
But now,
representing a
can only buy 300
combination of
P1000/P4
= 250 Pepsis. 200 goods X and Y, all
of which yield the
Notice: slope is 100 same total utility.
smaller, relative
price of pizza 0
now only 4 Pepsis. 0 20 40 60 80 100 Pizzas
An Indifference Curve
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INDIFFERENCE CURVES The shapes of


the indifference
We base the following analysis on four assumptions:
curves depend
1. We assume that this analysis is restricted to goods that on the
yield positive marginal utility, or, more simply, that more preferences of
is better. the consumer,
2. The marginal rate of substitution is defined as and the whole
MUX/MUY, or the ratio at which a household is willing to
set of
substitute X for Y. We assume a diminishing marginal
rate of substitution.
indifference
3. We assume that consumers have the ability to choose curves is called
among the combinations of goods and services a preference
available. map.
4. We assume that consumer choices are consistent with a
simple assumption of rationality. A Preference Map: A Family of Indifference Curves
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Preferences: What the Consumer Wants Preferences: What the Consumer Wants
Indifference curve: Marginal rate of substitution
shows consumption bundles (MRS): the rate at which a
that give the consumer the consumer is willing to trade
same level of satisfaction one good for another
Also, the slope of the
indifference curve

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Four Properties of Indifference Curves Four Properties of Indifference Curves


1. Higher indifference curves 3. Indifference curves do not cross.
are preferred to lower ones.
2. Indifference curves are If they did, like here,
downward sloping. then the consumer would be
indifferent between A and C.

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Four Properties of Indifference Curves One Extreme Case: Perfect Substitutes


4. Indifference curves are bowed inward. Perfect substitutes: two goods with
straight-line indifference curves,
The less pizza the consumer has, constant MRS
the more Pepsi he is willing to Example: nickels & dimes
trade for another pizza.
Consumer is always willing to trade
two nickels for one dime.

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Another Extreme Case: Perfect Complements Optimization: What the Consumer Chooses
Perfect complements: two goods with right- The optimal bundle is at the point
angle indifference curves where the budget constraint touches
Example: left shoes, right shoes the highest indifference curve.
{7 left shoes, 5 right shoes} MRS = relative price
is just as good as at the optimum:
{5 left shoes, 5 right shoes} The indifference curve
and budget constraint
have the same slope.

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CONSUMER CHOICE

PROPERTIES OF INDIFFERENCE CURVES


FIGURE Consumer Utility-
Maximizing Equilibrium

MU X X ( MU Y Y )
If we divide both sides by MUY and by X, we obtain

Y MU X

X MUY

The slope of an indifference curve is the ratio of the marginal


As long as indifference curves are convex to the origin, utility maximization utility of X to the marginal utility of Y, and it is negative.
will take place at the point at which the indifference curve is just tangent to
the budget constraint. 32 33

The Effects of an Increase in Income


Where two curves are tangent, they have the same
slope, which implies that the slope of the indifference
curve is exactly equal to the slope of the budget
constraint at the point of tangency:

MU X P
X
MU Y PY
slope of indifference curve = slope of budget constraint

By multiplying both sides of this equation by MUY


and dividing both sides by PX, we can rewrite this
utility-maximizing rule as
MU X MU Y

PX PY
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Exercise:
Inferior vs. normal goods
An increase in income increases the quantity
demanded of normal goods and reduces the
quantity demanded of inferior goods.
Suppose pizza is a normal good but Pepsi is an
inferior good.
Use a diagram to show the effects of an
increase in income on the consumers optimal
bundle of pizza and Pepsi.

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The Effects of a Price Change The Income and Substitution Effects


A fall in the price of Pepsi has two effects on the
optimal consumption of both goods.
Income effect
A fall in the price of Pepsi boosts the purchasing
power of the consumers income, allowing him to
reach a higher indifference curve.
Substitution effect
A fall in the price of Pepsi makes pizza more
expensive relative to Pepsi, causes consumer to
buy less pizza & more Pepsi.

