price, income &_consumption

Price, Income, and

Consumption Analysis

Learning Objectives

• Calculate and graph a household’s budget line

• Work out how the budget line changes when prices or income changes

• Make a map of preferences by using indifference curves

Learning Objectives (cont.)

• Explain the choices that households make

• Predict the effects of price and income changes on consumption choices

• Predict the effects of wage changes on work-leisure choices

Consumption Possibilities

• Consumption choices are limited by income and prices.

• A budget line describes the limits to a household’s consumption choices.

Consumption Possibilities

Divisible and Indivisible Goods

Divisible goods can be bought in any quantity desired

ex. Petrol

Indivisible goods cannot be bought in all quantities

ex. Car / A Flat / textbook

Consumption Cakes (Rs. 6) Softies (Rs. 3)

possibility (per week) (per week)

a 0 10

b 1 8

c 2 6

d 3 4

e 4 2

f 5 0

The Budget LineMr. MBA’s Income is Rs.

30

Affordable

The Budget Line

0 1 2 3 4 5 6 7 8 9 10

2

4

6

8

10

Cakes (per week)

Sof

ties

(pe

r w

eek)

Unaffordable

Income Rs.30Cakes Rs.6Softies Rs.3

a

b

c

d

e

f

The Budget Equation

The budget equation is based upon:

Expenditure = Income

Rs.3Qs + Rs.6Qc = Rs.30

Qs = 10 – 2Qc

The quantity of Softies can be found by first setting the quantity of Cakes.

The Budget Equation

Real Income is the maximum quantity of a good that a household can afford to buy.

Or, it is the value of money income expressed in terms of goods

Mr. MBA’s Real Income (in terms of Softies) is:

Income/Price of Softies = y/Ps

Rs.30/Rs.3 = 10

The Budget Equation

Relative Price

A relative price is the price of one good divided by the price of another good.

Mr. MBA’s relative price of a Cake in terms of Softies: Rs.6/Rs.3 = 2 per Cake

In other words, to see one more Cake, Mr. MBA must give up 2 Softies (i.e. opportunity cost)

Changes in Prices and Income

0 1 2 3 4 5 6 7 8 9 10

Sof

ties

( pe

r w

eek)

2

4

6

8

10

Cakes (per week)

a

f

Price of aCake is...

…Rs.6…Rs.12 …Rs.3

A Change in Price

Changes in Prices and Income

0 1 2 3 4 5 6 7 8 9 10

Sof

ties

(per

wee

k)

2

4

6

8

10

Cakes (per week)

a

f

A Change in Income

IncomeRs.30

IncomeRs.15

Preferences and Indifference Curves

• Between two alternatives A and B, there can be maximum of three possibilities

1. A is preferred to B

2. B is preferred to A

3. Consumer is indifferent between A and B

• An indifference curve is a line that shows combinations of goods among which a consumer is indifferent.

Preferred

Notpreferred

A Preference Map

0 2 4 6 8 10

Sof

ties

(per

wee

k)

2

4

6

8

10

Cakes (per week)

g

c

An indifference curve

A Preference Map

A preference map is a series of indifference curves.

A preference map consists of an infinite number of indifference curves; each one slopes downward, and none of them intersects.

I2

I1

0 2 4 6 8 10

Sof

ties

(per

wee

k)

2

4

6

8

10

Cakes (per week)

A Preference Map

g

c

I0

j

Learning Objectives (cont.)

• Explain the choices that households make

• Predict the effects of price and income changes on consumption choices

• Predict the effects of wage changes on work-leisure choices

Marginal Rate of Substitution

The Marginal Rate of Substitution (MRS) is the rate at which a person will give up one good in order to get more of another good and at the same time remain indifferent.

Marginal Rate of Substitution

The MRS is measured by the slope of an indifference curve.

• Steep indifference curves have a high MRS.

• Flat indifference curves have a low MRS.

I1

0 2 4 6 8 10

Sof

ties

(per

wee

k)

2

4

6

8

10

Cakes (per week)

Marginal Rate of Substitution

c

g

MRS = 2

MRS = 1/2

Marginal Rate of Substitution

Note:

As the consumption of Cakes increases, the MRS decreases.

This is referred to as the diminishing marginal rate of substitution.

The Degree of Substitutability

The shape of the indifference curves reveals the degree of substitutability between two goods.

• Three typical shapes can be considered here

• Convex curves (higher/ lower convexity)

• Downward sloping Straight lines

• Right Angled lines

0 2 4 6 8 10

Sof

ties

(can

s)

2

4

6

8

10

Cakes

Degree of SubstitutabilityOrdinary goods

0 2 4 6 8 10

Mar

ker

pens

at t

he lo

cal s

uper

mar

ket

2

4

6

8

10

Degree of SubstitutabilityPerfect substitutes

Marker pens at the campus bookstore

0 1 2 3 4 5

Lef

t run

ning

sho

es

1

2

3

4

5

Degree of SubstitutabilityPerfect complements

Right running shoes

Predicting Consumer Behavior

Individuals maximize their utility given their income budget line when they:

• Are on their their highest attainable indifference curve.

