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Preferences, Utility, Budget

Line and Consumer

Equilibrium

Consumer Theory

The Household’s Budget

Consumption Possibilities

A household’s consumption possibilities are constrained

by its income and the prices of the goods and services it

buys.

A household has a given amount of income to spend and

cannot influence the prices of the goods and services it

buys.

A household’s budget line describes the limits to a

household’s consumption choices.


Figure 7.1 shows a budget

line for movies and soda.

The household can afford

all the points on or below

the budget line.

The household cannot

afford the points beyond

the budget line.


Relative Price

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

price of another good.

The price of a movie is $6 and the price of soda is $3 a

six-pack.

So the relative price of a movie is $6 per movie divided by

$3 per six-pack, which equals 2 six-packs per movie.


A Price Change

A change in the price of

the good on the x-axis

changes the affordable

quantity of that good and

changes the slope of the

budget line.

Figure 7.2(a) shows the

rotation of a budget line

after a change in the

relative price of movies.


Real Income

A household’s real income is the household’s income

expressed as the quantity of goods that the household can

afford to buy.

Expressed in terms of soda, Lisa’s real income is 10 six-

packs—the maximum quantity of six-packs that she can

buy.

Lisa’s real income equals her money income ($30) divided

by the price of a six-pack ($3).


A Change in Income

An change in the income

brings a parallel shift of the

budget line.

The slope of the budget

line doesn’t change

because the relative price

doesn’t change.

Figure 7.2(b) shows how

the budget line shifts when

income changes.

Preferences and Utility

Preferences

A household’s preferences determine the benefits or

satisfaction a person receives consuming a good or

service.

The benefit or satisfaction from consuming a good or

service is called utility.

Total Utility

Total utility is the total benefit a person gets from the

consumption of goods. Generally, more consumption

gives more utility.


Table 7.1 on page 157

provides an example of

total utility schedule.

Figure 7.2(a) shows a total

utility curve.

Total utility increases with

the consumption of a

good.


Marginal Utility

Marginal utility is the change in total utility that results

from a one-unit increase in the quantity of a good

consumed.

As the quantity consumed of a good increases, the

marginal utility from consuming it decreases.

We call this decrease in marginal utility as the quantity of

the good consumed increases the principle of diminishing

marginal utility.


Figure 7.2(b) illustrates

diminishing marginal utility.

Utility is analogous to

temperature.

Both are abstract concepts

and both are measured in

arbitrary units.

Maximizing Utility

The key assumption of marginal utility theory is that the

household chooses the consumption possibility that

maximizes total utility.

The Utility-Maximizing Choice

We can find the utility-maximizing choice by looking at the

total utility that arises from each affordable combination.

Table 7.2 (page 158) shows an example of the utility-

maximizing combination, which is called a consumer

equilibrium.

Maximizing Utility

Equalizing Marginal Utility per Dollar

Using marginal analysis, a consumer’s total utility is

maximized by following the rule:

Spend all available income and equalize the marginal

utility per dollar for all goods.

The marginal utility per dollar is the marginal utility from

a good divided by its price.

Maximizing Utility

The Utility-Maximizing Rule:

Call the marginal utility of movies MUM .

Call the marginal utility of soda MUS .

Call the price of movies PM .

Call the price of soda PS .

The marginal utility per dollar from seeing movies is

MUM/PM .

The marginal utility per dollar from soda is MUS/PS.

Maximizing Utility

Total utility is maximized when:

MUM/PM = MUS/PS

Table 7.3 (page 159) and Figure 7.4 on the next slide

show why the utility maximizing rule works.

Maximizing Utility

If MUM/PM > MUS/PS,

then moving a dollar from

soda to movies increases

the total utility from movies

by more than it decreases

the total utility from soda,

so total utility increases.

Only when MUM/PM =

MUS/PS, is it not possible

to reallocate the budget

and increase total utility.

Maximizing Utility

If MUS/PS > MUM/PM,

then moving a dollar from

movies to soda increases

the total utility from soda by

more than it decreases the

total utility from movies, so

total utility increases.

Only when MUM/PM =

MUS/PS, is it not possible to

reallocate the budget and

increase total utility.

Predictions of Marginal Utility Theory

A Fall in the Price of a Movie

When the price of a good falls the quantity demanded of

that good increases—the demand curve slopes

downward.

For example, if the price of a movie falls, we know that

MUM/PM rises, so before the consumer changes the

quantities consumed, MUM/PM > MUS/PS.