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Income and The Substitution Effect for


Substitution Effects Substitutes and Complements
The substitution effect is huge when the goods are
very close substitutes.
If Pepsi goes on sale, people who are nearly
indifferent between Coke and Pepsi will buy
mostly Pepsi.
The substitution effect is tiny when goods are
nearly perfect complements.
If software becomes more expensive relative to
computers, people are not likely to buy less
software and use the savings to buy more
computers.
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INCOME AND SUBSTITUTION EFFECTS Deriving the Demand Curve for Pepsi
INCOME EFFECT When the price of something we buy falls,
Left graph: price of Pepsi falls from $2 to $1
we are better off. When the price of something we buy rises,
we are worse off. Right graph: Pepsi demand curve
SUBSTITUTION EFFECT Both the income and the
substitution effects imply a negative relationship between
price and quantity demandedin other words, downward-
sloping demand. When the price of something falls, ceteris
paribus, we are better off, and we are likely to buy more of
that good and other goods (income effect). Because lower
price also means less expensive relative to substitutes, we
are likely to buy more of the good (substitution effect). When
the price of something rises, we are worse off, and we will buy
less of it (income effect). Higher price also means more
expensive relative to substitutes, and we are likely to buy less
of it and more of other goods (substitution effect).
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DERIVING A DEMAND CURVE FROM INDIFFERENCE


CURVES AND BUDGET CONSTRAINTS
Application 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: buy less potatoes
income effect: buy more potatoes
If income effect > substitution effect,
then potatoes are a Giffen good, a good for which
an increase in price raises the quantity demanded.

Deriving a Demand Curve from Indifference Curves and Budget Constraint


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Giffen Goods
An Increase in the Wage...
(a) For a person with these . . . the labor supply curve slopes
Consumption

preferences upward.

Wage

1. When the
wage rises

I2
BC1
BC2

I1
0 0
Hours of Hours of Labor
2. hours of leisure Leisure Supplied
decrease 3. ...and hours of labor increase.
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An Increase in the Wage...
How do wages affect labor
(b) For a person with these . . . the labor supply curve slopes
supply?
Consumption

preferences backward.

Wage
BC2 If the substitution effect is greater
than the income effect for the worker,
1. When the he or she works more.
wage rises

If income effect is greater than the


BC1 I2
I1
substitution effect, he or she works
less.
0 0
Hours of Hours of Labor
Leisure Supplied
2. hours of leisure 3. ...and hours of labor decrease.
increase 48 49

Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.

An Increase in the Interest Rate...

(a) Higher Interest Rate (b) Higher Interest Rate


How do interest rates affect
Consumption

Consumption

BC2 Raises Saving Lowers Saving


household saving?
when Old

when Old

BC2
1. A higher
1. A higher
interest rate
interest rate
rotates the
rotates the Thus, an increase in the
budget constraint
budget constraint
outward...
outward... interest rate could either
BC1 I2
BC1 I2 encourage or discourage
I1 saving.
I1
0 0
Consumption Hours of
2. resulting in lower when Young 2. resulting in higher Leisure
consumption when young consumption when young
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and, thus, higher saving. and, thus, lower saving.

CHAPTER SUMMARY CHAPTER SUMMARY


A consumers budget constraint shows the possible The slope of an indifference curve at any point is the
combinations of different goods she can buy given her marginal rate of substitution the rate at which the
income and the prices of the goods. consumer is willing to trade one good for the other.
The slope of the budget constraint equals the relative The consumer optimizes by choosing the point on her
price of the goods. budget constraint that lies on the highest indifference
An increase in income shifts the budget constraint curve. At this point, the marginal rate of substitution
outward. A change in the price of one of the goods equals the relative price of the two goods.
pivots the budget constraint. When the price of a good falls, the impact on the
A consumers indifference curves represent her consumers choices can be broken down into two
preferences. An indifference curve shows all the effects, an income effect and a substitution effect.
bundles that give the consumer a certain level of
happiness. The consumer prefers points on higher
indifference curves to points on lower ones.
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CHAPTER SUMMARY
The income effect is the change in consumption that
arises because a lower price makes the consumer better
off. It is represented by a movement from a lower
indifference curve to a higher one.
The substitution effect is the change that arises because
a price change encourages greater consumption of the
good that has become relatively cheaper. It is
represented by a movement along an indifference curve.
The theory of consumer choice can be applied in many
situations. It can explain why demand curves can
potentially slope upward, why higher wages could either
increase or decrease labor supply, and why higher
interest rates could either increase or decrease saving.
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