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# Price, income &_consumption

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Published on: Mar 4, 2016

#### Transcripts - Price, income &_consumption

• 1. Price, Income, and Consumption Analysis
• 2. Learning Objectives <ul><li>Calculate and graph a household’s budget line </li></ul><ul><li>Work out how the budget line changes when prices or income changes </li></ul><ul><li>Make a map of preferences by using indifference curves </li></ul>
• 3. Learning Objectives (cont.) <ul><li>Explain the choices that households make </li></ul><ul><li>Predict the effects of price and income changes on consumption choices </li></ul><ul><li>Predict the effects of wage changes on work-leisure choices </li></ul>
• 4. Consumption Possibilities <ul><li>Consumption choices are limited by income and prices. </li></ul><ul><li>A budget line describes the limits to a household’s consumption choices. </li></ul>
• 5. Consumption Possibilities <ul><li>Divisible and Indivisible Goods </li></ul><ul><ul><li>Divisible goods can be bought in any quantity desired </li></ul></ul><ul><ul><ul><li>ex. Petrol </li></ul></ul></ul><ul><ul><li>Indivisible goods cannot be bought in all quantities </li></ul></ul><ul><ul><ul><li>ex. Car / A Flat / textbook </li></ul></ul></ul>
• 6. <ul><li>Consumption Cakes (Rs. 6) Softies (Rs. 3) </li></ul><ul><li>possibility (per week) (per week) </li></ul><ul><li>a 0 10 </li></ul><ul><li>b 1 8 </li></ul><ul><li>c 2 6 </li></ul><ul><li>d 3 4 </li></ul><ul><li>e 4 2 </li></ul><ul><li>f 5 0 </li></ul>The Budget Line Mr. MBA’s Income is Rs. 30
• 7. The Budget Line 0 1 2 3 4 5 6 7 8 9 10 2 4 6 8 10 Cakes (per week) Softies (per week) Unaffordable Affordable Income Rs.30 Cakes Rs.6 Softies Rs.3 a b c d e f
• 8. The Budget Equation <ul><li>The budget equation is based upon: </li></ul><ul><li>Expenditure = Income </li></ul><ul><ul><li>Rs.3Q s + Rs.6Q c = Rs.30 </li></ul></ul><ul><ul><li>Q s = 10 – 2Q c </li></ul></ul><ul><li>The quantity of Softies can be found by first setting the quantity of Cakes. </li></ul>
• 9. The Budget Equation <ul><li>Real Income is the maximum quantity of a good that a household can afford to buy. </li></ul><ul><li>Or, it is the value of money income expressed in terms of goods </li></ul><ul><ul><li>Mr. MBA’s Real Income (in terms of Softies) is: </li></ul></ul><ul><ul><ul><li>Income/Price of Softies = y/P s </li></ul></ul></ul><ul><ul><ul><li>Rs.30/Rs.3 = 10 </li></ul></ul></ul>
• 10. The Budget Equation <ul><li>Relative Price </li></ul><ul><li>A relative price is the price of one good divided by the price of another good. </li></ul><ul><li>Mr. MBA’s relative price of a Cake in terms of Softies: Rs.6/Rs.3 = 2 per Cake </li></ul><ul><li>In other words, to see one more Cake, Mr. MBA must give up 2 Softies (i.e. opportunity cost) </li></ul>
• 11. Changes in Prices and Income 0 1 2 3 4 5 6 7 8 9 10 Softies ( per week) 2 4 6 8 10 Cakes (per week) Price of a Cake is... A Change in Price a f … Rs.6 … Rs.12 … Rs.3
• 12. Changes in Prices and Income 0 1 2 3 4 5 6 7 8 9 10 Softies (per week) 2 4 6 8 10 Cakes (per week) A Change in Income a f Income Rs.30 Income Rs.15
• 13. Preferences and Indifference Curves <ul><li>Between two alternatives A and B, there can be maximum of three possibilities </li></ul><ul><ul><li>A is preferred to B </li></ul></ul><ul><ul><li>B is preferred to A </li></ul></ul><ul><ul><li>Consumer is indifferent between A and B </li></ul></ul><ul><li>An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. </li></ul>
