Rational consumer choice

ECO61 Microeconomic Analysis

Udayan Roy
Fall 2008
 Consumer Choice
• We have seen how the consumer’s
preferences are represented
• And how the consumer’s budget constraint is
represented
• Now it’s time to bring preferences and
constraints together to ask the consumer:
• What’s your choice? How do you decide what
to buy?
Example
 Consumer Maximization: What’s the best
affordable choice?
• PZ = $1, PB = 2, M = 50
B, Burritos per semester

25
c f

e
I3
d I2
a
I1
0 50
Z, Pizzas per semester
 Consumer Maximization: Interior Solution
•Would
Would
BundleLisa e isbe ableato
called to
B, Burritos per semester

consume
consumer’s
consume any bundle
any bundle
optimum. along
I1? If Lisa is bundle
consuming this
along I 3
(i.e. f)?
 Yes; she could afford bundles d, c, and
a.bundle, she has no
– No! Lisa does not have
incentive
Nevertheless, to
there change
are other her
affordable
25 enough income to affordand
bundles that should be preferred
c f behavior by substituting
affordable.
20
any
 bundle
For good along
instancefor I
bundle
3
e
one another.
B e
10
I3
d I2
A a
I1
0 10 30 50
Z, Pizzas per semester
 Consumer Maximization: Interior Solution
 The budget constraint and the indifference curve
have the same slope at the point e where they
B, Burritos per semester

touch.
 Therefore, at point e:
PZ
 MRS ZB 
PB
25

Slope of indifference curve

Slope of budget line
e

I2

0 50
Z, Pizzas per semester
 An algebraic example

max U  X  Y
X ,Y

subject to the budget constraint

XPX  YPY  M
As was explained in chapter 2, the ≤
symbol can be replaced by the = symbol.
Ch. 2: Budget constraint algebra
PX X  PY Y  M
PY Y  M  PX X
M  PX X
Y
PY
M PX
Y  X
PY PY
 Algebraic example (contd.)
• So, our choice problem becomes
 M PX  PX  M 2
max X     X     X   X 
X
 PY PY  PY  PX 
• … which changes the choice problem to

 M   M 2
  M 
2
M 

max X   X    
2
     X  X 2
X
 PX    2 PX   2 PX  PX 

As these two terms cancel out, there’s no harm placing them here.
 Algebraic example (contd.)
• But
 M 2
  M 
2
M   M 2
  M 
2

max      X  X 2        X 
X  2P   2 PX
 X   2 PX  PX
   2 PX 

• Therefore, our choice problem becomes

2
 M  M
min   X  which implies X 
X
 2 PX  2 PX
 Algebraic example (contd.)
• Then the budget constraint implies

M PX M PX M
Y  X  
PY PY PY PY 2 PX
M M M
Y  
PY 2 PY 2 PY
 Algebraic example (Done!)
• The choice problem
max U  X  Y
X ,Y

subject to the budget constraint

XPX  YPY  M
• has the solution:
M M
X and Y 
2 PX 2 PY
 Consumer Maximization: Corner
B, Burritos per semester
Solution
MRSZB ≤ PZ/PB. The consumer would
like to buy even less pizza, were the
amount of pizza not already zero.

e
25

I3

I2

Budget line
I1

50
Z, Pizzas per semester
 Food Stamps
• Nearly 11% of U.S. households worry about
having enough money to buy food and 3.3%
report that they suffer from inadequate food.

• Households that meet income, asset, and

employment eligibility requirements receive
coupons that can be used to purchase food
from retail stores.
 Food Stamps (cont).
• The Food Stamps Program is one of the
nation’s largest social welfare programs with
expenditures of $33.1 billion for nearly 29.1
million people in 2006.

• Would a switch to a comparable cash subsidy

increase the well-being of food stamp
recipients?
– Would the recipients spend less on food and
more on other goods?
 Food Stamps Versus Cash: Cash Wins
Budget line under a cash grant
All other goods per month
M + 100
f

C e
M I3
d I2

I1

B
Budget line with
food stamps
A Original
budget line

0 100 M M + 100
Food per month
 Food Stamps Versus Cash: Both Win
Budget line under a cash grant
All other goods per month
M + 100

C e The best choice

M under both policies
d

B
A Original Budget line with
budget line food stamps

0 100 M M + 100
Food per month
 Gifts: cash or kind?
• In the hit TV show Seinfeld, Elaine was once
furious when Jerry gave her cash as a birthday
gift
– She was not objecting to the amount, which was
$182
• Does Jerry deserve such harsh treatment?
Figure 5.11: Effect of a Change in the Price
of Soup on Consumption

5-20
The demand curve
 (a) Indifference Cu rves and Budget Const raints

Deriving

Wine, (W), Gallons per year

12.0

an Individual’s Initial optimal bundle of

Demand Curve Beer and Wine

Budget Line, L

M Pb e1
W= - b 2.8
PW PW
L1 (pb = $12) I1

0 26.7 Beer (b), Gallons per year

Initial Values (b) Demand Cu rve

Pb = price of beer = $12

p b, $ per unit
PW = price of wine = $35 12.0 E1

M = Income = $419.

