Transcript - lanfranconomics

Chapter 9: Going from Possibilities (Budget Constraint) and Preferences
(Preference Function) to understanding Price and Income Effects
9
Possibilities,
Preferences,
and Choices
After studying this chapter you will be able to
 Describe a household’s (consumer unit’s) budget line
and show how budget line changes when prices or
income change, and derive a demand curve
 Use indifference curves to map preferences, the
principle of diminishing marginal rate of substitution, and
re-discover Adam Smith’s “Invisible Hand”
proposition.
 Deconstructing a price effect into its “Substitution
Effect” and “Income Effect” components.
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You buy your music online and play it on an iPod.
The prices of a music download and an iPod have
tumbled, the volume of downloads and sales of
iPods have skyrocketed. (both Quantities of
complements rise based on falls in prices)
The price of a DVD has fallen and we’re buying
ever more of them. (actually we are not, why not?
ANS: because of downloads. )
Why are we going to movie theaters in ever-greater
numbers even though it is cheaper to buy a DVD?
This chapter studies a model of choice that
provides tools to explore these questions.
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Consumption Possibilities
Household 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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Consumption Possibilities
Lisa has $40 to spend, the
price of a movie is $8 and
the price of pop is $4 a case.
The rows of the table show
combinations of pop and
movies that Lisa can buy
with her $40.
The graph plots these seven
possible combinations.
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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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Consumption Possibilities
The Budget Equation
We can describe the budget line by using a budget
equation. The budget equation states that
Expenditure = Income
The price of pop PP, the quantity of pop QP, the price of a
movie PM, the quantity of movies QM, and income Y.
Lisa’s budget equation is:
PPQP + PMQM = Y.
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Consumption Possibilities
PPQP + PMQM = Y
Divide both sides of this equation by PP, to give:
QP + (PM/PP)QM = Y/PP
Then subtract (PM/PP)QM from both sides of the equation to
give:
QP = Y/PP – (PM/PP)QM
Y/PP is Lisa’s real income in terms of pop.
PM/PP is the relative price of a movie in terms of pop.
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Consumption Possibilities
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 pop is the point on her
budget line where it meets the y-axis, in terms of movies
the point where it meets the x-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 pop must be
forgone to see an additional movie.
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Consumption Possibilities
A Change in Prices
A change in the price of the
good on the x-axis changes the
affordable quantity of that good
and changes the slope of the
budget line. (PM up – slope
steeper; PM down – reverse)
Figure 9.2(a) shows the rotation
of a budget line after a change
(up to $16; down to $4) in the
relative price of movies.
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Consumption Possibilities
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 9.2(b) shows the
effect of a fall in income.
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Preferences and Indifference Curves
An indifference curve is
a line that shows/maps
combinations of goods
among which a consumer
is indifferent.
Figure 9.3(a) illustrates a
consumer’s indifference
curve. Let’s start with Lisa
seeing 2 movies and
drinking 6 cases of pop a
month.
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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.
IO
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 point C
and point G, and all points
on Io
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Indifference
curves are
always concave
from above
IO
Preferences and Indifference Curves
(everywhere dense like topographic maps,)
All the points on the
indifference curve are
preferred to all the points
below the indifference curve
And all the points above the
indifference curve are
preferred to all the points on
the indifference curve.
Think of Indifference Curves as
projections down from a third
axis measuring satisfaction,
where more means happier.
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Preferences and Indifference Curves
A preference mapping is a
depiction of the whole
family of indifference
curves.
I2 is an indifference curve
above I1, and I0 is below I1
Lisa prefers any point on I2
to any point on I1 . For
example, Lisa prefers point
J to either point C or point
G.
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Preferences and Indifference Curves
Marginal Rate of Substitution: Slope of Indifference Curve
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
remain indifferent (remain on the same indifference
curve).
The magnitude of the slope of the indifference curve
measures the marginal rate of substitution.
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Preferences and Indifference Curves
 If the indifference curve is relatively steep, the MRS is
high. (Give up a lot of “vertical” for a bit of “horizontal”)
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.