• 14. A Preference Map 0 2 4 6 8 10 Softies (per week) 2 4 6 8 10 Cakes (per week) g c An indifference curve Preferred Not preferred
• 15. A Preference Map <ul><li>A preference map is a series of indifference curves. </li></ul><ul><li>A preference map consists of an infinite number of indifference curves; each one slopes downward, and none of them intersects. </li></ul>
• 16. A Preference Map I 1 0 2 4 6 8 10 Softies (per week) 2 4 6 8 10 Cakes (per week) g c j I 2 I 0
• 17. Learning Objectives (cont.) <ul><li>Explain the choices that households make </li></ul><ul><li>Predict the effects of price and income changes on consumption choices </li></ul><ul><li>Predict the effects of wage changes on work-leisure choices </li></ul>
• 18. Marginal Rate of Substitution <ul><li>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. </li></ul>
• 19. Marginal Rate of Substitution <ul><li>The MRS is measured by the slope of an indifference curve. </li></ul><ul><ul><li>Steep indifference curves have a high MRS. </li></ul></ul><ul><ul><li>Flat indifference curves have a low MRS. </li></ul></ul>
• 20. Marginal Rate of Substitution 0 2 4 6 8 10 Softies (per week) 2 4 6 8 10 Cakes (per week) I 1 c g MRS = 2 MRS = 1/2
• 21. Marginal Rate of Substitution <ul><li>Note: </li></ul><ul><li>As the consumption of Cakes increases, the MRS decreases. </li></ul><ul><ul><li>This is referred to as the diminishing marginal rate of substitution. </li></ul></ul>
• 22. The Degree of Substitutability <ul><li>The shape of the indifference curves reveals the degree of substitutability between two goods. </li></ul><ul><li>Three typical shapes can be considered here </li></ul><ul><li>Convex curves (higher/ lower convexity) </li></ul><ul><li>Downward sloping Straight lines </li></ul><ul><li>Right Angled lines </li></ul>
• 23. Degree of Substitutability 0 2 4 6 8 10 Softies (cans) 2 4 6 8 10 Cakes Ordinary goods
• 24. Degree of Substitutability 0 2 4 6 8 10 Marker pens at the local supermarket 2 4 6 8 10 Perfect substitutes Marker pens at the campus bookstore
• 25. Degree of Substitutability 0 1 2 3 4 5 Left running shoes 1 2 3 4 5 Perfect complements Right running shoes
• 26. Predicting Consumer Behavior <ul><li>Individuals maximize their utility given their income budget line when they: </li></ul><ul><ul><li>Are on their their highest attainable indifference curve. </li></ul></ul><ul><ul><li>Have a marginal rate of substitution between the two goods equal to their relative price. </li></ul></ul>
• 27. The Best Affordable Point 0 2 4 6 8 10 Softies (per week) 2 4 6 8 10 Cakes (per week) h f 1 i I 1 Best affordable point I 2 I 0 c
• 28. Learning Objectives (contd..) <ul><li>Explain the choices that households make </li></ul><ul><li>Predict the effects of price and income changes on consumption choices </li></ul><ul><li>Predict the effects of wage changes on work-leisure choices </li></ul>
• 29. Predicting Consumer Behavior <ul><li>What effect will changes in prices and income have on the best affordable point? </li></ul>
• 30. A Change in Price <ul><li>Price effect </li></ul><ul><ul><li>The effect of a change in price on quantity of a good consumed. </li></ul></ul><ul><ul><li>A change in the price of a good will shift the budget line and will change the best affordable combination. </li></ul></ul>
• 31. Price Effect and Demand Curve 0 2 4 6 8 10 Softies (per week) 2 4 6 8 10 Cakes (per week) I 1 I 2 5 5 Best affordable point: Cakes Rs.6 c Best affordable point: Cakes Rs.3 j
• 32. Price Effect and Demand Curve 0 2 4 6 8 10 1 2 3 4 5 Cakes (per week) 6 Mr. MBA’s demand curve for Cakes a b Price (Rs. per Cake) 5
