Consumption Decision: Budget Constraints & Preferences

• The lecture notes are about the consumption decision, covering budget constraints, preferences, optimization, and income/substitution effects
• The objectives are to look at how consumers make choices, why choices are made, how consumers should respond to price changes, and what income/substitution effects are

Outline of Unit 2

• The budget constraint looks what a consumer can afford
• Studying preferences looks at what the consumer wants
• Optimization looks at what the consumer chooses
• Income and substitution effects
• Two applications

The Budget Constraint

• Spending is constrained relative to income, so people consume less than they desire
• The budget constraint is the limit of consumption bundles that a consumer can afford

Preferences

• A consumer chooses the bundle that best suits his/her tastes when offered two different bundles
• Indifference between two bundles happens when they suit his/her tastes equally well

Properties of Indifference Curves

• An indifference curve shows the combinations of consumption that make the consumer equally happy
• Consumers are indifferent among combinations on the same indifference curve
• Consumers prefer some indifference curves to others
• Indifference curves can rank any two bundles of goods and give a ranking of the consumer's preferences
• Higher indifference curves are preferred over lower ones
• Indifference curves are downward sloping
• Indifference curves do not cross
• Indifference curves are also bowed inward

Marginal Rate of Substitution

• The marginal rate of substitution is the rate at which a consumer is willing to trade one good for another

Optimization

• At the optimum, the indifference curve's slope equals the budget constraint's slope
• The indifference curve is tangent to the budget constraint
• Consumption of the two goods is chosen so that the marginal rate of substitution equals the relative price

Factors Affecting Consumer Choice

• Income changes affect the consumer’s choice
• Price changes also affect the consumer's choice

Normal Good

• A normal good is a good for which an increase in income raises the quantity demanded

Inferior Good

• An inferior good is a good for which an increase in income reduces the quantity demanded

Price Changes

• A fall in the price of any good shifts the budget constraint outward
• When one good's price changes relative to another, the slope of the budget constraint changes

Income and Substitution Effects

• The impact of a change in the price of a good can be decomposed into two effects: an income effect and a substitution effect
• Income Effect: The income effect is the effect of a change in purchasing power (with no change in relative price) on the quantities of commodities consumed
• Substitution Effect: The substitution effect is the effect of a change in relative price (with no change in welfare) on the quantities of commodities consumed

Price of Pepsi Falls

• Income effect: as the consumer is richer, so he buys more Pepsi
• Substitution Effect: as Pepsi is relatively cheaper, so the consumer buys more Pepsi
• Total Effect: Income and substitution effects act in the same direction, so the consumer buys more Pepsi

Income and Substitution Effects

• Income effect involves a price change that moves the consumer to a higher/lower indifference curve, resulting in a change in consumption
• Substitution effect: involves a price change that moves the consumer along a given indifference curve to a point, with a new marginal rate of substitution that results in a change in consumption

Applications

• When the price of taxis goes up, do you spend more or spend less on eating out?
• Income effect leads to less eating out and increased taxi consumption as taxis now take up more of your budget
• Substitution effect leads to more eating out as it is now relatively cheaper
• An increase in the absolute price of taxis leads to taxis being dearer and eating out being cheaper
• The combined income and substitution effects result in a downward sloping demand curve

Studying

• If you make better progress while studying, do you study more or take more time off?
• There are 10 hours to spend reviewing for the final studying and 3 pages can be reviewed per hours
• At 3 pages reviewed per hour more reviews are completed
• If 4 pages can be reviewed more reviews are completed and greater scores are achieved