0 26.7 Beer (b), Gallons per year

 (a) Indifference Cu rv
es and Budget Const raints

Deriving

Wine, (W), Gallons per year

12.0

an Individual’s
Demand Curve
Budget Line, L
e2
4.3
M Pb e1
W= - b 2.8 I2
PW PW
L1 (p = b$12) I1 L2 (p b = $6)

0 26.7 44.5 Beer (b), Gallons per year

New Values (b) Demand Cu rve

Pb = price of beer = $6
p b, $ per unit
PW = price of wine = $35 12.0 E1

M = Income = $419.

Price of Beer goes down! 6.0

E2

0 26.7 44.5 Beer (b), Gallons per year

 (a) Indifference Cu rves and Budget Const raints

Deriving

Wine, (W), Gallons per year

12.0

an Individual’s
Demand Curve
Budget Line, L e3
Price-consumption curve
5.2
e2
4.3
Y Pb e1 I3
W= - b 2.8 I2
PW PW
L1 (p = b$12) I1 L2 (p b = $6) L3 (p b = $4)

0 26.7 44.5 58.9 Beer (b), Gallons per year

New Values (b) Demand Cu rve

Pb = price of beer = $4
p b, $ per unit
PW = price of wine = $35 12.0 E1

Y = Income = $419.

Price of Beer goes down again! 6.0

E2

E3
4.0 D1, Demand for Beer

0 26.7 44.5 58.9 Beer (b), Gallons per year

Figure 5.17: Effect of a Change in Income
on Consumption

5-25
 Normal vs. Inferior Goods
• If a good is normal, an increase in income raises the
amount that is consumed
• If a good is inferior, an increase in income decreases
the amount that is consumed
• Consumption of many goods falls as income rises
because people shift toward higher-quality products
that fill similar needs
– Examples: replace posters with art reproductions,
margarine with butter

5-26
Changes in income shift the demand
curve: normal good case
 Effects of a Price Change
• substitution effect - the change in the
quantity of a good that a consumer demands
when the good’s price changes, holding other
prices and the consumer’s utility constant.

• income effect - the change in the quantity of a

good a consumer demands because of a
change in income, holding prices constant.
Substitution and Income Effects with
Normal Goods
Initial Values
PD = price of DVDs = $20
D, Movie DVDs, Units per year

PC = price of CDs = $15

M = Income = $300.

Budget Line, L1
15
L1
M PC
D= - C
PD PD
$300 $15
D= - C
e1
$20 $20

I1

12 20
C, Music CDs Units peryear
 Substitution and Income Initial Values
PD = price of DVDs = $20
Effects with Normal Goods PC = price of CDs = $15
D, Movie DVDs, Units per year M = Income = $300.
Budget Line, L

M PC
C
D= -
PD PD

15 $300 $15
$30
L1 D= - C
$20 $20
L2

e2 e1

I1

I2 PC goes up…
6 12 20
C, Music CDs Units peryear

Total effect = -6
 Substitution and Income Initial Values
PD = price of DVDs = $20
Effects with Normal Goods PC = price of CDs = $15
D, Movie DVDs, Units per year M = Income = $300.
L*
Budget Line, L2

M PC
D= - C
PD PD
15
L1 $300 $30
D= - C
$20 $20
L2
• What if we compensated Laura so she
e*
could afford the same utility she had
before the price of CDs increased?
e2 e1 – In other words, how much income she
would need to afford indifference curve
I1, with the new price of CDs ($30)

I1

I2
6 9 12 20
C, Music CDs Units peryear
Income effect = -3 Substitution effect = -3
Total effect = -6 = Substitution Effect + Income Effect = -3 + (-3)
Giffen Good When the price of movie
tickets decreases the budget
constraint rotates out…
Basketball, Tickets per year

L2

L1 e2

I2

e1
allowing the consumer to
increase her utility.

I1
Total effect Movies, Tickets per year

Nevertheless, the total effect

is negative. WHY?
 • Even though the
Giffen Good substitution effect is
Basketball, Tickets per year positive….
L2
– …the income effect is
larger and negative
L1 e2
(since this is an inferior
good).

