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  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 23 of 23 … The theory of consumer choice describes how people make decisions and has broad applicability. Examples covered this chapter included pizza and Pepsi and work and leisure. But it can apply to any economic choice between alternatives including whether to consume now or save for later. But, do people really think in terms of the theory of consumer choice? As a consumer you quickly decide what to buy every time you shop. You do not decide by thinking through and writing down budget constraints and indifference curves. … The theory of consumer choice is an economic model. Economic models are not intended to be completely realistic for practical use and do not try to give a literal explanation of how people make decisions. The best way to view the theory of consumer choice is as of a breakdown into components and...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 22 of 26 … Is the idea of a backward-sloping labor-supply curve, supply of labor decreasing as wage goes up, just a theoretical curiosity? Evidence shows the labor-supply curve over long periods does in fact slope backward. A hundred years ago, many people worked six days a week, today five-day work weeks are the norm. As the length of the work week has been falling the hourly wage of the typical worker has been rising. … Economists’ explanation for this historical pattern is: Over time, advances in technology raise workers' productivity and the demand for labor. The increase in labor demand raises equilibrium wages. As wages rise, so does the reward for working. Yet, rather than responding to this increased incentive by working more, most workers instead choose to take part or all of their greater prosperity as more le...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 21 of 26 … Sally's decision between leisure and consumption determines her supply of labor. This is because the more leisure time she takes the less time she has left to work to make more money to pay for more consumption. … In panels (a) and (b) the right graph shows the labor-supply curve resulting from Sally's decision. In panel (a) a higher wage · induces Sally to work more and enjoy less leisure · the labor-supply curve slopes upward In panel (b), a higher wage · induces Sally to enjoy more leisure and work less · the labor-supply curve slopes downward … At first, the backward-sloping labor-supply curve may seem puzzling Why would a person respond to a higher wage by working less? The answer comes from considering the income and substitution effects of a higher wage. The substitution effect When Sally's wag...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 20 of 26 … Figure 14 An Increase in the Wage An increase in the wage can either result in more or less hours worked. Panels (a) and (b) of this figure show how a person might respond to an increase in wage. The graphs on the left show the consumer’s · initial budget constraint, BC1, with lower wage · new budget constraint, BC2, with higher wage · before and after optimal choices between consumption and leisure, shown by dots on I1 and I2 curves The graphs on the right show the resulting labor-supply curves. … Because hours worked equal total awake time hours minus hours of leisure any quantity change in hours of leisure causes an opposite change in the quantity of hours of labor supplied. … In panel (a), when the wage rises · hours of work rises and leisure falls · resulting in a labor-supply curve that slopes upward In...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 19 of 26 Figure 13 – The Work-Leisure Decision This figure shows Sally's · budget constraint for deciding how much to work · indifference curves for consumption and leisure · optimum decision … Three main questions involving the theory of consumer choice: 1- Do all demand curves slope downward? 2- How do wages affect labor supply? 3- How do interest rates affect household saving? … 2- How do wages affect labor supply? Previously we’ve used the theory of consumer choice using indifference curves and budget constraint lines to analyze how a person allocates income between two goods. We can also apply the same theory to analyze how a person allocates time. … People spend most of their time awake either working, so they can buy consumption goods, or enjoying leisure. Consider the decision facing Sally, a freelance software ...

