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1Principle of Microeconomics Zhao
Mankiw Chapter 21
Principle of Microeconomics
Chapter 21
Consumer choices
Elements of consumer choices
• Total amount of money available to spend.
• Price of each item – consumers on a perfectly competitive market are price takers.
• More importantly, relative price between two items.– Price of apple is $2 and price of orange is $4
– The relative price between apple and orange: 1 apple = ½ orange = price of apple/price of orange
– The relative price between orange and apple: 1 orange =2 apple
• Preference: what consumers like and how much they like it.
units of measure
2Principle of Microeconomics Zhao
Mankiw Chapter 21
A generic representation of consumer choice
• From choice over many items to choice over two– Aggregation
– Extrapolation
• Represent a consumer choice – a consumption bundle– Example: household make choice over apple and oranges
– A consumption bundle could refer to a combination of 2 apples and 3 oranges.
• Use a point on positive quadrant to represent a consumption bundle. – The vertical axis is always the good
used as units of measure.
– A consumption bundle of 2 apple
and 3 orange is point (2,3)
Quantity of apple
Quantity of orange
2
3
Feasible choices for a consumer – budget constraint
• Notation:– A consumer has total income (I) of $100 to spend on apple and orange
– Price of apple (Px) is $2 and price of orange (Py) is $4.
– Quantity of apply (Qx) and quantity of orange (Qy)
• A consumption bundle (Qx, Qy) is feasible if it costs less than income.
Bundles (10,10) (0,25) (50,0) (20,15) (20,20)
Costs 60 100 100 100 120
Budget constraint
3Principle of Microeconomics Zhao
Mankiw Chapter 21
The boundary of the feasible choice – budget line
• Trace all consumption bundles one can afford when all the money are spent
• In our example, budget line is formed by bundles (Qx,Qy) such that
Quantity of apple
Quantity of orange
50
25
20
15
Budget constraint describe the limit on the consumption bundles that a consumer can afford
Raise income, expand the set of choices
Quantity of apple
Quantity of orange
50
25
20
15
Conversely, lower income, shrink the set of choices
35
70
Income raises from 100 to 140
4Principle of Microeconomics Zhao
Mankiw Chapter 21
Price also changes the set of choices
Raise the price of orange, shrink the set of choices
Quantity of apple
Quantity of orange
50
25
20
15
Conversely, lower the price of orange, expand the set of choices
20
Price of orange raises from 4 to 5
More examples of price and the set of choices
Quantity of apple
Quantity of orange
50
25
20
15
Price of apple raises from 2 to 4
25Quantity of apple
Quantity of orange
50
25
20
1520
Price of orange raises from 4 to 5 and price of apple raises from 2 to 4
25
5Principle of Microeconomics Zhao
Mankiw Chapter 21
Slope of the budget line
• It shows the trade-off between goods on the market– Rate at which the consumer can trade one good for the other on the market
– If one sells an apple, how many oranges can he get?
– Relative price of the two goods
Quantity of apple
Quantity of orange
50
25
20
15
Relative price between apple and orange
More on relative price
• Relative price between apple and orange = price of apple/price of orange
• When relative price between apple and orange goes up, we say that apple is relatively more expensive and orange is relatively cheaper.
• When relative price between apple and orange goes up, on the graph where orange (the unit of account) is on the vertical axis, the slope of the budget line is steeper.
• When will the relative price between apple and orange go up?– Only price of apple goes up.
– Only price of orange drops.
– Both price goes up, but % increase of apple price is larger than that of orange.
– Both price drops, but % decrease of apple price is smaller than that of orange.
6Principle of Microeconomics Zhao
Mankiw Chapter 21
Describe the impact of following price changes
Px = 2, Py = 4, I = 100 (black budget line)
Quantity of apple
Quantity of orange
50
25
12.5
25 33.3
case Px Py I
A 3 4 100
B 3 8 100
C 2 8 100
D 4 8 100
E 2 4 50
F 4 16 200
G 3 6 150
H 3 12 150
x is apple, y is orange
Preference: how much do consumers like each item
• Preference is described by an ordering.– From scale of 1 to 10 rank each GOP candidate.
