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Unformatted text preview: 9160335_CH08_p169-188.qxd 6/22/09 9:00 AM Page 169 8 Possibilities, Preferences, and Choices After studying this chapter, y ou will be able to: ■ Describe a household’s budget line and show how it changes when prices or income change ■ Use indifference curves to map preferences and explain the principle of diminishing marginal rate of substitution ■ Predict the effects of changes in prices and income on consumption choices ■ Predict the effects of changes in wage rates on workleisure choices You buy your music online and play it on an iPod. And as the prices of a music download and an iPod have tumbled, the volume of downloads and sales of iPods have skyrocketed. But a similar change hasn’t occurred in the way we buy and read books. Sure, electronic textbooks—e-books—are widely available, and their prices have fallen. At the same time, the prices of old-tech, printed paper books have risen. Yet most it once was, far more people now have jobs. Why has the students continue to buy printed textbooks. Why, when e-books average workweek declined? are cheaper than printed books, have e-books not caught on In this chapter, we’re going to study a model of choice and replaced printed books in the same way that the new music that predicts the effects of changes in prices and incomes technologies have replaced physical discs? on what people buy and the effects of changes in wage Dramatic changes have occurred in the way we spend our rates on how people allocate their time between leisure and time. The average workweek has fallen steadily from 70 work. At the end of the chapter, in Reading Between the hours a week in the nineteenth century to 35 hours a week Lines, we use the model to explain why e-books are having today. While the average workweek is now much shorter than a hard time replacing printed books. 169 9160335_CH08_p169-188.qxd 170 6/22/09 9:00 AM Page 170 CHAPTER 8 Possibilities, Preferences, and Choices ◆ Consumption Possibilities Divisible and Indivisible Goods Some goods— called divisible goods—can be bought in any quantity desired. Examples are gasoline and electricity. We can best understand household choice if we suppose that all goods and services are divisible. For example, Lisa can see half a movie a month on average by seeing one movie every two months. When we think of goods as being divisible, the consumption possibilities are not only the points A through F shown in Fig. 8.1, but also all the intermediate points that form the line running from A to F. This line is Lisa’s budget line. Affordable and Unaffordable Quantities Lisa’s budget line is a constraint on her choices. It marks the boundary between what is affordable and what is unaffordable. She can afford any point on the line and inside it. She cannot afford any point outside the line. The constraint on her consumption depends on the prices and her income, and the constraint changes when the price of a good or her income changes. To see how, we use a budget equation. Soda (cases per month) Consumption choices are limited by income and by prices. A household has a given amount of income to spend and cannot influence the prices of the goods and services it buys. A household’s budget line describes the limits to its consumption choices. Let’s look at Lisa’s budget line.* Lisa has an income of $40 a month to spend. She buys two goods: movies and soda. The price of a movie is $6, and the price of soda is $4 a case. Figure 8.1 shows alternative combinations of movies and soda that Lisa can afford. In row A, she sees no movies and buys 10 cases of soda. In row F, she sees 5 movies and buys no soda. Both of these combinations of movies and soda exhaust the $40 available. Check that the combination of movies and soda in each of the other rows also exhausts Lisa’s $40 of income. The numbers in the table and the points A through F in the graph describe Lisa’s consumption possibilities. The Budget Line FIGURE 8.1 10 A Income $40 Movies $8 each Soda $4 a case B 8 C 6 Unaffordable D 4 Affordable E 2 Budget line F 0 1 2 3 4 5 6 7 8 9 10 Movies (per month) Consumption possibility Movies Soda (per month) (cases per month) A 0 10 B 1 8 C 2 6 D 3 4 E 4 2 F 5 0 Lisa’s budget line shows the boundary between what she can and cannot afford. The rows of the table list Lisa’s affordable combinations of movies and soda when her income is $40, the price of soda is $4 a case, and the price of a movie is $8. For example, row A tells us that Lisa spends all of her $40 income when she buys 10 cases of soda and sees no movies. The figure graphs Lisa’s budget line. Points A through F in the graph represent the rows of the table. For divisible goods, the budget line is the continuous line AF. To calculate the equation for Lisa’s budget line, start with expenditure equal to income: $4QS + $8QM = $40. Divide by $4 to obtain QS + 2QM = 10. * If you have studied Chapter 7 on marginal utility theory, you have already met Lisa. This tale of her thirst for soda and zeal for movies will sound familiar to you—up to a point. But in this chapter, we’re going to use a different method for representing preferences—one that does not require the idea of utility. Subtract 2QM from both sides to obtain QS = 10 - 2QM. animation 9160335_CH08_p169-188.qxd 6/22/09 9:00 AM Page 171 Consumption Possibilities Budget Equation We can describe the budget line by using a budget equation. The budget equation starts with the fact that Expenditure = Income. Expenditure is equal to the sum of the price of each good multiplied by the quantity bought. For Lisa, Expenditure = 1Price of soda * Quantity of soda2 + 1Price of movie * Quantity of movies2. Call the price of soda PS, the quantity of soda QS, the price of a movie PM, the quantity of movies QM, and income Y. We can now write Lisa’s budget equation as PSQS PMQM Y. Or, using the prices Lisa faces, $4 a case of soda and $8 a movie, and Lisa’s income, $40, we get $4QS + $8QM = $40. Lisa can choose any quantities of soda (QS) and movies (QM) that satisfy this equation. To find the relationship between these quantities, divide both sides of the equation by the price of soda (PS) to get PM PS QS QM Y . PS Now subtract the term PM/PS × QM from both sides of this equation to get Y PS QS PM PS QM. For Lisa, income (Y ) is $40, the price of a movie (PM) is $8, and the price of soda (PS) is $4 a case. So Lisa must choose the quantities of movies and soda to satisfy the equation QS = $8 $40 * QM, $4 $4 or QS 10 2QM. To interpret the equation, look at the budget line in Fig. 8.1 and check that the equation delivers that budget line. First, set QM equal to zero. The budget equation tells us that QS, the quantity of soda, is Y/PS, which is 10 cases. This combination of QM and QS is the one shown in row A of the table in Fig. 8.1. Next set QM equal to 5. QS now equals zero (row F of the table). Check that you can derive the other rows. 171 The budget equation contains two variables chosen by the household (QM and QS) and two variables that the household takes as given (Y/PS and PM/PS). Let’s look more closely at these variables. Real Income A household’s real income is its income expressed as a quantity of goods that the household can afford to buy. Expressed in terms of soda, Lisa’s real income is Y/PS. This quantity is the maximum quantity of soda that she can buy. It is equal to her money income divided by the price of soda. Lisa’s money income is $40 and the price of soda is $4 a case, so her real income in terms of soda is 10 cases, which is shown in Fig. 8.1 as the point at which the budget line intersects the y-axis. Relative Price A relative price is the price of one good divided by the price of another good. In Lisa’s budget equation, the variable PM/PS is the relative price of a movie in terms of soda. For Lisa, PM is $8 a movie and PS is $4 a case, so PM/PS is equal to 2 cases of soda per movie. That is, to see 1 movie, Lisa must give up 2 cases of soda. You’ve just calculated Lisa’s opportunity cost of seeing a movie. Recall that the opportunity