To restore consumer equilibrium (maximum total utility)

the consumer increases the quantity of movies consumed

to drive down the MUM and restore MUM/PM = MUS/PS.

Predictions of Marginal Utility Theory

A change in the price of one good changes the demand

for another good.

You’ve seen that if the price of a movie falls, MUM/PM

rises, so before the consumer changes the quantities

consumed, MUM/PM > MUS/PS.

To restore consumer equilibrium (maximum total utility)

the consumer decreases the quantity of soda consumed to

drive up the MUS and restore MUM/PM = MUS/PS.


Household consumption choices are constrained by its

income and the prices of the goods and services available.

The budget line describes the limits to the household’s

consumption choices.


Figure 8.1 shows Lisa’s

budget line.

Divisible goods can be

bought in any quantity

along the budget line

(gasoline, for example).

Indivisible goods must be

bought in whole units at the

points marked (movies, for

example).

Lisa can afford any point

on the budget line or inside

it.


The budget line is a

constraint on Lisa’s

choices.

Lisa can afford any

point on her budget line

or inside it.

Lisa cannot afford any

point outside her

budget line.


The Budget Equation

We can describe the budget line by using a budget

equation.

The budget equation states that

Expenditure = Income

Call the price of soda PS, the quantity of soda QS, the price

of a movie PM, the quantity of movies QM, and income Y.

Lisa’s budget equation is:

PSQS + PMQM = Y.


A household’s real income is the income expressed as a

quantity of goods the household can afford to buy.

Lisa’s real income in terms of soda is the point on her

budget line where it meets the y-axis.

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

price of another good.

Relative price is the magnitude of the slope of the budget

line.

The relative price shows how many sodas must be

forgone to see an additional movie.


A Change in Prices

A rise in the price of the

good on the x-axis

decreases the affordable

quantity of that good and

increases the slope of the

budget line.

Figure 8.2(a) shows the

rotation of a budget line

after a change in the

relative price of movies.


A Change in Income

An change in money

income brings a parallel

shift of the budget line.

The slope of the budget

line doesn’t change

because the relative price

doesn’t change.

Figure 8.2(b) shows the

effect of a fall in income.

Preferences and Indifference Curves

An indifference curve

is a line that shows

combinations of goods

among which a

consumer is indifferent.

Figure 8.3(a) illustrates

a consumer’s

indifference curve.

At point C, Lisa

consumes 2 movies and

6 six-packs a month.


Lisa can sort all possible

combinations of goods into

three groups: preferred, not

preferred, and indifferent.

An indifference curve joins

all those points that Lisa

says are just as good as C.

G is such a point. Lisa is

indifferent between C and G.


All the points above the

indifference curve are

preferred to the points on

the curve.

And all the points on the

indifference curve are

preferred to the points

below the curve.


A preference map is

series of indifference

curves.

Call the indifference curve

that we’ve just seen I1.

I0 is an indifference curve

below I1.

Lisa prefers any point on

I1 to any point on I0 .


I2 is an indifference curve above I1.

Lisa prefers any point on I2

to any point on I1 .

For example, Lisa prefers

point J to either point C or

point G.


Marginal Rate of Substitution

The marginal rate of substitution, (MRS) measures the

rate at which a person is willing to give up good y, (the

good measured on the y-axis) to get an additional unit of

good x (the good measured on the x-axis) and at the same

time remain indifferent (remain on the same indifference

curve).

The magnitude of the slope of the indifference curve

measures the marginal rate of substitution.


If the indifference curve is relatively steep, the MRS is

high.

In this case, the person is willing to give up a large

quantity of y to get a bit more x.

If the indifference curve is relatively flat, the MRS is low.

In this case, the person is willing to give up a small

quantity of y to get more x.


A diminishing marginal rate of substitution is the key

assumption of consumer theory.

A diminishing marginal rate of substitution is a general

tendency for a person to be willing to give up less of good

y to get one more unit of good x, and at the same time

remain indifferent, as the quantity of good x increases.


Figure 8.4 shows the

diminishing MRS of

movies for soda.

At point C, Lisa is willing

to give up 2 six-packs to

see one more movie—her

MRS is 2.

At point G, Lisa is willing

to give up 1/2 a six-pack

to see one more movie—

her MRS is 1/2.


Degree of Substitutability

The shape of the indifference curves reveals the degree

of substitutability between two goods.

Figure 8.5 shows the indifference curves for ordinary

goods, perfects substitutes, and perfect complements.