– From scale of -10 to 10 rank the following consumption bundles:
(0,1), (2,0), (1,2), (2,3), (0,2)
• Representation of ordering by a number – utility function
For example
u(0,1) = -2
u(1,2) = 0
u(2,3) = 2
• Utility function using artificial scales to measure degree of satisfaction.
7Principle of Microeconomics Zhao
Mankiw Chapter 21
Basic logical requirements for preference ordering
• Completeness: When compare two bundles, red and blue
A) Red is preferred to blue
B) Blue is preferred to red
C) Indifferent between red and blue
D) Don’t know
• Transitivity: If you say that red is better than blue, blue is better than green, then you can’t say that green is better than red.
• No lexicographical ordering.
More apple is always better, no matter how much orange I get. If two bundles have the same amount of apples, then I prefer the one with more oranges.
Application of contour maps --Topographic maps
• Contour map: 2-D representation of 3-D object
8Principle of Microeconomics Zhao
Mankiw Chapter 21
Topographic maps of Stone mountain
US surface temperature contour maps
9Principle of Microeconomics Zhao
Mankiw Chapter 21
Graphical representation of preference – indifference curves
• An indifference curve is formed by connecting bundles that gives the same level of satisfaction.
• A typical indifference curve
apples
oranges
A
B
C
D
E
Four properties of indifference curves
• Higher indifference curves are preferred to lower ones– The more, the merrier.
– Higher indifference curves is to the northeast corner
• Indifference curves are downward sloping– To be indifferent, if have more of one thing must have less of the other thing
• Indifference curves do not cross
• Indifference curves are bowed inward (convex towards origin)
10Principle of Microeconomics Zhao
Mankiw Chapter 21
The Impossibility of Intersecting Indifference Curves
Oranges
Apples0
C
B
A
Slope of indifference curve – marginal rate of substitution
• Marginal rate of substitution (MRS) between apple and orangeThe maximum amount of oranges one is willing to give up to get one more apple
• MRS between apple and orange at point A = 3/1=3
apples
oranges
A
B
3 4
15
12
10 11
55.5
As happy as before, on the same indifference curve
Value of apple to consumers measured by numbers of oranges
11Principle of Microeconomics Zhao
Mankiw Chapter 21
MRS: trade-off between goods from consumers preference point of view.
• On a typical indifference curve (bowed), MRS is finite and changes along the indifference curve.
– Two goods are substitutable.
– They are not perfect substitutes -- The rate at which one can substitute one goods for another changes.
• Diminishing marginal rate of substitution along the indifference curve.– As one good (apple ) become more scarce (move to the left), it takes more
other good (orange) to substitute for this one. (apple).
– Vice versa.
• Interpretation– Relatively(compares among bundles that give the same level of satisfaction)
scarce goods are relatively more valuable.
– Consumers prefer variety
When MRS is constant, two goods are perfect substitutes
Nickels
6
2
4
Dimes 0 1 32
I1 I2 I3
12Principle of Microeconomics Zhao
Mankiw Chapter 21
When MRS is either infinite or zero, two goods are perfect complements
Leftshoes
Rightshoes
0 54
5
I2
I1
6
Constrained optimization
I want to live at the warmest place in the state of Georgia.
13Principle of Microeconomics Zhao
Mankiw Chapter 21
Consumers as utility maximizersTry to reach the highest level of satisfaction they could
• Feasibility – budget constraint
• Levels of satisfaction are represented by indifference curves.
Quantity of apple
Quantity of orange
50
25
feasible
Review of geometry
Two curves intersect each other Two curves tangent to each other
They only touch each other at one point
At the tangency point, the slopes of the two curves are equal
14Principle of Microeconomics Zhao
Mankiw Chapter 21
Where is the optimum?
Quantity of apple
Quantity of orange
50
25D
A
B
C
Description of the optimal choice
• The optimal choice is on the budget line– Optimal choice never leave money unspent.
– Full utilization of one’s resources.
• The optimal choice where an indifference curve tangent to the budget line.– Slope of this indifference curve = slope of the budget line
– MRS between apple and orange = relative price between apple and orange
– Decision at the margin again
– Measure marginal benefit and marginal cost of consuming one more apple in number of oranges
– Optimal choice is the point at which
Marginal benefit = marginal cost
15Principle of Microeconomics Zhao
Mankiw Chapter 21
Basic tools of analyzing consumer choices I: Income effect
• When nothing else changes, give a consumer more income, where will his optimal choice move to?