cost of an action is the best alternative forgone. For Lisa to see 1 more movie a month, she must forgo 2 cases of soda. You’ve also calculated Lisa’s opportunity cost of soda. For Lisa to buy 2 more cases of soda a month, she must forgo seeing 1 movie. So her opportunity cost of 2 cases of soda is 1 movie. The relative price of a movie in terms of soda is the magnitude of the slope of Lisa’s budget line. To calculate the slope of the budget line, recall the formula for slope (see the Chapter 1 Appendix): Slope equals the change in the variable measured on the y-axis divided by the change in the variable measured on the x-axis as we move along the line. In Lisa’s case (Fig. 8.1), the variable measured on the y-axis is the quantity of soda and the variable measured on the x-axis is the quantity of movies. Along Lisa’s budget line, as soda decreases from 10 to 0 cases, movies increase from 0 to 5. So the magnitude of the slope of the budget line is 10 cases divided by 5 movies, or 2 cases of soda per movie. The magnitude of this slope is exactly the same as the relative price we’ve just calculated. It is also the opportunity cost of a movie. A Change in Prices When prices change, so does the budget line. The lower the price of the good measured on the x-axis, other things remaining the same, the flatter is the budget line. For example, if the price of a movie falls from $8 to $4, real income 9160335_CH08_p169-188.qxd 6/22/09 Page 172 CHAPTER 8 Possibilities, Preferences, and Choices 172 Changes in Prices and Income FIGURE 8.2 Soda (cases per month) 9:00 AM 10 A Price of a movie is … 9 8 7 6 5 4 3 2 1 ... $16 ... $8 ... $4 F 0 1 2 3 4 5 6 7 89 10 Movies (per month) Soda (cases per month) (a) A change in price 10 A 9 8 in terms of soda does not change but the relative price of a movie falls. The budget line rotates outward and becomes flatter, as Fig. 8.2(a) illustrates. The higher the price of the good measured on the xaxis, other things remaining the same, the steeper is the budget line. For example, if the price of a movie rises from $8 to $16, the relative price of a movie increases. The budget line rotates inward and becomes steeper, as Fig. 8.2(a) illustrates. A Change in Income A change in money income changes real income but does not change the relative price. The budget line shifts, but its slope does not change. An increase in money income increases real income and shifts the budget line rightward. A decrease in money income decreases real income and shifts the budget line leftward. Figure 8.2(b) shows the effect of a change in money income on Lisa’s budget line. The initial budget line when Lisa’s income is $40 is the same as in Fig. 8.1. The new budget line shows how much Lisa can buy if her income falls to $20 a month. The two budget lines have the same slope because the relative price is the same. The new budget line is closer to the origin because Lisa’s real income has decreased. Review Quiz ◆ 7 6 1 5 2 4 3 3 Income $20 2 Income $40 1 F 0 1 2 3 4 5 Movies (per month) (b) A change in income In part (a), the price of a movie changes. A fall in the price from $8 to $4 rotates the budget line outward and makes it flatter. A rise in the price from $8 to $16 rotates the budget line inward and makes it steeper. In part (b), income falls from $40 to $20 while the prices of movies and soda remain the same. The budget line shifts leftward, but its slope does not change. animation 4 5 What does a household’s budget line show? How does the relative price and a household’s real income influence its budget line? If a household has an income of $40 and buys only bus rides at $2 each and magazines at $4 each, what is the equation of the household’s budget line? If the price of one good changes, what happens to the relative price and the slope of the household’s budget line? If a household’s money income changes and prices do not change, what happens to the household’s real income and budget line? Work Study Plan 8.1 and get instant feedback. We’ve studied the limits to what a household can consume. Let’s now learn how we can describe preferences and make a map that contains a lot of information about a household’s preferences. 9160335_CH08_p169-188.qxd 6/22/09 9:00 AM Page 173 Preferences and Indifference Curves ◆ Preferences and Soda (cases per month) You are going to discover a very neat idea: that of drawing a map of a person’s preferences. A preference map is based on the intuitively appealing idea that people can sort all the possible combinations of goods into three groups: preferred, not preferred, and indifferent. To make this idea more concrete, let’s ask Lisa to tell us how she ranks various combinations of movies and soda. Figure 8.3 shows part of Lisa’s answer. She tells us that she currently sees 2 movies and buys 6 cases of soda a month at point C. She then lists all the combinations of movies and soda that she says are just as acceptable to her as her current situation. When we plot these combinations of movies and soda, we get the green curve in Fig. 8.3(a). This curve is the key element in a preference map and is called an indifference curve. An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. The indifference curve in Fig. 8.3(a) tells us that Lisa is just as happy to see 2 movies and buy 6 cases of soda a month at point C as she is to have the combination of movies and soda at point G or at any other point along the curve. Lisa also says that she prefers all the combinations of movies and soda above the indifference curve in Fig. 8.3(a)—the yellow area—to those on the indifference curve. And she prefers any combination on the indifference curve to any combination in the gray area below the indifference curve. The indifference curve in Fig. 8.3(a) is just one of a whole family of such curves. This indifference curve appears again in Fig. 8.3(b), labeled I1. The curves labeled I0 and I2 are two other indifference curves. Lisa prefers any point on indifference curve I2 to any point on indifference curve I1, and she prefers any point on I1 to any point on I0. We refer to I2 as being a higher indifference curve than I1 and I1 as being higher than I0. A preference map is a series of indifference curves that resemble the contour lines on a map. By looking at the shape of the contour lines on a map, we can draw conclusions about the terrain. Similarly, by looking at the shape of the indifference curves, we can draw conclusions about a person’s preferences. Let’s learn how to “read” a preference map. A Preference Map 10 8 Preferred C 6 4 2 0 G Not preferred 2 4 6 Indifference curve 8 10 Movies (per month) (a) An indifference curve Soda (cases per month) Indifference Curves FIGURE 8.3 173 10 8 6 C J 4 2 0 G 2 4 6 I2 I1 I0 8 10 Movies (per month) (b) Lisa's preference map Part (a) shows one of Lisa’s indifference curves. She is indifferent between point C (with 2 movies and 6 cases of soda) and all other points on the green indifference curve, such as G. She prefers points above the indifference curve (in the yellow area) to points on it, and she prefers points on the indifference curve to points below it (in the gray area). Part (b) shows three of the indifference curves—I0, I1, and I2—in Lisa’s preference map. She prefers point J to point C or G, and she prefers all the points on I2 to those on I1. animation 9160335_CH08_p169-188.qxd 174 6/22/09 9:00 AM Page 174 CHAPTER 8 Possibilities, Preferences, and Choices Marginal Rate of Substitution Soda (cases per month) The marginal rate of substitution (MRS ) is the rate at which a person will give up good y (the good measured on the y-axis) to get an additional unit of good x (the good measured on the x-axis) while remaining indifferent (remaining on the same indifference curve). The magnitude of the slope of an indifference curve measures the marginal rate of substitution. ■ If the indifference curve is steep, the marginal rate of substitution is high. The person is willing to give up a large quantity of good y to get an additional unit of good x while remaining indifferent. ■ If the indifference curve is flat, the