Price, income &_consumption
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Transcript of 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