20110930152212956 - 138 PART II The Market System: Choices...

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Unformatted text preview: 138 PART II The Market System: Choices Made by Households and Firms HOUSEHOLD CHOICE IN OUTPUT MARKETS p.121 1. {\J Every household must make three basic decisions: (1) how much of each product, or output, to demand; (2) how much labor to supply; and (3) how much to spend today and how much to save for the future. . Income, wealth, and prices define household budget constraint. The budget constraint separates those combinations of goods and services that are available from those that are not. All the points below and to the left of a graph of a household budget constraint make up the choice set, or opportunity set. ' . It is best to think of the household choice problem as one of allocating income over a large number of goods and services. A change in the price of one good may change the entire allocation. Demand for some goods may rise, while demand for others may fall. . As long as a household faces a limited income, the real cost of any single good or service is the value of the next pre— ferred other goods and services that could have been pur- chased with the same amount of money. . Within the constraints of prices, income, and wealth, household decisions ultimately depend on preferences- likes, dislikes, and tastes. THE BASIS OF CHOICE: UTILITY p. 126 6. 7. budget constraint, p. 122 choice set or opportunity set, p. 123 diamond/water paradox, p. 129 financial capital market, p. 137 homogeneous products, p. 119 l. Whether one item is preferable to another depends on how much utility, or satisfaction, it yields relative to its alternatives. The low of diminishing marginal utility says that the more of any good we consume in a given period of time, the less sat- isfaction, or utility, we get out of each additional (or mar ginal) unit of that good. . Households allocate income among goods and services to maximize utility. This implies choosing activities that yield the highest marginal utility per dollar. In a twowgood world, households will choose to equate the marginal utility per Ali problems are available on www.myeconiabtom For each of the following events, consider how you might react. What things might you consume more or less of? Would you work more or less? Would you increase or decrease your saving? Are your responses consistent with the discussion of household behavior in this chapter? ' a. You have a very close friend who lives in another city, a 3ehour bus ride away. The price of a round-trip ticket rises from $20 to $45. 1). Tuition at your college is cut 25 percent. SUMMARY dollar spent on X with the marginal utility per dollar spent on Y. This is the unify—maximizing rule. INCOME AND SUBSTITUTION EFFECTS p.130 9. The fact that demand curves have a negative slope can be explained in two ways: (1) Marginal utility for all goods diminishes. (2) For most normal goods, both the income and the substitution effects of a price decline lead to more con- sumption of the good. HOUSEHOLD CHOICE IN INPUT MARKETS p. 132 ll]. In the labor market, a trade-off exists between the value of REVIEW TERMS AND CONCEPTS labor supply curve, p. 134 law of diminishing marginal utility, p. 126 marginal utility (MU), p. 126 perfect competition, p. 119 perfect knowledge, p. 119 PROBLEMS —— the goods and services that can be bought in the market or produced at home and the value that one places on leisure. The opportunity cost of paid work is leisure and unpaid work. The wage rate is the price, or opportunity cost, of the benefits of unpaid work or leisure. . The income and substitution effects of a change in the wage rate work in opposite directions. Higher wages mean that (1) leisure is more expensive (likely response: people work more—substitution effect) and (2) more income is earned in a given number of hours, so some time may be spent on ‘ leisure (liker response: people work less—income effect). 12. In addition to deciding how to allocate its present income among goods and services, a household may also decide to save or borrow. When a household decides to save part of its current income, it is using current income to finance future spending. When a household borrows, it finances current purchases with future income. . An increase in interest rates has a positive effect on saving if the substitution effect dominates the income effect and a negative effect if the income effect dominates the substitu- tion effect. Most empirical evidence shows that the substitu- tion effect dominates here. ' real income, p. 124 total utility, p. 126 utility, p. 126 utility~n1axirnizing rule, p. 129 it? _" c. You receive an award that pays you $300 per month for the next 5 years. d. Interest rates rise dramatically, and savings accounts are now paying 10% interest annually. e. The price of food doubles. (If you are on a meal plan, assume that your board charges double.) f. A new business opens up nearby offering part-time jobs at $20 per hour. mmammmmmmmmW, , , 2. The following table gives a hypothetical total utility schedule for the Cookie Monster (CM): # OF COOKIES PER DAY TOTAL UTILITY PER DAY 0 100 200 y 275 , 325 ' 350 360 360 xtoxuunwmrao Calculate the CM’s marginal utility schedule. Draw a graph of total and marginal utility. If cookies cost the CM 5 cents each and CM had a good income, what is the maximum number of cookies he would most likely eat in a day? 3. Kamika lives in Chicago but goes to school in Tucson, Arizona. For the last 2 years, she has made four trips home each year. During 2010, the price of a round-trip ticket from Chicago to Tucson increased fiom $350 