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  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 18 of 26 … More examples of Giffen goods. Consider the Irish potato famine of 1845~1852. Potatoes were such a large part of people's diet that when the price of potatoes rose, it had a large income effect. Evidence shows a higher price of potatoes actually raised the quantity of potatoes demanded. People in Ireland responded to their reduced living standard by cutting back on the luxury of meat and buying more of the potatoes staple food. … In 2007 Robert Jensen and Nolan Miller conducted a five month experiment in the Chinese province of Hunan. They gave randomly selected households vouchers that subsidized the purchase of rice, making the price lower, a staple in local diets. They then surveyed the households to measure how consumption of rice responded to changes in the price. They found poor households exhibited Gif...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 17 of 26 … Figure 12 – A Giffen Good In the case of a “Giffen Good” Here, when the price of potatoes rises, the consumer's optimum shifts from point C to point E. The consumer has responded to a higher price of potatoes by buying less meat and more potatoes. … Using the theory of consumer choice we can consider and offer answers to the following three questions about how the economy works. Because each question involves household buying decision-making, we can apply the model of consumer choice. The three questions: 1- Do all demand curves slope downward? 2- How do wages affect labor supply? 3- How do interest rates affect household saving? … 1- Do all demand curves slope downward? Usually, when the price of a good rises people buy less of it. This behavior, called the law of demand, results in a downward-sloping demand...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 16 of 26 … Figure 11 – Deriving the Demand Curve Panel (a) shows · when the price of Pepsi falls from $2 to $1 · the consumer's optimum moves from point A to point B · the quantity of Pepsi consumed rises from 250 to 750 pints Panel (b) demand curve reflects the relationship between the price and the quantity demanded. … We have seen how changes in the price of a good alter the consumer's budget constraint and therefore the quantities of the two goods that he chooses to buy. We can consider a consumer's demand curve as a summary of the optimal decisions that arise from his budget constraint and indifference curves. … Figure 11 panel (a) shows when the price of a pint falls from $2 to $1 the consumer's budget constraint shifts outward from initial to new. Because of both income and substitution effects the c...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 15 of 26 … Figure 10 – Income and Substitution Effects The effect of a change in price can be broken down into · substitution effect · income effect The substitution effect is the movement along an indifference curve to a point with a different marginal rate of substitution. This is shown along indifference curve I1 as the change from point A to B. The income effect is the shift to a higher indifference curve. This is shown here as the change · from point B on indifference curve I1 · to point C on indifference curve I2 … The impact of a change in the price of a good on consumption can be separated into two effects: substitution effect and income effect. In a consumer’s response to a new lower price of Pepsi, he would reason in the two following ways: 1- substitution effect Now the price of Pepsi has fallen, I get more p...

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  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 14 of 26 … Figure 9 – A Change In Price When the price of Pepsi falls, the consumer's budget constraint shifts outward and changes slope. The consumer moves from the initial optimum to the new optimum. This changes his/her purchases of both pizza and Pepsi. In this case: · the quantity of Pepsi consumed rises · the quantity of pizza consumed falls … Here we look at how a change in the price of one of two goods alters consumer choice between the two. In Figure 9 the price of Pepsi falls from $2 to $1 per pint. The new lower price expands the consumer's set of buying opportunities. A fall in the price of any good shifts the budget constraint outward. If the consumer wants to spend his entire $1,000 income on pizza the new lower price of Pepsi is irrelevant and only consumption of pizza point A stays the same at 100 pi...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 13 of 26 … Figure 8 – An Inferior Good A good is an inferior good if the consumer buys less of it when his income rises. Here Pepsi is an inferior good. When the consumer's income increases the budget constraint shifts outward. The consumer buys more pizza but less Pepsi. … If a consumer buys less of a good when his income rises, economists call it an inferior good. Figure 8 shows a situation where pizza is a normal good and Pepsi is an inferior good. An increase in income, indicated by the rightward move of the budget constraint induces the consumer to buy more pizza but less Pepsi, indicated by the new optimum. … Most goods are normal goods, as is pizza here, people want more as their incomes increase. One example of an inferior good is bus rides. As income increases consumers are more likely to own cars or take a tax...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 12 of 26 … Figure 7 – An Increase in Income When the consumer's income rises, the budget constraint shifts out from A to B. If both goods are normal goods the consumer responds to the increase in income by buying more of both of them. Here the consumer buys more pizza and more Pepsi. … The indifference curves I1 and I2 are drawn assuming both pizza and Pepsi are normal goods. If a consumer wants more of a good when his income rises economists call it a normal good. If a consumer wants less of a good when his income rises economists call it an inferior good. … In Figure 7 a consumer’s income increases and budget constraint line shifts right from A to B. With higher income, the consumer can afford more of both goods, pizza and Pepsi. Because the relative price of the two goods has not changed the slopes of the new budget ...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 11 of 26 … Utility is a measure of the satisfaction or happiness a consumer receives from a bundle of goods. A consumer prefers one bundle of goods to another if one provides more utility (satisfaction) than the other. … Utility and indifference curves are closely related. Because the consumer is equally happy with all points on the same indifference curve all these bundles provide the same utility. An indifference curve can be thought of as an equal-utility curve. The marginal utility of any good is the increase in utility, satisfaction, the consumer gets from an additional unit of that good. … Most goods are assumed to exhibit diminishing marginal utility · the more of the good the consumer already has · the lower the marginal utility an extra unit of that good provides · the less the consumer is willing to pay for th...

