Price, income &_consumption
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Transcript of Price, income &_consumption
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Price, Income, and
Consumption Analysis
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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
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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
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Consumption Possibilities
• Consumption choices are limited by income and prices.
• A budget line describes the limits to a household’s consumption choices.
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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
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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
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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
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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.
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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
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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)
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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
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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
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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.
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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
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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.
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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
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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
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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.
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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.
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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
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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.
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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
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0 2 4 6 8 10
Sof
ties
(can
s)
2
4
6
8
10
Cakes
Degree of SubstitutabilityOrdinary goods
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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
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0 1 2 3 4 5
Lef
t run
ning
sho
es
1
2
3
4
5
Degree of SubstitutabilityPerfect complements
Right running shoes
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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.
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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
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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
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Predicting Consumer Behavior
What effect will changes in prices and income have on the best affordable point?
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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.
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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
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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
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Predicting Consumer Behavior
What effect will changes in Mr. MBA’s income have on the best affordable point?
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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.
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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
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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
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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.
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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.
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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
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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
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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
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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.
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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.
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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
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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
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Labour Supply
Real World Applications
• Work week declines.
• Women in the workforce.
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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
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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
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The End