to $600. As a result, Kamika decided not to buy a new outfit that year and decided not to drive to Phoenix with friends for an expensive rock concert. at. Explain how Kamika’s demand for ciothing and concert tick- ets can be affected by an increase in air travel prices. b. By using this example, explain why both income and substi— tution effects might be expected to reduce Kamika’s number of trips home. 4. Sketch the following budget constraints: PK Py INCOME a. $20 $50 $1,000 b. 40 50 1,000 c. 20 a 100 1,000 d. 20 50 2,000 e. 0.25 0.25 7.00 f. 0.25 0.50 7.00 g. 0.50 0.25 7.00 L On January 1, Professor Smith made a resolution to lose some I weight and save some money. He decided that he would strictly budget $100 for lunches each month. For lunch, he has only two I choices: the faculty club, where the price of a lunch is $5, and Alice’s Restaurant, where the price of a lunch is $10. Every day that he does not eat lunch, he runs 5 miies. 3. Assuming that Professor Smith spends the $100 each month at either Alice’s or the club, sketch his budget constraint. Show actual numbers on the axes. Last month Professor Smith chose to eat at the club 10 times and at Alice’s 5 times. Does this choice fit within his budget constraint? Explain your answer. Last month Alice ran a halfaprice lunch special all month. All lunches were reduced to $5. Show the effect on Professor Smith’s budget constraint. uring 2010, Congress debated the advisability of retaining the or all of the tax cuts signed into law by former President Urge W. Bush in 2001 and 2003 and set to expire at the end of 1_0. By reducing tax rates acrOss the hoard, take-home pay for Taxpayng workers would increase. The purpose, in part, was Encourage work and increase the supply of labor. Households 01110 respond the way the president hoped, but only if income 1 r4 10. NO. PER MONTH TU CHAPTER 6 Household Behavior and Consumer Choice 139 effects were stronger than substitution effects. Do you agree or disagree? Explain your answer. Assume that Mei has $100 per month to divide between dinners at a Chinese restaurant and evenings at Zanzibar, a locai pub. Assume that going to Zanzibar costs $20 and eating at the Chinese restaurant, costs $10. Suppose Mei spends two evenings at Zanzibar and eats six times at the Chinese restaurant. a. Draw Mei’s budget constraint and show that she can afford six dinners and two evenings at Zanzibar. b. Assume that Mei comes into some money and can now spend $200 per month. Draw her new budget constraint. c. AS a result of the increase in income, Mei decides to Spend eight evenings at Zanzibar and eat at the Chinese restaurant four times. What kind of a good is Chinese food? What kind of a good is a night at Zanzibar? d. What part of the increase in Zanzibar trips is due to the income effect, and what part is due to the substitution effect? Explain your answer. . Decide whether you agree or disagree with each of the following statements and explain your reason: a. If the income effect of a wage change dominates the substitu- tion effect for a given household and the household works longer hours following a wage change, wages must have risen. b. In product markets, when a price falls, the substitution effect leads to more consumption; but for normal goods, the income effect leads to less consumption. . Suppose the price of X is $5 and the price of Yis $10 and a hypo- thetical household has $500 to spend per month on goods X and Y. a. Sketch the household budget constraint. b. Assmne that the household splits its income equally between X and Y. Show where the household ends up on the budget constraint. c. Suppose the household income doubles to $1,000. Sketch the new budget constraint facing the household. cl. Suppose after the change the household spends $200 on Y and $800 on X. Does this hnply thatX is a normal or an infe— rior good? What about Y? For this problem, assume that Ioe has $80 to Spend on books and movies each month and that both goods must be purchased whole (no fractional units). Movies cost $8 each, and books cost $20 each. Joe’s preferences for movies and books are summa~ rized by the following information: MOVIES BOOKS NO. PER MU MU/$ MONTH TU MU MU/$ 1 50 i 22 80 42 100 52. 110 57 116 60 121 62 123 63 \Immamm \JmUIJhOJN 3.. Fill in the figures for marginal utility and marginal utility per dollar for both movies and books. b. Are these preferences consistent with the law of diminishing marginal utility? Explain briefly c. Given the budget of $80, what quantity of books and what quantity of movies will maximize Joe’s level of satisfaction? Explain briefly. 140 PART II The Market System: Choices Made by Households and Firms 11. 12. (1. Draw the budget constraint (with books on the horizontal axis) and identify the optimal combination of books and movies as point A. e. Now suppose the price of books fails to $10. Which of the columns in the table must be recalculated? Do the required recalculations. 