L* I2

e1

e*

I1
Total effect Substitution effect Movies, Tickets per year
Income effect
 Labor-Leisure Choice
• Leisure - all time spent not working.
• The number of hours worked per day, H,
equals 24 minus the hours of leisure or
nonwork, N, in a day:
H = 24 − N.

– The price of leisure is forgone earnings.

• The higher your wage, the more an hour of leisure
costs you.
 Labor-Leisure Choice: Example
• Jackie spends her total income, M, on good Y.
– The price of good Y is $1 per unit.

• Her utility, U, depends on how many goods and how much leisure she
consumes:
U = U(Y, N).

• Jackie’s earned income equal:

wH.

• And her total income, M, is her earned income plus her unearned
income, M*:

Y = wH + M*.
 (a) Indifference Curves and Constraints

Demand for Leisure

Time constraint

Y, Goods per day

I1

Budget Line, L1
L1
Y = w1H –w1
1 e1
Y1
Y = w1(24 − N). 0 N1 = 16 24 N, Leisure hours per day
24 H1 = 8 0 H, Work hours per day
(b) Demand Curve

Each extra hour of w, Wage per hour

leisure she consumes

costs her w1 goods.

w1 E1

0 N1 = 16 N, Leisure hours per day

H1 = 8 H, Work hours per day
 (a) Indifference Curves and Constraints

Demand for Leisure Time constraint

Y, Goods per day

I2

L2

–w2

I1 1
e2
Y2

Budget Line, L1
L1
Y = w1H –w1
1 e1
Y1
Y = w1(24 − N). 0 N2 = 12 N1 = 16 24 N, Leisure hours per day
24 H2 = 12 H1 = 8 0 H, Work hours per day
(b) Demand Curve

Budget Line, L2 w, Wage per hour

Y = w2H w2
E2

Y = w2(24 − N).

E1
w2 > w1 w1

Demand for leisure

0 N2 = 12 N1 = 16 N, Leisure hours per day

H2 = 12 H1 = 8 H, Work hours per day
Supply Curve of Labor
Income and Substitution Effects of a
Wage Change
Y, Goods per d ay

I2 Time constraint
L2

I1
Since income effect
is positive, leisure is
a normal good.
L* e2
e*

L1 e1

0 N* N1 N 2 24 N, Leisure hours per d ay

24 H* H1 H 2 0 H, Work hours per d ay
Substitution effect Total effect
Income effect
 Labor Supply Curve That Slopes Upward and
Then Bends Backward
(a) Labor-Leisure Choice (b) Supply Curve of Labor

Supply curve of labor

Y, Goods per d ay

w, Wage per hour

L3 I3 Time const raint E3

I2
E2
I1
e3
L2
e2 E1

L1 e1

24 H2 H H1 0 0 H1 H3 H2 24
3
H, Work hours per d ay H, Work hours per d ay

butlow
At at high
wages,
wages,
an increase
an increase
in the wage causes the worker
worker
to work toless….
work more….
 Why leisure is different
• When the price of apples goes up,
– the substitution effect reduces the consumption of apples, and
– Moreover, the consumer’s income decreases in terms of purchasing
power. This too reduces the consumption of apples, assuming apples
are a normal good
• When the wage rate (w), which is also the price of leisure, goes up,
the substitution effect works as in the apples example and reduces
leisure
• But, the higher wage implies not a decrease but an increase in
income. This increases leisure, assuming leisure is a normal good
• So, although an increase in the price of apples should reasonably be
expected to reduce the consumption of apples, an increase in the
price of leisure should not be expected to reduce the consumption
of leisure
• That is, a backward bending labor supply should by no means be
considered a freak phenomenon
 Leisure and consumption
wR is the reservation
• The price of leisure
wage: the minimum
wage at which this (N) is the wage (w)
individual will work Time constraintthat is lost
Y, Goods per d ay

• The budget
constraint is wN +
PYY = M = 24w + M*
(24w R+ M*) /PY • The slope is -w/PY

Consumption with non-

labor income (M*/PY)

0 N* N1 N 2 24 N, Leisure hours per d ay

24 H* H1 H 2 0 H, Work hours per d ay
 Leisure and consumption
• As the wage rate
increases, labor
supply first
increases and
Y, Goods per d ay

Time constraint
then decreases
• This is an instance
of a backward-
bending labor
(24w R+ M*) /PY supply curve

Consumption with non-

labor income (M*/PY)

0 N* N1 N 2 24 N, Leisure hours per d ay

24 H* H1 H 2 0 H, Work hours per d ay