marginal rate of substitution is low. The person is willing to give up a small amount of good y to get an additional unit of good x while remaining indifferent. Figure 8.4 shows you how to calculate the marginal rate of substitution. At point C on indifference curve I1, Lisa buys 6 cases of soda and sees 2 movies. Her marginal rate of substitution is the magnitude of the slope of the indifference curve at point C. To measure this magnitude, place a straight line against, or tangent to, the indifference curve at point C. Along that line, as the quantity of soda decreases by 10 cases, the number of movies increases by 5—or 2 cases per movie. At point C, Lisa is willing to give up soda for movies at the rate of 2 cases per movie—a marginal rate of substitution of 2. At point G on indifference curve I1, Lisa buys 1.5 cases of soda and sees 6 movies. Her marginal rate of substitution is measured by the slope of the indifference curve at point G. That slope is the same as the slope of the tangent to the indifference curve at point G. Now, as the quantity of soda decreases by 4.5 cases, the number of movies increases by 9—or 1/2 case per movie. At point G, Lisa is willing to give up soda for movies at the rate of 1/2 case per movie—a marginal rate of substitution of 1/2. As Lisa sees more movies and buys less soda, her marginal rate of substitution diminishes. Diminishing marginal rate of substitution is the key assumption about preferences. A diminishing marginal rate of substitution is a general tendency for a person to be willing to give up less of good y to get one more unit of good x, while at the same time remaining indifferent as the quantity of x increases. In Lisa’s case, she is less willing to give up soda to see one more movie as the number of movies she sees increases. The Marginal Rate of Substitution FIGURE 8.4 10.0 MRS = 2 C 6.0 4.5 1 MRS = – 2 G 1.5 I1 0 5 2 6 9 Movies (per month) The magnitude of the slope of an indifference curve is called the marginal rate of substitution (MRS). The red line at point C tells us that Lisa is willing to give up 10 cases of soda to see 5 movies. Her marginal rate of substitution at point C is 10 divided by 5, which equals 2. The red line at point G tells us that Lisa is willing to give up 4.5 cases of soda to see 9 movies. Her marginal rate of substitution at point G is 4.5 divided by 9, which equals 1/2. animation Your Own Diminishing Marginal Rate of Substitution Think about your own diminishing marginal rate of substitution. Imagine that in a week, you drink 10 cases of soda and see no movies. Most likely, you are willing to give up a lot of soda so that you can see just 1 movie. But now imagine that in a week, you buy 1 case of soda and see 6 movies. Most likely, you will now not be willing to give up much soda to see a seventh movie. As a general rule, the greater the number of movies you see, the smaller is the quantity of soda you are willing to give up to see one additional movie. The shape of a person’s indifference curves incorporates the principle of the diminishing marginal rate of substitution because the curves are bowed toward the origin. The tightness of the bend of an indifference curve tells us how willing a person is to substitute one good for another while remaining indifferent. Let’s look at some examples that make this point clear. 9160335_CH08_p169-188.qxd 6/22/09 9:00 AM Page 175 Preferences and Indifference Curves Degree of Substitutability Most of us would not regard movies and soda as being close substitutes, but they are substitutes. No matter how much you love soda, some increase in the number of movies you see will compensate you for being deprived of a can of soda. Similarly, no matter how much you love going to the movies, some number of cans of soda will compensate you for being deprived of seeing one movie. A person’s indifference curves for movies and soda might look something like those for most ordinary goods and services shown in Fig. 8.5(a). Close Substitutes Some goods substitute so easily for each other that most of us do not even notice which we are consuming. The different brands of marker pens and pencils are examples. Most people don’t care which brand of these items they use or where they buy them. A marker pen from the campus bookstore is just as good as one from the local grocery store. You would be willing to forgo a pen from the campus store if you could get one more pen from Complements Some goods do not substitute for each other at all. Instead, they are complements. The complements in Fig. 8.5(c) are left and right running shoes. Indifference curves of perfect complements are L-shaped. One left running shoe and one right running shoe are as good as one left shoe and two right shoes. Having two of each is preferred to having one of each, but having two of one and one of the other is no better than having one of each. The extreme cases of perfect substitutes and perfect complements shown here don’t often happen in reality, but they do illustrate that the shape of the indifference curve shows the degree of substitutability between two goods. The closer the two goods are to perfect substitutes, the closer the marginal rate of substitution is to being constant (a straight line), rather than diminishing (a curved line). Indifference Ordinary goods 8 6 4 2 4 6 (a) Ordinary goods 8 10 Movies 10 Perfect substitutes 8 5 Perfect complements 4 6 3 4 2 2 1 0 4 2 6 8 10 Marker pens at the campus bookstore (b) Perfect substitutes The shape of the indifference curves reveals the degree of substitutability between two goods. Part (a) shows the indifference curves for two ordinary goods: movies and soda. To drink less soda and remain indifferent, one must see more movies. The number of movies that compensates for a reduction in soda increases as less soda is consumed. Part (b) shows the indifference curves for two perfect substitutes. For animation Left running shoes Marker pens at the local grocery store Pop (cans) 10 2 the local grocery store. When two goods are perfect substitutes, their indifference curves are straight lines that slope downward, as Fig. 8.5(b) illustrates. The marginal rate of substitution is constant. The Degree of Substitutability FIGURE 8.5 0 175 0 1 2 3 4 5 Right running shoes (c) Perfect complements the consumer to remain indifferent, one fewer marker pen from the local grocer y store must be replaced by one extra marker pen from the campus bookstore. Part (c) shows two perfect complements—goods that cannot be substituted for each other at all. Having two left running shoes with one right running shoe is no better than having one of each. But having two of each is preferred to having one of each. 9160335_CH08_p169-188.qxd 176 6/22/09 9:00 AM Page 176 CHAPTER 8 Possibilities, Preferences, and Choices ◆ Predicting Consumer Choices We are now going to predict the quantities of movies and soda that Lisa chooses to buy. We’re also going to see how these quantities change when a price changes or when Lisa’s income changes. Finally, we’re going to see how the substitution effect and the income effect, two ideas that you met in Chapter 3 (see p. 55), guarantee that for a normal good, the demand curve slopes downward. Best Affordable Choice white or a Coke.” © The New Yorker Collection 1988 Robert Weber from cartoonbank.com. All Rights Reserved. curves for poor substitutes are tightly curved and lie between the shapes of those shown in Figs. 8.5(a) and 8.5(c). As you can see in the cartoon, according to the waiter’s preferences, Coke and Alsatian white wine are perfect substitutes and each is a complement of pork. We hope the customers agree with him. Review Quiz ◆ 1 2 3 4 What is an indifference curve and how does a preference map show preferences? Why does an indifference curve slope downward and why is it bowed toward the origin? What do we call the magnitude of the slope of an indifference curve? What is the key assumption about a consumer’s marginal rate of substitution? Work Study Plan 8.2 and get instant feedback. The two components of the model of household choice are now in place: the budget line and the preference map. We will now use these components to work out a household’s choice and to predict how choices change when prices and income change. The Best Affordable Choice FIGURE 8.6 Soda (cases per month) “With the pork I’d recommend an Alsatian When Lisa makes her best affordable choice of movies and soda, she spends all her income and is on her highest attainable indifference curve. Figure 8.6 illustrates this choice: The budget line is from Fig. 8.1 and the indifference curves are from Fig. 8.3(b). Lisa’s best affordable choice is 2 movies and 6 cases of soda at point C—the best affordable point. 