1". After the price change, how many movies and how many books will Joe purchase? g. Draw the new budget constraint and identify the new opti— mal combination of books and movies as point B. h. If you calculated correctly, you found that a decrease in the price of books caused Joe to buy more movies as well as more books. How can this be? [Related to the Economics in Practice on p. 133] John’s New York—based firm has sent him to work in its Paris office. Recognizing that the cost of living differs between Paris and New York, the company wants to adjust John’s salary so that Iohn is as well off (or happy) in Paris as he was in New York. John suggests that he submit a list of the things he bought in New York in a typical month. The firm can use the list to determine John’s salary by figuring out how much the same items cost in Paris. Is this a good idea? Explain your answer. {Related to the Economics in Practice on p. 136} Using graphs, show what you would expect to see happen to the labor supply curve facing companies offering unpaid internships as the job market starts to improve. . Thomas has allocated $48 per month for entertainment expenses, which he uses either to go bowling or to play billiards. One night of howling costs Thomas $8, and one night of billiards costs Thomas $4. Use the information in the following graphs to determine how many nights Thomas should spend bowling and how many nights he should play billiards in order to maximiie his utility. Explain your answer. Marginal utility of bowling 56 n 48 w 40 — 32 - —| ---- - - 1- - - 24~4a71 16 ——J———1———1——— I | | : 1 : 5 I 1 I l l | 0 1 2 3 4 5 6 7 Bowling (nights per month) Marginal utility of billiards 1 1 m—mLmfiim_m___i_m_.__ Billiards (nights per month) 14. For most normal goods, the income effect and the substitution effect work in the same direction; so when the price of a good falls, both the income and substitution effects lead to a higher quantity demanded. How would this change if the good is an inferior good? 15. Explain why in product markets the substitution and income J ' effects work in the same direction for normal goods, but in the 1,6. labor market, the income and substitution effects work in oppo- site directions when leisure is considered a normal good. Samantha has $7 to spend on apples and bananas and wants to maximize her utility on her purchase. Based on the data in the table, how many apples and bananas should Samantha pur- chase, and what is her total utility from the purchase? Does the utility-maximizing rule hold true for her purchase? Explain. APPLES $1.00 BANANAS $0.50 QUANTITY MU TU QUANTITY MU TU 1 28 23 1 12 12 2 24 52 2 10 22 3 20 72 3 s 30 4 16 as 4 6 36 5 12 100 5 4 40 6 s 103 6 2 42 7 4 112 7 0 '42 s 0 112 s —2 40 17. _...— The table shows Regina’s marginal utility numbers for ham- burgers and pizzas. Regina is trying to decide which item to purchase first, a hamburger or a pizza, knowing that she wants to receive the most utility for each dollar she spends. Assuming she has enough money in her budget to purchase either item, which item should she purchase first? HAMBURGERS $4 PIZZAS $6 QUANTITY MU QUANTITY MU 1 12 1 18 2 8 2 14 3 4 3 8 18. Jake and Gonzalo are roommates and have saved a total of $360 to spend on summer entertainment. They have decided toruse this money on tickets to baseball games and on tickets to their local amusement park. Their original budget constraint is shown in the graph below. LetX represent amusement park tickets and Y represent baseball tickets. ifference Curves - in this chapter, we saw how a consumer choosing en two goods is constrained by the prices of those goods yhis or her income. This Appendix returns to that exam— 'd analyzes the process of choice more formally. (Before ceed, carefully review the text under the heading “The et Constraint More Formally,” p. 123} Ese the following analysis on four assumptions: 3 assume that this analysis is restricted to goods that 1d positive marginal utility, or, more simply, that “more 53 7 er.” One way to justify this assumption is to say that 'énmore of something makes you worse off, you can lit-throw it away at no cost. This is the assumption of osal. marginal rate of substitution is defined as MUX/MU}, tio at which a household is willing to substitute X When M UX/MUY is equal to 4, for example, I would g to trade 4 units of onr 1 additional unit of X. assume a diminishing marginal rate of substitution. 35 more of X and less of Y are consumed, MU X/MUY Baseball tickets (Y) 20 New it», budget 5%! constraint . ill 15 CHAPTER 6 Household Behavior and Consumer Choice 141 What is the equation of the original budget constraint? What is the price of an amusement park ticket? abaseball ticket? Assume a price change occurs and lake and Gonzalo now face the new budget constraint. What is the equation of the new budget constraint? . With the new budget constraint, what is the price of an amusement park ticket? a baseball ticket? .nc‘e - Original budget = ' constraint Amusement park tickets (X) declines. As you consume more of X and less of Y, X becomes less valuable in terms of units of Y, or Ybecomes more valuable in terms of X. This is almost but not precisely equivalent to assuming diminishing marginal utility. . We assume that consumers have the ability to choose among the combinations of goods and services available. Confronted with the choice between two alternative com« binations of goods and services, A and B, a consumer responds in one of three ways: {1) She prefers A over B, (2} she prefers B over A, or (3) she is indifferent between A and Bmthat is, she likes A and B equally. We assume that consumer choices are consistent with a simple assumption of rationality. If a consumer shows that he prefers A to B and subsequently shows that he prefers B to a third alternative, C, he should prefer A to C when confronted with a choice between the two. Deriving Indifference Curves If we accept these four assumptions, we can construct a “map” of a consumer’s preferences. These preference maps are made up of indifference curves. An indifference curve is a set of points, each point representing a combination of goods X and Y, all of which yield the same total utility. ...
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20110930152212956 - 138 PART II The Market System: Choices...

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