(Give up only a bit of “vertical” for a lot of “horizontal”)
In this case, the person is willing to give up a small
quantity of y to get more x.
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Preferences and Indifference Curves
A diminishing marginal rate of substitution is the key
assumption of consumer theory, and is similar to the
Principle of diminishing marginal utility. (either implies the
other)
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.
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Preferences and Indifference Curves
Figure 9.4 shows the
diminishing MRS of
movies for pop.
At point C, Lisa is willing
to give up 2 cases of pop
to see one more movie—
her MRS is 2.
At point G, Lisa is willing
to give up 1/2 case of pop
to see one more movie—
her MRS is 1/2.
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Preferences and Indifference Curves
Degree of Substitutability
The shape of the indifference curves reveals the degree
of substitutability between two goods.
Figure 9.5 shows the indifference curves for ordinary
goods, perfects substitutes, and perfect complements.
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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
QY = Inc/ PY – (PX/ PY) QX
Slope
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Predicting Consumer Choices
Here, the best affordable
point is C.
Lisa can afford to consume
more pop and see fewer
movies at point F.
And she can afford to see
more movies and consume
less pop at point H.
But she is indifferent
between F, I, and H and
she prefers C to I.
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Predicting Consumer Choices
At point F, Lisa’s MRS is
greater than the relative
price, and at point H, Lisa’s
MRS is less than the
relative price.
At point C, Lisa’s MRS is
equal to the relative price.
At C Lisa’s MRS of pop
for movies = (Pm/Pp) so
her subjective MRS is the
same as the objective rate
at which they substitute
in the market
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Predicting Consumer Choices
At C: Lisa’s MRS of pop for
movies = (Pm/Pp).
Her subjective MRS is the
same as the objective rate at
which they substitute in the
market.
If all face similar prices:
MRSLisa = MRSeverybody
is same as
Lisa’s MUX/MUy = MUX/MUy
for everybody. (utility theory)
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Adam Smith’s
“Invisible
Hand” at work
Predicting &
Deconstructing
A Change in Price
Effect of a change in the price of
a good on the quantity consumed
is called the price effect (sliding
along demand curve).
Figure 9.7: The price effect
reflects how the consumer’s
demand curve is generated.
The price of a movie is $8 and
Lisa consumes at point C in part
(a) and at point A in part (b).
Then drop Price and follow
changes in Quantity
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Generating the
Demand Curve
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.
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Deconstructing
the price effect
First look at a Change in
Income
The effect of a change in
income on the quantity of a
good consumed is called the
income effect.
Figure 9.8 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).
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Predicting …
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).
Price has not changed in
either part (a) or part (b)
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Deconstructing the Price Effect
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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Deconstructing the Price Effect
Initially, Lisa has an
income of $40, the price of
a movie is $8, and she
consumes at point C.
The price of a movie falls
from $8 to $4 and her
budget line rotates outward.
Lisa’s best affordable point
is now J.
The move from point C to
point J is the price effect.
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Deconstructing the Price Effect
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.
Thought experiment:
Change price of movies
but leave Lisa just as
well off (on I1)
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Deconstructing the Price Effect
Substitution Effect
The substitution effect is
the effect of a change in
price on the quantity
bought when the
consumer remains on the
same indifferent curve.
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Deconstructing the Price Effect
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.
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Deconstructing the Price Effect
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.
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Deconstructing the Price Effect
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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Deconstructing the Price Effect
For Lisa, movies are a
normal good.
With more income to spend,
she sees more movies—the
income effect is positive.
M
For a normal good, the
income effect reinforces the
substitution effect and is the
second reason why the
demand curve slopes
downward. (Bare Naked Ladies,
“If I had a million dollars”)
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Deconstructing the Price Effect
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.
(If movies were an inferior good Lisa would go
somewhere like M)
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Deconstructing the Price Effect
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! (or curves back)
This case does not appear
to occur often in the real
world.
P
D
Inferior good
Range: macaroni
and cheese so
cheap we can
buy more meat
D
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Q