10 Best affordable point F 8 6 5 C I 4 H 2 I2 I1 I0 0 2 4 6 8 10 Movies (per month) Lisa’s best affordable choice is at point C, the point on her budget line and on her highest attainable indifference curve. At point C, Lisa’s marginal rate of substitution between movies and soda (the magnitude of the slope of the indifference curve I1) equals the relative price of movies and soda (the slope of the budget line). animation 9160335_CH08_p169-188.qxd 6/22/09 9:00 AM Page 177 Predicting Consumer Choices On the Highest Attainable Indifference Curve Every Price Effect and Demand Curve FIGURE 8.7 Soda (cases per month) On the Budget Line The best affordable point is on the budget line. For every point inside the budget line, such as point I, there are points on the budget line that Lisa prefers. For example, she prefers all the points on the budget line between F and H to point I, so she chooses a point on the budget line. 177 10 point on the budget line lies on an indifference curve. For example, points F and H lie on the indifference curve I0. By moving along her budget line from either F or H toward C, Lisa reaches points on ever higher indifference curves that she prefers to points F or H. When Lisa gets to point C, she is on the highest attainable indifference curve. Best affordable point: movies $8 8 C 6 Best affordable point: movies $4 J 4 I2 2 I1 Marginal Rate of Substitution Equals Relative Price Let’s now see how Lisa’s choices change when a price changes. A Change in Price The effect of a change in the price on the quantity of a good consumed is called the price effect. We will use Fig. 8.7(a) to work out the price effect of a fall in the price of a movie. We start with the price of a movie at $8, the price of soda at $4 a case, and Lisa’s income at $40 a month. In this situation, she buys 6 cases of soda and sees 2 movies a month at point C. Now suppose that the price of a movie falls to $4. With a lower price of a movie, the budget line rotates outward and becomes flatter. The new budget line is the darker orange one in Fig. 8.7(a). For a refresher on how a price change affects the budget line, check back to Fig. 8.2(a). Lisa’s best affordable point is now point J, where she sees 6 movies and drinks 4 cases of soda. Lisa drinks less soda and watches more movies now that movies are cheaper. She cuts her soda purchases from 6 to 4 cases and increases the number of movies she sees from 2 to 6 a month. When the price of a movie falls and the price of soda and her income remain constant, Lisa substitutes movies for soda. 0 1 2 3 4 5 6 7 8 9 10 Movies (per month) (a) Price effect Price (dollars per movie) At point C, Lisa’s marginal rate of substitution between movies and soda (the magnitude of the slope of the indifference curve) is equal to the relative price of movies and soda (the magnitude of the slope of the budget line). Lisa’s willingness to pay for a movie equals her opportunity cost of a movie. A 8 6 B 4 Lisa’s demand curve for movies 2 0 1 2 3 4 5 6 7 8 9 10 Movies (per month) (b) Demand curve Initially, Lisa’s best affordable point is C in part (a). If the price of a movie falls from $8 to $4, Lisa’s best affordable point is J. The move from C to J is the price effect. At a price of $8 a movie, Lisa sees 2 movies a month, at point A in part (b). At a price of $4 a movie, she sees 6 movies a month, at point B. Lisa’s demand curve for movies traces out her best affordable quantity of movies as the price of a movie varies. animation 9160335_CH08_p169-188.qxd 178 6/22/09 9:00 AM Page 178 CHAPTER 8 Possibilities, Preferences, and Choices The Demand Curve In Chapter 3, we asserted A Change in Income The effect of a change in income on buying plans is called the income effect. Let’s work out the income effect by examining how buying plans change when income changes and prices remain constant. Figure 8.8 shows the income effect when Lisa’s income falls. With an income of $40, the price of a movie at $4, and the price of soda at $4 a case, Lisa’s best affordable point is J—she buys 6 movies and 4 cases of soda. If her income falls to $28, her best affordable point is K—she sees 4 movies and buys 3 cases of soda. When Lisa’s income falls, she buys less of both goods. Movies and soda are normal goods. The Demand Curve and the Income Effect A change in income leads to a shift in the demand curve, as shown in Fig. 8.8(b). With an income of $40, Lisa’s demand curve for movies is D0, the same as in Fig. 8.7(b). But when her income falls to $28, she plans to see fewer movies at each price, so her demand curve shifts leftward to D1. Income Effect and Change in Demand Soda (cases per month) F IGURE 8.8 10 8 Income $40 6 J 4 K 3 2 I2 Income $28 I1 0 1 2 4 3 5 6 7 8 9 10 Movies (per month) (a) Income effect Price (dollars per movie) that the demand curve slopes downward. We can now derive a demand curve from a consumer’s budget line and indifference curves. By doing so, we can see that the law of demand and the downward-sloping demand curve are consequences of a consumer’s choosing her or his best affordable combination of goods. To derive Lisa’s demand curve for movies, lower the price of a movie and find her best affordable point at different prices. We’ve just done this for two movie prices in Fig. 8.7(a). Figure 8.7(b) highlights these two prices and two points that lie on Lisa’s demand curve for movies. When the price of a movie is $8, Lisa sees 2 movies a month at point A. When the price falls to $4, she increases the number of movies she sees to 6 a month at point B. The demand curve is made up of these two points plus all the other points that tell us Lisa’s best affordable quantity of movies at each movie price, with the price of soda and Lisa’s income remaining the same. As you can see, Lisa’s demand curve for movies slopes downward—the lower the price of a movie, the more movies she sees. This is the law of demand. Next, let’s see how Lisa changes her purchases of movies and soda when her income changes. 8 6 4 B C 2 D0 D1 0 1 2 3 4 5 6 7 8 9 10 Movies (per month) (b) Demand curve for movies A change in income shifts the budget line, changes the best affordable point, and changes demand. In part (a), when Lisa’s income decreases from $40 to $28, she sees fewer movies and buys less soda. In part (b), when Lisa’s income is $40, her demand curve for movies is D0. When Lisa’s income falls to $28, her demand curve for movies shifts leftward to D1. For Lisa, going to the movies is a normal good. Her demand for movies decreases because she now sees fewer movies at each price. animation 9160335_CH08_p169-188.qxd 6/22/09 9:00 AM Page 179 Predicting Consumer Choices For a normal good, a fall in its price always increases the quantity bought. We can prove this assertion by dividing the price effect into two parts: ■ ■ Substitution effect Income effect Figure 8.9(a) shows the price effect, and in Fig. 8.9(b) we separate the price effect into its two parts. Substitution Effect The substitution effect is the effect Income Effect To calculate the substitution effect, we gave Lisa a $12 pay cut. To calculate the income effect, we give Lisa back her $12. The $12 increase in income shifts Lisa’s budget line outward, as shown in Fig. 8.9(b). The slope of the budget line does not change because both prices remain the same. This change in Lisa’s budget line is similar to the one illustrated in Fig. 8.8. As Lisa’s budget line shifts outward, her consumption possibilities expand and her best affordable point becomes J on indifference curve I2. The move from K to J is the income effect of the price change. In this example, as Lisa’s income increases, she sees more movies. For Lisa, a movie is a normal good. For a normal good, the income effect reinforces the substitution effect. 