Predicting Consumer Behavior

The consumer’s best affordable point is:

On the budget line

On the highest attainable indifference curve

Has a marginal rate of substitution between the two

goods equal to the relative price of the two goods


Here, the best affordable

point is C.

Lisa can afford to consume

more soda and see fewer

movies at point F.

And she can afford to see

more movies and consume

less soda at point H.

But she is indifferent

between F, I, and H and

she clearly prefers C to I.


At point F, Lisa’s MRS is

greater than the relative

price.

At point H, Lisa’s MRS is

less than the relative price.

At point C, Lisa’s MRS is

equal to the relative price.

Predicting …

A Change in Price

The effect of a change in the

price of a good on the quantity of

the good consumed is called the

price effect.

Figure 8.7 illustrates the price

effect and shows how the

consumer’s demand curve is

generated.

Initially, the price of a movie is $6

and Lisa consumes at point C in

part (a) and at point A in part (b).

Predicting …

The price of a movie then

falls to $3.

The budget line rotates

outward.

Lisa’s best affordable point is

now J in part (a).

In part (b), Lisa moves to point

B, which is a movement along

her demand curve for movies.

Predicting …

A Change in Income

The effect of a change in

income on the quantity of a

good consumed is called the

income effect.

Figure 8.8 illustrates the effect

of a decrease in Lisa’s income.

Initially, Lisa consumes at point

J in part (a) and at point B on

demand curve D0 in part (b).

Predicting …

Lisa’s income decreases and

her budget line shifts leftward

in part (a).

Her new best affordable point

is K in part (a).

Her demand for movies

decreases, shown by a leftward

shift of her demand curve for

movies in part (b).


Substitution Effect and Income Effect

For a normal good, a fall in price always increases the

quantity consumed.

We can prove this assertion by dividing the price effect in

two parts:

Substitution effect

Income effect


Initially, Lisa has an

income of $30, the price of

a movie is $6, and she

consumes at point C.

Lisa’s best affordable point

is then J.

The move from point C to

point J is the price effect.

The price of a movie falls

from $6 to $3 and her

budget line rotates outward.


We’re going to break the

move from point C to

point J into two parts.

The first part is the

substitution effect and

the second is the

income effect.


Substitution Effect

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


To isolate the substitution

effect, we give Lisa a

hypothetical pay cut.

Lisa is now back on her

original indifference curve

but with a lower price of

movies and her best

affordable point is K.

The move from C to K is

the substitution effect.


The direction of the substitution

effect never varies:

When the relative price falls,

the consumer always

substitutes more of that

good for other goods.

The substitution effect is the

first reason why the demand

curve slopes downward.


Income Effect

To isolate the income effect,

we reverse the hypothetical

pay cut and restore Lisa’s

income to its original level

(its actual level).

Lisa is now back on

indifference curve I2 and her

best affordable point is J.

The move from K to J is

the income effect.


For Lisa, movies are a normal

good.

When her income increases,

she sees more movies—the

income effect is positive.

For a normal good, the

income effect reinforces the

substitution effect and is the

second reason why the

demand curve slopes

downward.


Inferior Good

For an inferior good, when income increases, the

quantity bought decreases.

For an inferior good, the income effect works against

the substitution effect.

So long as the substitution effect dominates, the

demand curve still slopes downward.


If the negative income effect is stronger than the

substitution effect, a lower price for inferior goods brings a

decrease in the quantity demanded—the demand curve

slopes upward!

This case does not appear to occur in the real world.

Work-Leisure Choices

The model of consumer choice can be used to study the allocation of time between work and leisure.

The two “goods” are leisure and income—where income represents all other goods.

Lisa buys leisure by not supplying labor and by forgoing income.

So the “price” of leisure is the wage rate forgone.


The Labor Supply Curve

By changing the wage rate,

we can find a person’s labor

supply curve.

An increase in the wage rate

makes leisure relatively more

expensive (higher opportunity

cost to not working) and has a

substitution effect toward less

leisure (toward more work).


A higher wage also has a positive income effect on leisure.

If the income effect is weaker than the substitution effect, the quantity of work hours increases as the wage rate rises.

When the wage rate rises from $5 to $10 an hour, work increases from 20 to 35 hours a week—the move from A to B.


But if the income effect is

stronger than the substitution

effect, the quantity of work

hours decreases as the wage

rate rises.

When the wage rate rises

from $10 to $15 an hour,

work decreases from 35 to 30

hours a week —the move

from B to C.


Historical evidence shows

that the average workweek

has declined over the

centuries, implying that

people have preferred to

seek greater leisure despite

its higher opportunity cost.

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