Microeconomics Chapter 21

Microeconomics Chapter 21: The theory of consumer choice After developing the basic theory of consumer choice, we apply it to three questions about households decisions 1)Do all demand curves slope downward? 2)How do wages affect labour supply? 3)How do interest rates affect households saving? The budget constraint: What the consumer can afford -People consume less than they desire because their spending is constrained or limited by their income

Budget constraint: the limit on the consumption bundles that a consumer can afford -The slope of the budget constraint measures the rate at which the consumer can trade one good for the other Preferences: What the consumer wants -The budget constraint is one piece of the analysis: it shows what combination of goods the consumer can afford given his income and the prices of the goods -The consumers’ choice, however, depend not only on his budget constraint but also on his preferences regarding the two goods -The consumer’s preferences are the next piece of our analysis

Representing Preferences with Indifference Curves Indifference curve: a curve that shows consumption bundles that give the consumer the same level of satisfaction -The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other Marginal rate of substitution: the rate at which a consumer is willing to trade one good for another Because the indifference curve are not straight lines, the marginal rate of substitution is not the same at all points on a given indifference curve -The rate at which a consumer is willing to trade one good for the other depends on the amounts of the goods he is already consuming -The consumer is equally happy at all points on any given indifference curve, but he prefers some indifference curve to others -A consumer’s set of indifference curves gives a complete ranking of the consumer’s preferences -We can use the indifference curve to rank any two bundles of goods Four properties of Indifference curves

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Property 1: Higher indifference curves are preferred to lower ones. People usually prefer more of something to less of it. This preference of greater quantities is reflected in the indifference curves Property 2: Indifference curves are downward sloping. The slope of an indifference curve reflects the rate at which the consumer is willing to substitute one good for the other, In most cases, the consumer like both goods. Therefore, if the quantity of one good is reduced, the quantity of the other good must increase in order for the consumer to be happy Property 3: Indifference curves do not cross.

Contradicts our assumption that the consumer always prefers more of both goods to less. Thus, indifference curves cannot cross. (Refer to example) Property 4: Indifference curves are bowed inward. The slope of an indifference curve is marginal rate of substitution-the rate at which the consumer is willing to tradeoff one good for the other. The MRS usually depends on the amount of each good the consumer is currently consuming. People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little, the indifference curves are bowed inward

Two Extreme Examples of Indifference Curves -The shape of an indifference curve tells us about the consumer’s willingness to trade one good for the other -When the goods are easy to sub. For each other, the indifference curve are less bowed; when the goods are hard to sub, the indifference curves are very bowed Perfect Substitute -Because the marginal rate of substitution is constant, the indifference curves are straight lines - In this extreme case of straight indifference curve, we say that they two goods are perfect subs. Perfect Complements The indifference curve, therefore are right angles -In this extreme case of right-angle indifference curves, we say that the two goods are perfect complements -Real world- most goods are neither perfect substitutes nor perfect complements but typically, the indifference curves are bowed inward, but not so bowed as to become right angles Optimization: What the consumer chooses -Two necessary pieces for this analysis: the consumer’s budget constraint and the consumer’s preferences- put it together and choose what the consumer should buy The consumer’s optimal choices The consumer must also end up on or below his budget constraint, which measures the total resources available to him -The highest indifference curve that the consumer can reac is the one that just barely touches the budget constraint -The point at which this indifference curve and the budget constraint touch is called the optimum -At the optimum, the slope of the indifference curve equals the slope of the budget constraint - the indifference curve is tangent to the budget constraint -the consumer chooses consumption of the two goods so that the marginal rate of substitution equals to the relative price - the consumer takes as given the relative price of the two goods and then chooses an optimum at which his marginal rate of substitution equals to the relative price -The relative price is the rate at which the market is willing to trade one good for the other, whereas the marginal rate of substitution is the rate at which the consumer is willing to trade one good for the other How changes in Income Affect the consumer’s choices Normal good: a good for which, other things equal, an increase in income leads to an increase in demands Inferior good: A good for which, other things equal, an increase in income leads to a decrease in demand -Although most goods are normal goods, there are some inferior goods in the world How changes in prices affect the consumer’s choice A fall in the price of any good shifts the budget constraint outward Income and substitution effects Income effect: the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve Substitution effect: The change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution -The income effect is the change in consumption that results from the movement to a higher indifference curve -The substitution effect is the change in consumption that results from being at a point on an indifference curve with a different marginal rate of substitution Deriving the Demand Curve The demand curve for any good reflects those consumption decisions -A demand curve shows the quantity demanded of a good for any given price -The theory of consumer choice provides the theoretical foundation for the consumer’s demand curve -The theory of consumer choice is, however, very useful in studying various decisions that people make as they go about their lives Three Applications Do All Demand Curves Slope Downward? -Demand curves can sometimes slope upward -Consumers can sometimes violate the law of demand and buy more of a good when the price rises Giffen good: A good for which an increase in the price raises the quantity demanded -Giffen goods are inferior goods for which the income effect dominates the substitution effect- therefore- the demand curve has a slope upwards How do wages affect labour supply? The substitution effect induces Sally to work harder in response to higher wages, which tends to make the labour supply curve slope upwards -The income effect induces her to work less, which tends to make the labour supply curve slope backwards -Economic theory does not give a clear prediction about whether an increase in the wage induces Sally to work more or less -If the sub. effect is greater than the income effect for Sally, she works more -If the income effect is greater than the substitution effect, she works less -The labour supply curve, therefore, could be either upward or backward sloping How do interest rates affect household saving? Substitution effect: when the interest rate rises, consumption when old becomes less costly relative to consumption when young-therefore- consume more wen old and less when young

Income effect: when the interest rate rises, he moves to a higher indifference curve. As long as consumption in both periods consists of normal goods, he tends to want to use this increase in well-being to enjoy higher consumption in both periods- income effect induces him to save less -The theory of consumer choice says that an increase in the interest rate could either encourage or discourage savings Conclusion: Do people really think this way? -The theory of consumer choice does not try to present a literal account of how people make decisions -The theory of consumer choice tries to describe this implicit, psychological process in a way that permits explicit, economic analysis -Test of theory is in the application

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