10 Income $40 Movies $4 8 C 6 J 4 2 I2 Income $40 Movies $8 I1 0 1 2 3 4 5 6 7 8 9 10 Movies (per month) (a) Price effect Soda (cases per month) of a change in price on the quantity bought when the consumer (hypothetically) remains indifferent between the original situation and the new one. To work out Lisa’s substitution effect when the price of a movie falls, we cut her income by enough to keep her on the same indifference curve as before. When the price of a movie falls from $8 to $4, suppose (hypothetically) that we cut Lisa’s income to $28. What’s special about $28? It is the income that is just enough, at the new price of a movie, to keep Lisa’s best affordable point on the same indifference curve as her original point C. Lisa’s budget line is now the light orange line in Fig. 8.9(b). With the lower price of a movie and a smaller income, Lisa’s best affordable point is K on indifference curve I1. The move from C to K along indifference curve I1 is the substitution effect of the price change. The substitution effect of the fall in the price of a movie is an increase in the quantity of movies from 2 to 4. The direction of the substitution effect never varies: When the relative price of a good falls, the consumer substitutes more of that good for the other good. Substitution Effect and Income Effect FIGURE 8.9 Soda (cases per month) Substitution Effect and Income Effect 179 10 8 Substitution effect 7 C 6 Income effect 5 J 4 K 3 2 I2 Substitution effect I1 0 1 2 3 4 5 6 7 8 9 10 Movies (per month) (b) Substitution effect and income effect The price effect in part (a) is separated into a substitution effect and an income effect in part (b). To isolate the substitution effect, we confront Lisa with the new price but keep her on her original indifference curve, I1. The substitution effect is the move from C to K. To isolate the income effect, we confront Lisa with the new price of movies but increase her income so that she can move from the original indifference curve, I1, to the new one, I2. The income effect is the move from K to J. animation 9160335_CH08_p169-188.qxd 180 6/22/09 9:00 AM Page 180 CHAPTER 8 Possibilities, Preferences, and Choices Inferior Goods The example that we have just studied is that of a change in the price of a normal good. The effect of a change in the price of an inferior good is different. Recall that an inferior good is one whose consumption decreases as income increases. For an inferior good, the income effect is negative and a lower price does not always lead to an increase in the quantity demanded. The lower price has a substitution effect that increases the quantity demanded, but a negative income effect that reduces the demand for the inferior good. The income effect works in the opposite direction to and offsets the substitution effect to some degree. If the negative income effect exceeded the positive substitution effect, the demand curve would slope upward. This case does not appear to occur in the real world. Back to the Facts We started this chapter by observing how the way we buy music has changed in recent years. The indifference curve model explains those changes. The best affordable choices determine spending patterns. Changes in prices and incomes change the best affordable choices and change consumption patterns. Review Quiz ◆ 1 2 3 4 5 When a consumer chooses the combination of goods and services to buy, what is she or he trying to achieve? Explain the conditions that are met when a consumer has found the best affordable combination of goods to buy. (Use the terms budget line, marginal rate of substitution, and relative price in your explanation.) If the price of a normal good falls, what happens to the quantity demanded of that good? Into what two effects can we divide the effect of a price change? For a normal good, does the income effect reinforce the substitution effect or does it partly offset the substitution effect? Work Study Plan 8.3 and get instant feedback. The model of household choice can explain many other household choices. Let’s look at one of them. ◆ Work–Leisure Choices People make many choices other than those about how to spend their income on the various goods and services available. Economists use the indifference curve model to understand many other choices, one of which is how to allocate time between working and leisure activities. This choice determines a person’s supply of labor. Let’s study this choice. Labor Supply Every week, we allocate our 168 hours between working—called labor—and all other activities— called leisure. How do we decide how to allocate our time between labor and leisure? We can answer this question by using the theory of household choice. The more hours we spend on leisure, the smaller is our income. The relationship between leisure and income is described by an income-time budget line. Figure 8.10(a) shows Lisa’s income-time budget line. If Lisa devotes the entire week to leisure—168 hours—she has no income and is at point Z. By supplying labor in exchange for a wage, she can convert hours into income along the income-time budget line. The slope of that line is determined by the hourly wage rate. If the wage rate is $5 an hour, Lisa faces the flattest budget line. If the wage rate is $10 an hour, she faces the middle budget line. And if the wage rate is $15 an hour, she faces the steepest budget line. Lisa “buys” leisure by not supplying labor and by forgoing income. The opportunity cost of an hour of leisure is the hourly wage rate forgone. Figure 8.10(a) also shows Lisa’s indifference curves for income and leisure. Lisa chooses her best attainable point. This choice of income and time allocation is just like her choice of movies and soda. She gets onto the highest possible indifference curve by making her marginal rate of substitution between income and leisure equal to her wage rate. Lisa’s choice depends on the wage rate she can earn. At a wage rate of $5 an hour, Lisa chooses point A and works 20 hours a week (168 minus 148) for an income of $100 a week. At a wage rate of $10 an hour, she chooses point B and works 35 hours a week (168 minus 133) for an income of $350 a week. And at a wage rate of $15 an hour, she chooses point C and works 30 hours a week (168 minus 138) for an income of $450 a week. 9160335_CH08_p169-188.qxd 6/22/09 9:00 AM Page 181 Work–Leisure Choices Income (dollars per week) FIGURE 8.10 The Supply of Labor The Labor Supply Curve 1,020 $15 680 $10 C 450 B 350 340 I2 $5 A 100 I1 ZI 0 0 100 Wage rate (dollars per hour) 168 133 138 148 Leisure (hours per week) (a) Time allocation decision LS C 15 B 10 5 A Figure 8.10(b) shows Lisa’s labor supply curve. This curve shows that as the wage rate increases from $5 an hour to $10 an hour, Lisa increases the quantity of labor supplied from 20 hours a week to 35 hours a week. But when the wage rate increases to $15 an hour, she decreases her quantity of labor supplied to 30 hours a week. Lisa’s supply of labor is similar to that described for the economy as a whole at the beginning of this chapter. As wage rates have increased, the workweek has shortened. At first, this pattern seems puzzling. We’ve seen that the wage rate is the opportunity cost of leisure, so a higher wage rate means a higher opportunity cost of leisure. This fact on its own leads to a decrease in leisure and an increase in work hours. But instead, we’ve cut our work hours. Why? Because our incomes have increased. As the wage rate increases, incomes increase, so people demand more of all normal goods. Leisure is a normal good, so as incomes increase, people demand more leisure. The higher wage rate has both a substitution effect and an income effect. The higher wage rate increases the opportunity cost of leisure and so leads to