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  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 10 of 26 … Figure 6 – The Consumer’s Optimum The consumer chooses the point on his/her budget constraint line that lies on the highest indifference curve. At this optimum point the marginal rate of substitution equals the relative price of the two goods. Along the budget constraint line the highest indifference curve he can reach is I2. … The consumer prefers point A which lies on indifference curve I3. But he cannot afford this bundle of pizza and Pepsi. Point B is affordable. But because it lies on a lower indifference curve he does not prefer B. The consumer can afford and wants the optimum point which is on I2. … At the optimum point · the indifference curve is tangent to the budget constraint · the slope of the indifference curve equals the slope of the budget constraint · the slope of the indifference curve is the...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 9 of 26 Figure 5 - Perfect Substitutes and Perfect Complements Panel (a) when two goods are perfectly substitutable, such as nickels and dimes, the indifference curves are straight lines. Panel (b) when two goods are perfectly complementary, such as left shoes and right shoes, the indifference curves are right angles. … The shape of an indifference curve shows the consumer's willingness to trade one good for the other. When the goods are easy to substitute for each other, the indifference curves are less bowed. When the goods are hard to substitute for each other, the indifference curves are more bowed. … Consider the two extreme cases · perfect substitutes · perfect complements Perfect Substitutes Suppose someone offers you the choice of bundles of nickels or dimes. Most likely you would care only about the total mone...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 8 of 26 … Figure 4 – Bowed Indifference Curves Indifference curves are bowed inward. This shape shows the marginal rate of substitution (MRS) depends on the quantity of the two goods the consumer is currently consuming. … Here we consider four properties of most indifference curves. Property 1 – higher (further right) indifference curves are preferred to lower ones Property 2 - indifference curves are downward sloping Property 3 - indifference curves do not cross Property 4 - indifference curves are bowed inward … Property 4 - indifference curves are bowed inward The slope of an indifference curve is the marginal rate of substitution (MRS). This is the rate at which the consumer is willing to trade one good for the other. The MRS depends on the amount of each good the consumer is currently consuming. … On Figure 4 at po...

  Mostly summarized from Gregory Mankiw’s Principles of Economics, 5th Ed. PART 7 Topics for Further Study Chapter 21 of 36 The Theory of Consumer Choice Section 7 of 26 … Figure 3 - The Impossibility of Intersecting Indifference Curves A situation of intersecting indifference curves can never happen. According to these indifference curves the consumer would be equally satisfied at points A, B, and C, even though point C has more of both goods than point A. … Four properties of indifference curves: Property 1 - higher (farther right) indifference curves are preferred to lower ones Property 2 - indifference curves are downward sloping Property 3 - indifference curves do not cross Property 4 - indifference curves are bowed inward … Property 3 - Indifference curves do not cross Suppose two indifference curves did cross, as in Figure 3. Because point A is on the same indifference curve as point B, the two points would make the consumer equally happy. Because point B is on the same i...