This chapter explores how consumers make The households tastes and preferences
choices like these. The households expectations about future income,
wealth, and prices
2 3
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
1
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
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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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2
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.
12 13
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.
14 15
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
16 17
3
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
18 19
4
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
24 25
26 27
28 29
5
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.
30 31
CONSUMER CHOICE
MU X X ( MU Y Y )
If we divide both sides by MUY and by X, we obtain
Y MU X
X MUY
MU X P
X
MU Y PY
slope of indifference curve = slope of budget constraint
6
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.
36
38 39
7
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).
42 43
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.
46 47
8
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
Harcourt, Inc. items and derived items copyright 2001 by Harcourt, Inc.
Consumption
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
50 51
and, thus, higher saving. and, thus, lower saving.
9
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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