a substitution effect away from leisure. The higher wage rate increases income and so leads to an income effect toward more leisure. This outcome of rational household choice explains why the average workweek has fallen steadily as wage rates have increased. With higher wage rates, people have decided to use their higher incomes in part to “buy” more leisure. Review Quiz ◆ 1 0 20 2 30 35 Labor (hours per week) (b) Labor supply curve In part (a), at a wage rate of $5 an hour, Lisa takes 148 hours of leisure and works 20 hours a week at point A. If the wage rate increases from $5 to $10 an hour, she decreases her leisure to 133 hours and increases her work to 35 hours a week at point B. But if the wage rate increases from $10 to $15 an hour, Lisa increases her leisure to 138 hours and decreases her work to 30 hours a week at point C. Part (b) shows Lisa’s labor supply curve. Points A, B, and C on the supply curve correspond to Lisa’s choices in part (a). animation 181 What is the opportunity cost of leisure? Why might a rise in the wage rate lead to an increase in leisure and a decrease in work hours? Work Study Plan 8.4 and get instant feedback. ◆ Reading Between the Lines on pp. 182–183 shows you how the theory of household choice explains why e-books have not taken off, and why most people continue to buy their books in traditional paper format. In the chapters that follow, we study the choices that firms make in their pursuit of profit and how those choices determine the supply of goods and services and the demand for productive resources. 9160335_CH08_p169-188.qxd 6/22/09 9:00 AM Page 182 READING BETWEEN THE LINES Paper Books Versus e-Books Are Books Passé? http://www.iht.com September 6, 2007 Technology evangelists have predicted the emergence of electronic books for as long as they have envisioned flying cars and video phones. It is an idea that has never caught on with mainstream book buyers. … In October, the online retailer Amazon.com will unveil the Kindle, an electronic book reader that has been the subject of industry speculation for a year, according to several people who have tried the device and are familiar with Amazon’s plans. The Kindle will be priced at $400 to $500 and will wirelessly connect to an e-book store on Amazon’s site. … Hopes for e-books began to revive last year with the introduction of the widely marketed Sony Reader. Sony’s $300 gadget, the size of a trade paperback, has a six-inch screen, enough memory to hold 80 books and a battery that lasts for 7,500 page turns, according to the company. It uses screen display technology from E Ink, a company based in Cambridge, Mass., that emerged from the Media Lab at the Massachusetts Institute of Technology and creates power-efficient digital screens that uncannily mimic the appearance of paper. … Copyright 2007 International Herald Tribune. All Rights Reserved. Essence of the Story ■ Electronic books have not displaced paper books with mainstream book buyers. ■ Amazon.com sells an electronic book reader called Kindle that wirelessly connects to Amazon’s e-book store. 182 ■ Sony sells the Sony Reader, an electronic book reader the size of a paperback that mimics the appearance of paper, priced at $300. 6/22/09 9:00 AM Page 183 Economic Analysis ■ Print books and e-books are substitutes. ■ For most people, though, e-books and print books are extremely poor substitutes. ■ For a committed print-book lover, no quantity of e-books can compensate for a print book—the marginal rate of substitution between print books and e-books is zero. Beth’s annual book budget is $500. The price of an ebook reader is $360 (the current price of the Kindle reader). The price of an e-book is $10 and the price of a print book is $20. I2 Budget line if Beth buys reader With print books on the x-axis, Beth’s indifference curves are vertical. They tell us that Beth prefers more print books but gets no benefit from e-books. ■ I1 20 Beth is a print-book lover and Fig. 1 shows her indifference curves for print books and e-books. ■ I0 30 14 ■ We’ll assume that an e-book reader has only a one-year life. (Buyers know they will want the next-generation, improved reader next year.) ■ The orange line is Beth’s budget line if she buys a reader. She can afford 14 e-books if she buys no print books ($360 + (14 × $10) = $500) and along this line, by forgoing 2 e-books she can buy 1 print book. ■ ■ ■ ■ ■ ■ If Beth doesn’t buy an e-book reader, she buys no ebooks and can afford 25 print books ($500 ÷ $20 = 25). The red dot shows this affordable point. Best affordable point 0 15 25 30 Print books (number per year) 7 Figure 1 Print books versus e-books for a print-book lover Albums (number per year) ■ e-Books (number per year) 9160335_CH08_p169-188.qxd 80 Budget line for albums and print books 72 60 Best affordable point 36 The red dot is also the best affordable choice because this choice gets her onto her highest attainable indifference curve, I2. 22 16 Andy differs from Beth: He thinks that print books and e-books are perfect substitutes. But he also likes music and buys albums. Figure 2 shows Andy’s indifference curves for books (all types) and albums. 0 Budget line for albums and e-books 5 10 I1 I0 15 20 25 30 36 40 Books (number per year) Andy’s annual budget for albums and books is $720. The price of an album is $10 and the prices of an ebook reader, an e-book, and a print book are the same as those that Beth faces. ■ Figure 2 shows Andy’s two budget lines: one if he buys only e-books and albums and another if he buys only print books and albums. If Andy buys print books and albums, he can afford 25 print books and 22 albums [(25 × $20) + (22 × $10) = $720]. ■ Andy’s best affordable choice is 25 print books and 22 albums. ■ So even Andy, who thinks that e-books and print books are perfect substitutes, doesn’t buy e-books. But he probably would if he had a larger budget. If Andy buys e-books, he must spend $360 on a reader, which leaves him with $360 for albums and e-books. If he buys 20 e-books, he can afford 16 albums. [(20 × $10) + (16 × $10) = $360]. Figure 2 Books versus albums 183 9160335_CH08_p169-188.qxd 184 6/22/09 9:00 AM Page 184 CHAPTER 8 Possibilities, Preferences, and Choices SUMMARY ◆ Key Points Predicting Consumer Choices (pp. 176–180) ■ Consumption Possibilities (pp. 170–172) ■ ■ ■ ■ The budget line is the boundary between what a household can and cannot afford, given its income and the prices of goods. The point at which the budget line intersects the y-axis is the household’s real income in terms of the good measured on that axis. The magnitude of the slope of the budget line is the relative price of the good measured on the x-axis in terms of the good measured on the y-axis. A change in the price of one good changes the slope of the budget line. A change in income shifts the budget line but does not change its slope. ■ ■ ■ ■ Preferences and Indifference Curves (pp. 173–176) ■ ■ ■ ■ A consumer’s preferences can be represented by indifference curves. The consumer is indifferent among all the combinations of goods that lie on an indifference curve. A consumer prefers any point above an indifference curve to any point on it and prefers any point on an indifference curve to any point below it. The magnitude of the slope of an indifference curve is called the marginal rate of substitution. The marginal rate of substitution diminishes as consumption of the good measured on the y-axis decreases and consumption of the good measured on the x-axis increases. ■ A household consumes at its best affordable point. This point is on the budget line and on the highest attainable indifference curve and has a marginal rate of substitution equal to relative price. The effect of a price change (the price effect) can be divided into a substitution effect and an income effect. The substitution effect is the effect of a change in price on the quantity bought when the consumer (hypothetically) remains indifferent between the original choice and the new choice. The substitution effect always results in an increase in consumption of the good whose