1

Consumer Choice

DAMIEN KING
University of the West Indies, Jamaica

does the demand curve slope ? Why downward? Think of your favourite restaurant Why do you not have it every ? dish. day? come higher wages sometimes ? How cause people to work less?

Outline

1 Budget Constraint 2 Preferences 3 Optimizing

What you can afford
What you like Making the best choice

Budget Constraint

What can you afford?

Budget Informatio n

Weekly income = $1,000 Price of a beer = $200 Price of a patty = $100

=
All the combinatio ns of patties and beer that can be afforded

8 7 6 5

4
3 2 1 0

0 1

9 10

8 7 6 5 Budget Constraint

4
3 2 1 0

0 1

9 10

8 7 6 5

4
3 2 1 0

Suppos e Income Rises

0 1
2

9 10

8 7 6 5

Beers

Patties

Quantit Quantit Cost Cost y y

6 5 4 3 2
0 1
2

1200 1000 800 600 400

0 2 4 6 8

0 200 400 600 800

4
3 2 1 0

9 10

200

10 1000

8 7 6 5

4
3 2 1 0

0 1

9 10

A change in income shifts the budget line

8 7 6 5

4
3 2 1 0

The further away from the origin, the more you can afford.

0 1

9 10

A change in income shifts the budget line

8 7 6 5

4
3 2 1 0

Suppos e the price of a patty rises

0 1
2

9 10

8 7 6 5

Beers

Patties

Quantit Quantit Cost Cost y y

5 4 3 2 1
0 1
2

1000 800 600 400 200

0 1 2 3 4

0 200 400 600 800

4
3 2 1 0

9 10

1000

8 7 6 5

4
3 2 1 0

0 1

9 10

A change in price changes the slope the budget line

8 7 6 5

= $100 =

3 2 1 0

Market Price of a Patty (in beer)

8

0 1

9 10

8 7 6 5

4
3 2 1 0

The cost of the horizontal good equals the slope of the line.

Market Price of a Patty (in beer)

0 1

9 10

8 7 6 5

4
3 2 1 0

1
0 1
2

Market Price of a Patty (in beer)

3 4
5

9 10

Budget line provides the following informatio n

Y P Rate at which you can trade off

Distance of the line from the origin The slope of the line

Amount of purchasing power you have

Preferences

What you like.

All the combinatio ns of patties and beer amongst which you are indifferent

Equally happy with either bundle

Marginal Rate of Substitution

The subjectiv e value of a patty changes

2 beers

1 beer

1/3 of a beer

8 7 6 5

4
3 2 1 0

0 1

9 10

8 7 6 5 Indifferenc e Curve

4
3 2 1 0

0 1

9 10

Indifference Curve
A curve linking all the combinations of two commodities that a consumer regards as providing equal satisfaction

8 7 6 5

2
1

4
3 2 1 0

MRS = slope of indifferen ce curve

Marginal Rate of Substitution 0 1

2

9 10

8 7 6 5

4
3 2 1 0

Choose a different starting point

0 1

9 10

8 7 6 5

4
3 2 1 0

Higher Indifferen ce Curves preferred

0 1

9 10

8 7 6 5

Indifferen ce Map

4
3 2 1 0

0 1

9 10

This person likes patties

An indifferenc e map is particular to each person

This person prefers beer

An indifferenc e map is particular to each person

8 7 6 5

4
3 2 1 0

0 1
2

Convex

9 10

8 7 6 5

4
3 2 1 0

0 1
2

Downwar d sloping

9 10

5
3 2

B C

Nonintersecti ng

4 6 7

Optimizing

Making the best choice.

We know what you can afford. We know what you like. So what are you actually going to consume?

The Best Choice

The Best Choice

2 1
68

The Best Choice

Why dont I have lobster in butter sauce for lunch?

Mona house

Cant afford both lobster and Mona housing

Housing

Would have to live in cardboard box to afford lobster

Food

fast food

lobster

Why a gift basket is sub-optimal.

Gift Basket
4 3
B

Best use of cash

Changing Income and Prices

7 6

An Increase in Income
4 5

Income Effect
The effect of a change in purchasing power on the quantities of commodities consumed
The income effect is usually positive

An Increase in Income

An Increase in Income Inferior Good

Normal v Inferior Good

Whereas for a normal good, an increase in income causes quantity consumed to rise, for an inferior good, consumption will fall

A Change in Relative Price (patties cheaper)

A Change in Relative Price (patties cheaper)

Substitution Effect
The effect of a change in relative price on the quantities of commodities consumed
The substitution effect is always negative

Income & Substitutio n Effects

A Rise in the Price of Patties

B A

Two changes at once: 1. Patties dearer / beer cheaper substitution effect 2. Consumer poorer income effect Why the demand curve is downward-sloping

Incom Subst e

B A

Incom e

Subst

Applicatio ns of Income and Substitutio n Effects

the price of phone calls goes up, will ? If you spend more or less on clothes? If the cost of textbooks rises, how will spending on entertainment ? your change? energy costs fall, is it possible ? When that people spend less on eating out?

Suppose studying gets easier, do you study more or take more time off?

Leisure (in hours)

An Applicatio n to Studying

Studying (in pages)

Leisure (in hours)

3 pages per hour

Leisure 10 9 8 7 6 5 4 3 2 1 0

Studying 0 3 6 9 12 15 18 21 24 27 30

Studying (in pages)

Leisure (in hours)

4 pages per hour

Leisure 10 9 8 7 6 5 4 3 2 1 0

Studying 0 4 8 12 16 20 24 28 32 36 40

Studying (in pages)

Incom e Leisure (in hours)

B A

Income & Substituti on Effects: Studying

Incom Studying (in pages) e

Subst

Subst

Incom e Leisure (in hours)

Subst

A B

Income & Substituti on Effects: Studying

Subst

Incom Studying (in pages) e

How would you respond to a higher wage?

9000

Con s.

8000
7000 6000 5000 4000 3000 2000

The LabourLeisure Choice

Hours
Leisur e Work

Money
0 2 4 6 8 10 12 14 16 16 14 12 10 8 6 4 2 0

1000 0

9000

8000
7000 6000 5000 4000 3000 2000

Con s.

Wage Rate = $250/hr

1000 0
0 2 4 6 8 10 12 14 16 16 14 12 10 8 6 4 2 0
Leisur e Work

9000

8000
7000 6000 5000 4000 3000 2000

Con s.

Wage Rate = $375/hr Wage Rate = $250/hr

1000 0
0 2 4 6 8 10 12 14 16 16 14 12 10 8 6 4 2 0
Leisur e Work

Cons.

Incom e

You will choose to earn more Will you choose to work more?
Incom e

Respon se to a Pay Raise?

Leisure

Subst

Subst

Cons.

C B

The LabourLeisure Choice

Incom e

Subst

Incom e

A
Subst

Leisure

1 2

Consumption choices reflect the highest level of satisfaction that affordability allows. Changes in prices have both income and substitution effects.