Consumption Choices

Consumption Choices

The Households Consumption Choice

Interlude
Predicting Consumer Behavior
Income and Substitution Effects
The Households Consumption
Choice
Lisa chooses the best affordable point at which to
consume
The best affordable point is:
On the budget line
On the highest attainable indifference curve
Lets look at Lisas choice
Choice
Summary of the properties of the best affordable
point:
It exhausts the consumer's budget--it is on the budget
line
The marginal rate of substitution--the slope of the
indifference curve--equals the relative price--the slope
of the budget line
Opportunity cost equals willingness to pay
Interlude

The Nobel Prize for Economic Science

Awarded each year in October
Prize money is $1,000,000 U.S.
Watch for the announcement of the winner of the
1997 prize!
Predicting Consumer Behavior

Generating the demand curve from a change in

price
The price effect is the change in the quantity of a
good bought that results from a change in the price
of the good, holding constant all other influences
on buying plans
Predicting Consumer Behavior

The price effect generates the demand curve

Fig. 8.8 shows an example of the price effect and
generates a demand curve
Lets look at this figure
 Predicting Consumer Behavior
Initially, pop costs
$3 and movies
cost $6
Lisa consumes at
point c, which is
her best
affordable point
 Predicting Consumer Behavior
So, when movies
cost $6, Lisa sees
2 movies a month
In this figure, she
consumes at
point a
 Predicting Consumer Behavior
With, pop
remaining at $3,
the price of a
movie falls to $3
Lisas budget line
rotates outward.
 Predicting Consumer Behavior
Her best
affordable point is
now j
Se consumes 5
pops and 5
movies
 Predicting Consumer Behavior
So, when movies
cost $3, Lisa sees
5 movies a month
In this figure, she
consumes at
point b
 Predicting Consumer Behavior
Points a and b lie
on Lisas demand
curve for movies
And Lisa has
moved along that
demand curve
Predicting Consumer Behavior

The effect of a change in income

The income effect is the change in the quantity of a
good bought that results from a change in the
consumer's income, holding constant all other
influences on buying plans
Predicting Consumer Behavior

Fig. 8.9 shows an example of the income effect

Lisa's income increases from $30 to $42
Lets look at this figure
 Predicting Consumer Behavior
Both pop and
movies cost $3
and Lisas income
is $30 a month
She consumes at
point j
 Predicting Consumer Behavior
Now, her income
falls to $21 a
month
Her budget line
shifts leftward
She now
consumes at point
k
 Predicting Consumer Behavior
Pop and movies are
normal goods
When Lisas income
falls, she consumes
less of both of these
goods
 Predicting Consumer Behavior
With a fall in
income, Lisas
demand curve for
movies shifts
leftward
Income and Substitution Effects

The price effect is the change in the quantity of a

good bought that results from a change in the price
of the good, holding constant all other influences
on buying plans
Income and Substitution Effects

We can divide the price effect into two parts:

the income effect
the substitution effect
We use this division, to prove that the demand
curve for a normal good always slopes downward
Income and Substitution Effects

The income effect is the same effect that youve

already seen.
It is change in the quantity of a good bought that
results from a change in income, holding constant
all other influences on buying plans
Income and Substitution Effects

The substitution effect is the change in the

quantity of a good bought that results from:
a change in the price of the good
a simultaneous (and hypothetical) change in the
consumer's income that makes the consumer indifferent
between the original situation and the new situation
Income and Substitution Effects

The price effect is equal to the sum of the income

effect and the substitution effect
Figure 8.10 shows the division of the price effect
into the income effect and the substitution effect.
Income and Substitution Effects
This figure
(8.10a) reviews
the price effect
that youve seen
before
Income and Substitution Effects
When the price of
a move falls from
$6 to $3, Lisa
increases her
consumption of
movies from 2 to
5 a month
Income and Substitution Effects
Lisa is better off in
the new situation
She is on a higher
indifference curve
Income and Substitution Effects
Were now going
to isolate the
substitution effect
To do so, we give
Lisa a pay cut
Income and Substitution Effects
The pay cut is
hypothetical--it
doesnt actually
happen
We cut her
income to make
her indifferent to
being at c
Income and Substitution Effects
Lisa faces the
new prices--pop
$3 and movies
$3
But we now cut
her income
Income and Substitution Effects
With the new
prices--pop $3
and movies $3--
and a lower
income, Lisas
best affordable
point is k
Income and Substitution Effects
The move from
point c to point
is k is the
substitution
effect
Income and Substitution Effects
We can predict
the direction of
the substitution
effect
Income and Substitution Effects
Because of the law
of diminishing MRS,
we know that a fall
in the price of a
good always brings
an increase in the
quantity bought
Income and Substitution Effects
This is the first step
in proving that the
demand curve
slopes downward
The second step
involves the income
effect
Income and Substitution Effects
Here, Lisas income
is $21 a month
Suppose we now
increase her income
to $30 a month and
leave prices
unchanged
Income and Substitution Effects
The change in her
consumption that
well observe is the
income effect
Income and Substitution Effects
This income effect is
exactly like the one
youve already
studies, but in
reverse
Here, we raise Lisas
income
Income and Substitution Effects
With an increase in
income, Lisa moves
from k to j
Income and Substitution Effects
Because a movie is
a normal good, Lisa
increases the
quantity of movies
when her income
increases
Income and Substitution Effects
This is the second
step in the proof
that the demand
curve for a normal
good slopes
downward
Income and Substitution Effects
The lower price of a
movie increases
Lisas real income
and increases the
quantity movies she
buys
Income and Substitution Effects
Pulling it all
together:
at $6 a movie, Lisa
is at point c
at $3 a movie and
with a fall in
income, she moves
to k k
Income and Substitution Effects
Pulling it all
together:
at $3 a movie and
income restored to
its initial level, she
moves from k to j

k
Income and Substitution Effects
The move from c to
k is the
substitution effect
The move from k to
j is the income
effect
The move from c to k

j is the price effect