• 33. Predicting Consumer Behavior <ul><li>What effect will changes in Mr. MBA’s income have on the best affordable point? </li></ul>
• 34. A Change in Income <ul><li>Income effect </li></ul><ul><ul><li>The effect of a change in income on consumption. </li></ul></ul><ul><ul><li>A change in income will shift the budget line and will change the best affordable combination. </li></ul></ul>
• 35. Income Effect and Change in Demand 0 2 4 6 8 10 Softies (per week) 2 4 6 8 10 Cakes (per week) 3 I 2 I 1 Income Rs.30 Income Rs.21 j
• 36. Income Effect and Change in Demand 0 2 4 6 8 10 Price (Rs. per Cake) 1 2 3 4 5 Cakes (per week) 6 D 0 b D 1 c
• 37. Substitution Effect and Income Effect <ul><li>Substitution effect </li></ul><ul><li>The effect of a change in price on the quantity bought when the consumer (hypothetically) remains indifferent between the original and the new situation. </li></ul>
• 38. Substitution Effect and Income Effect <ul><li>Income effect </li></ul><ul><li>The change in consumption that results from a change in the consumer’s income, ceteris paribus. </li></ul><ul><li>The substitution and income effects can be calculated using the indifference curves and budget line. </li></ul>
• 39. Substitution Effect and Income Effect 0 2 4 6 8 10 Softies (per week) 2 4 6 8 10 Cakes (per week) I 1 I 2 Price Effect 5 5 c j Income Rs.30 Cakes Rs.3 Income Rs.30 Cakes Rs.6
• 40. Substitution Effect and Income Effect 0 2 4 6 8 10 Softies (per week) 2 4 6 8 10 Cakes (per week) I 1 I 2 5 5 3 7 Substitution effect and price effect c j k Income effect Substitution effect Substitution effect
• 41. Learning Objectives (cont.) <ul><li>Explain the choices that households make </li></ul><ul><li>Predict the effects of price and income changes on consumption choices </li></ul><ul><li>Predict the effects of wage changes on work-leisure choices </li></ul>
• 42. Work-Leisure Choices <ul><li>Households must also make choices on how to allocate their time between labour and leisure . </li></ul><ul><li>More leisure means less income. We buy leisure by foregoing income. </li></ul><ul><li>The relationship between leisure and income is described by the income-time budget line. </li></ul>
• 43. Work-Leisure Choices <ul><li>As wage rates increase, people substitute Labour for leisure — substitution effect . </li></ul><ul><li>However, higher wage rates lead to higher income which causes people to shift toward more leisure — income effect . </li></ul>
• 44. The Supply of Labour Leisure (hours per week) 100 168 Income (Rs. per week) 0 350 I 1 133 138 148 100 450 Z Time allocation decision Rs.5 Rs.10 I 0 a I 2 I 1 Rs.15 b c
• 45. The Supply of Labour Labour (hour per week) Wage rate (Rs. per hour) 0 20 30 35 5 10 15 LS a b c
• 46. Labour Supply <ul><li>Real World Applications </li></ul><ul><ul><li>Work week declines. </li></ul></ul><ul><ul><li>Women in the workforce. </li></ul></ul>
• 47. Merits of IC over Utility Analysis <ul><li>Better approach (ordinal) to measure utility </li></ul><ul><li>No controversy of constancy of MU of Money </li></ul><ul><li>Explains better how the price effect can be decomposed </li></ul><ul><li>Helps to understand the nature of goods as substitutes / complements </li></ul>
• 48. Limitations of IC Analysis <ul><li>Not all consumers are capable of equating the MRS with price ratio for equilibrium </li></ul><ul><li>Buying in many cases takes place more as custom/ habit and price changes (particularly smaller) tend to get ignored. </li></ul><ul><li>Indivisibility of commodities prevent precise price adjustments </li></ul><ul><li>For many consumers, lack of time and patience </li></ul>
• 49. The End