– Parallel shift of budget line
– Increase the set of possible choices
– Should achieve a higher level of satisfaction. (new indifference curve)
Quantity of apple
Quantity of orange
50
25
20
15
35
70
Budget raises from 100 to 140
An Increase in Income
Quantityof orange
Quantity of apple0
New budget constraint
I2
I1
New optimum
Initialbudgetconstraint
Initial optimum
The case of a normal goods
16Principle of Microeconomics Zhao
Mankiw Chapter 21
An Increase in Income
Quantityof orange
Quantity of apple0
New budget constraint
I2
I1
New optimum
Initialbudgetconstraint
Initial optimum
The case of an inferior goods
Everything else stays the same, price of apple goes up
• Raise the price of apple, reduce the purchasing power of income, reduce the set of choices, though not uniformly as a reduction of income would do.
• In addition, raise the price of apple, increase the opportunity cost of apple. The budget line has a steeper slope.
Quantity of apple
Quantity of orange
50
25
40
17Principle of Microeconomics Zhao
Mankiw Chapter 21
The overall effect of an increase of price of apple
Quantityof orange
Quantity of apple0
Initial budget constraint
I1I2
Initial optimum
New budgetconstraint
new optimum
This consumer wants less apple because 1) apple is more expensive, 2) he is poorer
• The relative price between two goods changes. If a consumer still has means to stay on the same indifference curve (as happy as before), where will he choose to be?
Basic tools of analyzing consumers choices II: Substitution effect
Quantityof orange
Quantity of apple0
Budget line with high apple price
Budget line with low apple price
Consumers always have less of more expensive things and more of cheaper things.
18Principle of Microeconomics Zhao
Mankiw Chapter 21
Separate the income effect and substitution effect of a price rise
Quantityof orange
Quantity of apple0
Budget line with high apple price
Budget line with low apple price
A
B
C
A to B is substitution effect, B to C is income effect
Consumers demand for apple
When nothing else change, a change of price leads consumers to choose a different quantity of apple to maximize their level of satisfaction
Quantityof orange
Quantity of apple0
A
C
Price of apple
Quantity of apple0
A
C
Consumers choice Consumers demand for apple
19Principle of Microeconomics Zhao
Mankiw Chapter 21
Increase of income leads to shift of demand curveThe case of a normal good
Quantityof orange
Quantity of apple0
B
A
Price of apple
Quantity of apple0
A B
Income increases Demand for apple increases
Price of related goods – are all goods substitutes?
Quantityof orange
Quantity of apple
0
A
B
Price of apple
Quantity of apple0
AB
Price of orange increasesDemand for apple increases
C
Income effect
Substitution effect
Substitutes, if substitution effect dominatesincome effect
20Principle of Microeconomics Zhao
Mankiw Chapter 21
Price of related goods – are all goods substitutes?
Quantityof orange
Quantity of apple
0
A
B
Price of apple
Quantity of apple0
AB
Price of orange increasesDemand for apple increases
C
Income effect
Substitution effect
Complements, if substitution effect is dominated by income effect
Optimal choice when goods are perfect compliments
Quantity of apple
Quantity of orange
50
25
feasible
is still when there is a indifference curve touch the budget line.
21Principle of Microeconomics Zhao
Mankiw Chapter 21
Price of orange increases when orange and apple are compliments
Quantity of apple
Quantity of orange
50
25
A
B
Price of apple
Quantity of apple0
AB
Demand for apple decreases
Exception of law of demand – Giffen good
• Law of demand: When the price of a good rises, demand for the good falls -- downward sloping demand curve
• Giffen good: An increase in the price of the good raises the quantity demanded. – upward sloping demand curve
– A price change has both income effect and substitution effect
– Giffen goods are inferior goods, so that income effect and substitution effect goes the opposite direction.
