Economics
Ram
12.ppt© 2013 Pearson Australia
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© 2013 Pearson Australia
12
Consumer Choices
and Constraints
Notes and teaching tips: 5, 18, 33, 38 and 42.
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After studying this chapter you will be able to
Describe a household’s budget line and show how it changes when prices or income change
Use indifference curves to map preferences and explain the principle of diminishing marginal rate of substitution
Predict the effects of changes in prices and income on consumption choices
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As the prices of music downloads and e-books have fallen, we’re downloading ever more songs and books.
But e-books have made a smaller inroad into the overall market for books than downloads have in the market for recorded music.
Why?
As the price of a DVD rental has fallen we’re renting ever more of them, but we’re also going to movie theatres in ever-greater numbers.
Why are we going to the movies more when it is so cheap and easy to rent a DVD?
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Consumption Possibilities
A household’s 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.
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The budget line is like a restaurant menu. This example has been well received: Emphasize that the consumer’s budget line is like a menu showing what affordable combinations of food and drink are available to the consumer. Ask them to compare the relative prices between two goods: food and drink and depict the affordable combinations a diner can purchase with a set income.
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Consumption Possibilities
Lisa has $40 to spend, the price of a movie is $8 and the price of soft drink is $4 a case.
The rows of the table show combinations of soft drink and movies that Lisa can buy with her $40.
The graph plots these six possible combinations.
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Consumption Possibilities
Lisa can afford any of the combinations at points A to F.
Some goods are indivisible goods and must be bought in whole units at the points marked (such as movies).
Other goods are divisible goods and can be bought in any quantity (such as petrol).
The line through points A to F is Lisa’s budget line.
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Consumption Possibilities
The budget line is a constraint on Lisa’s consumption choices.
Lisa can afford any point on her budget line or inside it.
Lisa cannot afford any point outside her budget line.
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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 soft drink PS, the quantity of soft drink QS, the price of a movie PM, the quantity of movies QM, and income Y.
Lisa’s budget equation is:
PSQS + PMQM = Y.
Consumption Possibilities
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PSQS + PMQM = Y
Divide both sides of this equation by PS, to give:
QS + (PM/PS)QM = Y/PS
Then subtract (PM/PS)QM from both sides of the equation to give:
QS = Y/PS – (PM/PS)QM
Y/PS is Lisa’s real income in terms of soft drink.
PM/PS is the relative price of a movie in terms of soft drink.
Consumption Possibilities
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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 soft drink 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 cases of soft drink must be forgone to see an additional movie.
Consumption Possibilities
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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.
The budget line has become steeper because the relative price of movies has increased.
Consumption Possibilities
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© 2013 Pearson Australia
Consumption Possibilities
A fall in the price of the good on the x-axis increases the affordable quantity of that good and decreases the slope of the budget line.
The budget line has become flatter because the relative price of movies has decreased.
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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 12.2(b) shows the effect of a fall in income.
Consumption Possibilities
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An indifference curve is a line that shows combinations of goods among which a consumer is indifferent.
Figure 12.3(a) illustrates a consumer’s indifference curve.
At point C, Lisa sees
2 movies and drinks 6 cases of soft drink a month.
Preferences and Indifference Curves
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Decisions, decisions: Chardonnay or cheesecake? What combination of food and drink will the diner select? It depends upon the willingness to give up some food for additional drink. Is the diner willing to forgo the appetiser in order to enjoy a second glass of wine with dinner? Or will the diner have only ice water in order to afford a dessert after the main course? Have them construct a preference map reflecting the diner’s indifference between exchanging a quantity of drink for a quantity of food. (Be sure that the indifference curves for both scenarios reflect diminishing marginal rate of substitution.)
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Preferences and Indifference Curves
Lisa can sort all possible combinations of goods into three groups: preferred, not preferred, and just as good as point C.
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 the combination at point C and at point G.
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All the points on the indifference curve are preferred to all the points below the indifference curve.
All the points above the indifference curve are preferred to all the points on the indifference curve.
Preferences and Indifference Curves
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A preference map is a series of indifference curves.
Call the indifference curve that we’ve just seen I1.
I0 is an indifference curve below I1.
Lisa prefers any point on I1 to any point on I0 .
Preferences and Indifference Curves
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I2 is an indifference curve above I1.
Lisa prefers any point on I2 to any point on I1 .
For example, Lisa prefers the combination at point J to the combination at either point C or point G.