relative price has fallen. The income effect is the effect of a change in income on consumption. For a normal good, the income effect reinforces the substitution effect. For an inferior good, the income effect works in the opposite direction to the substitution effect. Work–Leisure Choices (pp. 180–181) ■ ■ The indifference curve model of household choice enables us to understand how a household allocates its time between work and leisure. Work hours have decreased and leisure hours have increased because the income effect on the demand for leisure has been greater than the substitution effect. Key Figures Figure 8.1 Figure 8.2 Figure 8.3 Figure 8.4 Figure 8.6 The Budget Line, 170 Changes in Prices and Income, 172 A Preference Map, 173 The Marginal Rate of Substitution, 174 The Best Affordable Choice, 176 Figure 8.7 Figure 8.8 Figure 8.9 Price Effect and Demand Curve, 177 Income Effect and Change in Demand, 178 Substitution Effect and Income Effect, 179 Key Terms Budget line, 170 Diminishing marginal rate of substitution, 174 Income effect, 178 Indifference curve, 173 Marginal rate of substitution, 174 Price effect, 177 Real income, 171 Relative price, 171 Substitution effect, 179 9160335_CH08_p169-188.qxd 7/1/09 3:44 PM Page 185 Problems and Applications PROBLEMS and APPLICATIONS 185 ◆ Work problems 1–10 in Chapter 8 Study Plan and get instant feedback. Work problems 11–20 as Homework, a Quiz, or a Test if assigned by your instructor. 1. Sara’s income is $12 a week. The price of popcorn is $3 a bag, and the price of a smoothie is $3. a. What is Sara’s real income in terms of smoothies? b. What is her real income in terms of popcorn? c. What is the relative price of smoothies in terms of popcorn? d. What is the opportunity cost of a smoothie? e. Calculate the equation for Sara’s budget line (with bags of popcorn on the left side). f. Draw a graph of Sara’s budget line with the quantity of smoothies on the x-axis. g. In f, what is the slope of Sara’s budget line? What determines its value? 2. Sara’s income falls from $12 to $9 a week, while the price of popcorn remains at $3 a bag and the price of a smoothie remains at $3. a. What is the effect of the fall in Sara’s income on her real income in terms of smoothies? b. What is the effect of the fall in Sara’s income on her real income in terms of popcorn? c. What is the effect of the fall in Sara’s income on the relative price of a smoothie in terms of popcorn? d. What is the slope of Sara’s new budget line if it is drawn with smoothies on the x-axis? 3. Sara’s income is $12 a week. The price of popcorn rises from $3 to $6 a bag, and the price of a smoothie remains at $3. a. What is the effect of the rise in the price of popcorn on Sara’s real income in terms of smoothies? b. What is the effect of the rise in the price of popcorn on Sara’s real income in terms of popcorn? c. What is the effect of the rise in the price of popcorn on the relative price of a smoothie in terms of popcorn? d. What is the slope of Sara’s new budget line if it is drawn with smoothies on the x-axis? 4. The Year in Medicine Sudafed, used to clear up those autumn sniffles, … contains as one of its active ingredients pseudoephedrine, widely used in backyard labs to make methamphetamine. ... Now, allergy sufferers looking for relief have to ask a pharmacist or salesclerk for their Sudafed, show photo ID, and sign a logbook. Unfortunately, the most common alternative, phenylephrine, isn’t as effective. Time, December 4, 2006 a. Draw an indifference curve for Sudafed and phenylephrine that is consistent with this news clip. b. On your graph in a, identify combinations that allergy sufferers prefer, do not prefer, and are indifferent among. c. Explain how the marginal rate of substitution changes along this indifference curve. 5. Draw figures that show your indifference curves for the following pairs of goods: ■ Right gloves and left gloves ■ Coca-Cola and Pepsi ■ Baseballs and baseball bats ■ Tylenol and acetaminophen (the generic form of Tylenol) ■ Eye glasses and contact lenses ■ Desktop computers and laptop computers ■ Skis and ski poles a. For each pair, state whether the goods are perfect substitutes, perfect complements, or neither. b. Discuss the shape of your indifference curve for each pair and explain the relationship between its shape and the marginal rate of substitution as the quantities of the two goods change. 6. Pam has chosen her best affordable combination of cookies and comic books. She has spent all of her income on 30 cookies at $1 each and 5 comic books at $2 each. Next month, the price of a cookie falls to 50¢ and the price of a comic book rises to $5. a. Will Pam be able to buy and want to buy 30 cookies and 5 comic books next month? b. Which situation does Pam prefer: cookies at $1 and comic books at $2 or cookies at 50¢ and comic books at $5? c. If Pam changes the quantities that she buys, will she buy more or fewer cookies and more or fewer comic books? 9160335_CH08_p169-188.qxd 186 6/22/09 9:00 AM Page 186 CHAPTER 8 Possibilities, Preferences, and Choices d. When the prices change next month, will there be an income effect and a substitution effect at work or just one of them? 7. Boom Time For “Gently Used” Clothes Unlike most retailers who are blaming the economy for their poor sales, one store chain is boldly declaring that an economic downturn can actually be a boon for its business. … [It] sells used name-brand children’s clothes, toys, and furniture. … Last year, the company took in $20 million in sales, up 5% from the previous year. “Our sales are already up 5% so far this year.” CNN, April 17, 2008 a. According to this article, is used clothing a normal good or an inferior good? b. If the price of used clothing falls and income remains the same, explain how the quantity of used clothing bought changes. c. If the price of used clothing falls and income remains the same, describe the substitution effect and the income effect that occur. d. Draw a graph to illustrate a family’s indifference curves for used clothing and other goods and services. e. In your graph in d, draw two budget lines to show the effect of a fall in income on the quantity of used clothing purchased. 8. Gas Prices to Stunt Memorial Day Travel 12% have cancelled road trips altogether. ... 11% of respondents will be vacationing closer to home this weekend. … That may save consumers some money, but it will also likely … hurt on a variety of businesses that serve the traveler. Service stations will suffer as they not only presumably sell less gas, but also fewer snacks, drinks and sundry items. … Hotel chains, especially those with a heavy roadside presence [suffer]. … Also under pressure are casual-dining chains that rely heavily on highway traffic. … MarketWatch, May 22, 2008 a. Describe the degree of substitutability between gasoline and roadside hotels and draw a preference map that illustrates your description. b. Draw a budget line for gasoline and roadside hotels and identify the best affordable point. c. Show on your graph how the best affordable point changes when the price of gasoline rises. 9. Does a Second Income Pay? When considering whether two paychecks are worth it, figure out how much of the lower earner’s salary will be eaten [up] by expenses incurred if both parents work. Childcare is likely to be the biggest cost. … Also, take into account the costs of going to work. The commute, the clothes, the dry cleaning, the lunches. … And you may not have as much time or energy to do the housework or make dinner. So you may end up hiring a housekeeper or doing take-out more often. … CNN, March 15, 2006 a. What is the opportunity cost of a parent staying home with her or his children? b. What is the opportunity cost of a parent working instead of staying home? c. Why does the opportunity cost of working increase as the number of children in a family increases? d. How does the number of children in a family influence the marginal rate of substitution between leisure and goods and services? 