– This is the case where income effect dominates substitution effect
22Principle of Microeconomics Zhao
Mankiw Chapter 21
Potato during Irish famine
Quantity ofPotatoes
Quantity of Meat0
I1
AB
C
I2
Substitution effect
Income effect
Household labor supply
• Consumption bundles: (goods and services, leisure)
• Time constraint
• Prices– Price of goods and services is P – price index (CPI)
– Price of leisure is its opportunity cost – nominal hourly wage, W (current dollars)
– Real wage is nominal wage adjusted for inflation, w (constant dollars)
labor supply
23Principle of Microeconomics Zhao
Mankiw Chapter 21
Budget constraint of consumption-leisure choice
• In current dollars
• In constant dollars Relative price between time and goods
Consumption
leisure8760h
w = 25
$219000
Budget constraint with non-wage income
In constant dollars
Consumption
leisure8760h
w = 25
$224000
$5000
24Principle of Microeconomics Zhao
Mankiw Chapter 21
Consumption-leisure choice
Consumption
leisure8760h
w = 25
$220000
$5000
$50000
6960h
US average working hour = 1800
“The parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would” -- Andrew Carnegie
Consumption
leisure8760h
$220000
6760h
Income effect
25Principle of Microeconomics Zhao
Mankiw Chapter 21
Budget constraint when wage increases
In constant dollars
Consumption
leisure8760
w = 25
219000w = 30
Labor supply curve
Wage increases for most of workers
Consumption
Leisure0
Wage
Hours of LaborSupplied
0
Labor supply
I2
I1
BC2
BC1A
B
1. When real wage rises . . .
2. . . . hours of leisure decrease . . . 3. . . . and hours of labor increase
Demand for leisure is downward sloping
26Principle of Microeconomics Zhao
Mankiw Chapter 21
Labor supply for some high wage workers
Consumption
Hours of Leisure0
Wage
Hours of LaborSupplied
0
Labor supply
I2I1
BC2
BC1
1. When the wage rises . . .
2. . . . hours of leisure increase . . .3. . . . and hours of labor decrease
Leisure is Giffen good?!
Longer time horizon
• Hours per worker decreases starting as early as 1900.Year 1900 1929 1945 1973 1993
Hours per week 54.3 48 38.8 38 37.2
• More recent change
27Principle of Microeconomics Zhao
Mankiw Chapter 21
Decompose the impact of a real wage increase
In constant dollars
1) Real wage increase increases the price of leisure (Py). (blue line)a) Substitution effect,
b) Negative income effect,
2) Real wage increase increases
income I – bigger positive income
effect. (red line)
c
8760
w = 25
219000w = 30
h
Household saving decision – supply of capital
• Consumption bundle: (consumption now, consumption in the future)
• What is the relative price between consumption now and consumption in the future?
• It is gross (real) interest rate. – Bank pays 5% interest rate on your saving.
– The gross (nominal) interest rate is 105% = 1.05
– Inflation rate is 2%.
– Real interest rate is 5%-2%= 3%
– The gross real interest rate is 103%.
28Principle of Microeconomics Zhao
Mankiw Chapter 21
Budget constraint in saving decision
Household has total income of $10000 now that can be spend now or in the future. Nominal interest rate is 5% and there is no inflation.
Consumption now
Consumption in the future
10000
10500
11000
r=10%
Household saving decision
Consumption in the future
10000
10500
Consumption nowsaving
29Principle of Microeconomics Zhao
Mankiw Chapter 21
An Increase in the Interest Rate
Consumptionwhenold
(a) Higher Interest Rate Raises Saving
Consumption when Young0
I2
I1
BC2
BC1
Consumptionwhenold
(b) Higher Interest Rate Lowers Saving
Consumption when Young0
I2
I1
BC2
BC1
THE ECONOMIC WAY OF LOOKING AT LIFEGary Becker --1992 Nobel price winner
His research uses the economic approach to analyze social issues that range
beyond those usually considered by economists.
Examples• Discrimination
• Crime
• Education
• Fertility choice
• Marriage and Divorce
• Suicide
• Addiction
30Principle of Microeconomics Zhao
Mankiw Chapter 21
As an economy grows, it goes through a demographic transition from high mortality rate and high birth rate to low mortality rate and low birth rate.
(experience of England from Soares)
Quantity and quality tradeoffs
• Consumption bundles (quantity of kids, quality of kids)
Quantity as an inferior goods
Quality
quantity