Preferences and Indifference Curves
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Marginal Rate of Substitution
The marginal rate of substitution, (MRS) measures the rate at which a person is willing to give up good y to get an additional unit of good x while at the same time remaining indifferent (remaining on the same indifference curve).
The magnitude of the slope of the indifference curve measures the marginal rate of substitution.
Preferences and Indifference Curves
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- 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.
Preferences and Indifference Curves
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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, while at the same time remain indifferent as the quantity of good x increases.
Preferences and Indifference Curves
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Figure 12.4 shows the diminishing MRS of movies for soft drink.
At point C, Lisa is willing to give up 2 cases of soft drink to see one more movie—her MRS is 2.
At point G, Lisa is willing to give up 1/2 case of soft drink to see one more movie—her MRS is 1/2.
Preferences and Indifference Curves
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Degree of Substitutability
The shape of the indifference curves reveals the degree of substitutability between two goods. Figure 12.5 shows the indifference curves for ordinary goods, perfect substitutes, and perfect complements.
Preferences and Indifference Curves
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Predicting Consumer Choices
Best Affordable Choice
The consumer’s best affordable choice 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
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Here, the best affordable point is C.
Lisa can afford to consume more soft drink and see fewer movies at point F.
And she can afford to see more movies and consume less soft drink at point H.
But she is indifferent between F, I, and H and she prefers C to I.
Predicting Consumer Choices
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Waiter? We’re ready to order now. Have the students identify which combination of food and drink would equate the MRS to the relative price ratio for a given budget. Have the students show how a rise in the price of drinks would rotate the budget line and push the diner away from drink and toward food. Show how an increase in income shifts the budget line, allowing both dessert and the second glass of wine.
The meaning of tangency. Emphasise to the student the meaning behind the tangency point between the indifference curve and the budget line.
The marginal rate of substitution (MRS) shows the consumer’s willingness to give up one good to get more of the other good.
The relative price of the two goods shows what the consumer must give up of one good to get more of the other good.
When a consumer equates the marginal rate of substitution (MRS) with the relative price ratio, he or she leaves no unrealised gains from substituting one good for another.
The consumer is just willing to give up what he or she must give up, and there are no unrealised gains from substituting one good for another.
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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.
Predicting Consumer Choices
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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 12.7 illustrates the price effect and shows how the consumer’s demand curve is generated.
Initially, the price of a movie is $8 and Lisa consumes at point C in part (a) and at point A in part (b).
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© 2013 Pearson Australia
The price of a movie then falls to $4.
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.
Predicting …
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Explain that the fall in the price of a movie leads Lisa to substitute away from soft drink and into movies. The change in the relative price changes the best affordable point. She can reach a higher indifference curve by substituting away from the relatively more expensive good and towards the relatively inexpensive good.
The new consumption bundle satisfies the three properties: it is on the new budget line, it is on the highest attainable indifference curve, and the MRS has changed, matching the slope of the new budget line.
Also emphasise that tracking the change in the quantity of the good for which the price falls reveals the demand curve for that good.
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A Change in Income
The effect of a change in income on the quantity of a good consumed is called the income effect.
Figure 12.8 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 D0 in part (b).
Predicting …
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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).
Predicting …
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Predicting Consumer Choices
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
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Students find this topic hard. Take it slowly. Get the students to tell you how it goes. That’s the best way of judging the pace that will work for them.
© 2013 Pearson Australia
Initially, Lisa has an income of $40, the price of a movie is $8, and she consumes at point C.
Lisa’s best affordable point is now J.
The move from point C to point J is the price effect.
The price of a movie falls from $8 to $4 and her budget line rotates outward.
Predicting Consumer Choices
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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.
Predicting Consumer Choices
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Substitution Effect
The substitution effect is the effect of a change in price on the quantity bought when the consumer remains on the same indifference curve.
Predicting Consumer Choices
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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.
Predicting Consumer Choices
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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.
Predicting Consumer Choices
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Predicting Consumer Choices
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 I2 and her best affordable point is J.
The move from K to J is the income effect.
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For Lisa, movies are a normal good.
With more income to spend, 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.
Predicting Consumer Choices
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Inferior Goods
For an inferior good, when income increases, the quantity bought decreases.
The income effect is negative and works against the substitution effect.
So long as the substitution effect dominates, the demand curve still slopes downward.
Predicting Consumer Choices
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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.
Predicting Consumer Choices
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