10. Floyd Mayweather Jr. Announces Retirement Unbeaten world champion boxer Floyd Mayweather Jr. backed out of negotiations for a September rematch against Oscar De La Hoya … announcing his retirement. … In May 2007, Mayweather Jr. won a split-decision over De La Hoya in a bout that established new records for pay-per-view and total revenue. … [De La Hoya’s business partner] didn’t believe Mayweather is employing a tactic to earn more money in a De La Hoya fight. … “He has made enough money to live comfortably for the rest of his life, and if he wants to spend time with his babies, that’s a good thing. …” Los Angeles Times, June 6, 2008 a. Use the concepts of the substitution effect and the income effect to explain Mayweather’s decision. b. At the income he earns per fight, is Mayweather’s labor supply curve upwardsloping or backward-bending? c. Draw a graph of Mayweather’s indifference curves and budget line between leisure time and income and illustrate his decision to fight or not to fight. Show how an increase in the income per fight changes his decision. 9160335_CH08_p169-188.qxd 6/22/09 9:00 AM Page 187 Problems and Applications Books 5 4 3 2 I1 1 I0 0 1 2 3 4 5 6 7 8 9 10 Albums a. If Rashid chooses 3 books and 2 albums, what is his marginal rate of substitution? b. If Rashid chooses 2 books and 6 albums, what is his marginal rate of substitution? c. Do Rashid’s indifference curves display diminishing marginal rate of substitution? Explain why or why not. 13. Sara’s income is $12 a week. The price of popcorn is $3 a bag, and the price of cola is $1.50 a can. The figure shows Sara’s preference map for popcorn and cola. Popcorn (bags) 11. Gas Prices Straining Budgets …many say they are staying in and scaling back spending to try to keep up, … driving as little as possible, cutting back on shopping and eating out, and other discretionary spending. CNN, February 29, 2008 a. Draw a budget line for a household that consumes only two goods: gasoline and eating out. Identify the combinations of gasoline and eating out that are affordable and those that are unaffordable. b. Draw a second budget line to show how a rise in the price of gasoline changes the affordable and unaffordable combinations of gasoline and eating out. Describe how the household’s consumption possibilities change. c. How does a rise in the price of gasoline change the relative price of eating out? d. How does a rise in the price of gasoline change real income in terms of eating out? 12. Rashid buys only books and albums and the figure shows his preferences. 187 8 7 6 5 I4 4 I3 3 2 I2 1 0 I1 I0 1 2 3 4 5 6 7 8 Cola (cans) a. What quantities of popcorn and cola does Sara buy? b. What is Sara’s marginal rate of substitution at the point at which she consumes? 14. Now suppose that in problem 13, the price of cola rises to $3.00 a can and the price of popcorn and Sara’s income remain the same. a. What quantities of cola and popcorn does Sara now buy? b. What are two points on Sara’s demand curve for cola? Draw Sara’s demand curve. c. What is the substitution effect of this price change? d. What is the income effect of the price change? e. Is cola a normal good or an inferior good? 15. Jim has made his best affordable choice of muffins and coffee. He spends all of his income on 10 muffins at $1 each and 20 cups of coffee at $2 each. Now the price of a muffin rises to $1.50 and the price of coffee falls to $1.75 a cup. a. Will Jim now be able and want to buy 10 muffins and 20 coffees? b. Which situation does Jim prefer: muffins at $1 and coffee at $2 a cup or muffins at $1.50 and coffee at $1.75 a cup? c. If Jim changes the quantities that he buys, will he buy more or fewer muffins and more or less coffee? d. When the prices change, is there an income 9160335_CH08_p169-188.qxd 188 6/22/09 9:00 AM Page 188 CHAPTER 8 Possibilities, Preferences, and Choices effect and a substitution effect at work or just one of them? 16. Rising Gas Costs Crimping Budgets More Americans are substituting higher-priced goods with cheaper ones—choosing McDonald’s coffee over Starbucks, for example, or hitting a bulk warehouse chain such as Costco or Sam’s Club instead of a pricier grocery store. MSNBC, March 20, 2008 a. If an increase in the price of gasoline results in consumers substituting McDonald’s coffee for Starbucks coffee, what type of good is McDonald’s coffee—normal or inferior? Explain. b. Draw a graph of an indifference curve and two budget lines to illustrate the effect of a rise in the price of gasoline on the quantity of coffee purchased from McDonald’s and from Starbucks. 17. Gas Prices Send Surge of Travelers to Mass Transit With the price of gas approaching $4 a gallon, more commuters are abandoning their cars and taking the train or bus instead. … “It’s very clear that a significant portion of the increase in transit use is directly caused by people who are looking for alternatives to paying $3.50 a gallon for gas.” Some cities with long-established public transit systems, like New York and Boston, have seen increases in ridership of 5 percent or more so far this year. But the biggest surges — of 10 to 15 percent or more over last year — are occurring in many metropolitan areas in the South and West where the driving culture is strongest and bus and rail lines are more limited. The New York Times, May 10, 2008 a. Draw a graph of a preference map and a budget line to illustrate the best affordable combination of gasoline and public transit. b. On your graph in a, show the effect of a rise in the price of gasoline on the quantities of gasoline and public transit services purchased. c. Assuming that the increase in the price of gasoline has been similar in all regions, compare the marginal rate of substitution in the Northeast to that in the South and West. Explain how you have inferred the different marginal rates of substitution from the information provided in the news clip. 18. You May Be Paid More (or Less) Than You Think It’s so hard to put a price on happiness, isn’t it? But if you’ve ever had to choose between a job you like and a better-paying one that you like less, you probably wished some economist would … tell you how much job satisfaction is worth. … Trust in management is by far the biggest component to consider. Say you get a new boss and your trust in management goes up a bit … (say, up one point on a 10-point scale). That’s like getting a 36 percent pay raise. In other words, that increased level of trust will boost your level of overall satisfaction in life by about the same amount as a 36 percent raise would. CNN, March 29, 2006 a. Measure trust in management on a 10–point scale, measure pay on the same 10–point scale, and think of them as two goods. Draw an indifference curve (with trust on the x-axis) that is consistent with the information in the news clip. b. What is the marginal rate of substitution between trust in management and pay according to this news clip? c. What does the news clip imply about the principle of diminishing marginal rate of substitution? Is that implication likely to be correct? 19. Study Reading Between the Lines about print books and e-books on pp. 182–183, and then answer the following questions. a. How do you buy books? b. Sketch your budget line for books and other goods. c. Sketch your indifference curves for books and other goods. d. What would happen to the way that you buy books if Amazon gave you its Kindle reader at a zero price if you buy just one e-book? 20. The sales tax is a tax on goods. Some people say that a consumption tax, a tax on both goods and services, would be better. Explain and illustrate with a graph what would happen if the sales tax were replaced with a consumption tax to a. The relative price of books and haircuts. b. The budget line showing the quantities of books and haircuts you can afford to buy. c. Your purchases of books and haircuts. ...
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This note was uploaded on 02/07/2010 for the course ECON 251 taught by Professor Blanchard during the Fall '08 term at Purdue University-West Lafayette.

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