• Have a marginal rate of substitution between the two goods equal to their relative price.

0 2 4 6 8 10

Sof

ties

(per

wee

k)

2

4

6

8

10

Cakes (per week)

h

The Best Affordable Point

f

1

Bestaffordablepoint

iI2

I0

I1

c

Learning Objectives (contd..)

• Explain the choices that households make

• Predict the effects of price and income changes on consumption choices

• Predict the effects of wage changes on work-leisure choices

Predicting Consumer Behavior

What effect will changes in prices and income have on the best affordable point?

A Change in Price

Price effect

The effect of a change in price on quantity of a good consumed.

A change in the price of a good will shift the budget line and will change the best affordable combination.

0 2 4 6 8 10

Sof

ties

(per

wee

k)

2

4

6

8

10

Cakes (per week)

Price Effect and Demand Curve

I1

I2

Best affordablepoint: Cakes Rs.6

c Best affordablepoint: Cakes Rs.3j

5

5

Price Effect and Demand Curve

0 2 4 6 8 10

1

2

3

4

5

Cakes (per week)

6

Mr. MBA’s demandcurve for Cakes

a

b

Pri

ce (

Rs.

per

Cak

e)

5

Predicting Consumer Behavior

What effect will changes in Mr. MBA’s income have on the best affordable point?

A Change in Income

Income effect

The effect of a change in income on consumption.

A change in income will shift the budget line and will change the best affordable combination.

0 2 4 6 8 10

Sof

ties

(per

wee

k)

2

4

6

8

10

Cakes (per week)

IncomeRs.30

3I2

I1

IncomeRs.21

j

Income Effect and Change in Demand

0 2 4 6 8 10

Pri

ce (

Rs.

per

Cak

e)

1

2

3

4

5

Cakes (per week)

6

D0

b

D1

c

Income Effect and Change in Demand

Substitution Effect andIncome Effect

Substitution effect

The effect of a change in price on the quantity bought when the consumer (hypothetically) remains indifferent between the original and the new situation.

Substitution Effect andIncome Effect

Income effect

The change in consumption that results from a change in the consumer’s income, ceteris paribus.

The substitution and income effects can be calculated using the indifference curves and budget line.

0 2 4 6 8 10

Sof

ties

(per

wee

k)

2

4

6

8

10

Cakes (per week)

I1

I2

cj

Income Rs.30Cakes Rs.3

Income Rs.30Cakes Rs.6

Price Effect

5

5

Substitution Effect andIncome Effect

0 2 4 6 8 10

Sof

ties

(per

wee

k)

2

4

6

8

10

Cakes (per week)

I1

I2

cj

5

5

3

7

k

Incomeeffect

Substitutioneffect

Substitutioneffect

Substitution effect and price effect

Substitution Effect andIncome Effect

Learning Objectives (cont.)

• Explain the choices that households make

• Predict the effects of price and income changes on consumption choices

• Predict the effects of wage changes on work-leisure choices

Work-Leisure Choices

• Households must also make choices on how to allocate their time between labour and leisure.

• More leisure means less income. We buy leisure by foregoing income.

• The relationship between leisure and income is described by the income-time budget line.

Work-Leisure Choices

• As wage rates increase, people substitute Labour for leisure — substitution effect.

• However, higher wage rates lead to higher income which causes people to shift toward more leisure — income effect.

The Supply of Labour

Leisure (hours per week)100 168

Inco

me

(Rs.

per

wee

k)

0

350

I1

133 138 148

100

450

Rs.5

Rs.10

I0

aZ

I2

I1

Rs.15

bc

Time allocation decision

The Supply of LabourLS

Labour (hour per week)

Wag

e ra

te (

Rs.

per

hou

r)

0 20 30 35

5

10

15

a

b

c

Labour Supply

Real World Applications

• Work week declines.

• Women in the workforce.

Merits of IC over Utility Analysis

• Better approach (ordinal) to measure utility

• No controversy of constancy of MU of Money

• Explains better how the price effect can be

decomposed

• Helps to understand the nature of goods as

substitutes/ complements

Limitations of IC Analysis• Not all consumers are capable of equating the

MRS with price ratio for equilibrium

• Buying in many cases takes place more as custom/ habit and price changes (particularly smaller) tend to get ignored.

• Indivisibility of commodities prevent precise price adjustments

• For many consumers, lack of time and patience

The End