978-1285165905 Chapter 21 Part 2

Chapter 21/The Theory of Consumer Choice ❖ 373

b. Second, the consumer shifts to higher indifference curve

I

2 by moving from point B to C.

indifference curve

I

1 at point B is equal to the slope of indifference curve

I

2 at point C.

F. Deriving the Demand Curve

2. We can view a consumer’s demand curve as a summary of the optimal decisions that arise

from her budget constraint and indifference curves.

3. When the price of Pepsi falls from $2 per liter to $1, the consumer’s budget constraint shifts

4. Note that at a price of $2, the consumer’s quantity of Pepsi demanded is 50. At a price of $1,

quantity demanded is 150. These are two of the points on her demand curve for Pepsi.

IV. Three Applications

A. Do All Demand Curves Slope Downward?

3. Example: A consumer spends his entire budget on meat and potatoes. The price of potatoes

rises.

a. The budget constraint will shift in.

Figure 11

Figure 12

Students can learn to separate the substitution effects easily if they follow a simple

rule: Have them draw a line tangent to the original indifference curve but parallel to

the new budget constraint. Make sure that they realize that the substitution effect is

seen as the movement along one indifference curve (due to changes in relative

prices), and the income effect is seen as the movement from one budget constraint

to a parallel budget constraint (because the individual’s purchasing power has

changed).

374 ❖ Chapter 21/The Theory of Consumer Choice

b. The substitution effect suggests that the consumer will choose more meat and fewer

potatoes.

c. The income effect suggests that the individual has suffered a decline in purchasing

increase her consumption of inferior goods.

d. Suppose that potatoes are an inferior good. When the price of potatoes rises, the

potatoes rose.

4. Definition of Giffen good: a good for which an increase in the price raises the

quantity demanded.

5.

Case Study: The Search for Giffen Goods

b. Poor households exhibited Giffen behavior by purchasing less rice (a staple) when its

price fell and more when its price rose.

B. How Do Wages Affect Labor Supply?

1. Example: Carrie has 100 hours per week that she can devote to working or enjoying leisure.

2. We can show Carrie‘s budget constraint graphically.

consumption goods.

$5,000.

3. Carrie’s optimum will occur where the highest possible indifference curve is tangent to the

budget constraint.

4. If Carrie’s wage increases, her budget constraint will shift outward.

a. The budget constraint will become steeper, because Carrie can get more consumption for

every hour of leisure that she gives up.

Figure 13

Chapter 21/The Theory of Consumer Choice ❖ 375

c. The response of leisure to the change in Carrie’s wage is not as straightforward. This

d. If the substitution effect is greater than the income effect, Carrie will decrease leisure

and work more hours if her wage rises. This results in an upward-sloping labor supply

curve.

5.

Case Study: Income Effects on Labor Supply: Historical Trends, Lottery Winners, and the

Carnegie Conjecture

b. The income effect can be isolated by examining the effects of winning the lottery on an

individual’s labor supply. Studies have shown that lottery prizes lead to significant

lead his children to become unproductive.

C. How Do Interest Rates Affect Household Saving?

1. Example: Saul is planning ahead for retirement. There are two time periods. Currently, Saul

interest rate is 10 percent.

2. We can view “consumption while young” and “consumption while old” as the two goods that

Saul must choose between.

3. The interest rate determines the relative price of these two goods. For every dollar that Saul

4. We can draw Saul’s budget constraint.

have “consumption while old.”

Figure 14

Figure 15

376 ❖ Chapter 21/The Theory of Consumer Choice

b. If Saul saves nothing, he will consume $100,000 when he is young and zero when he is

old. Likewise, if he consumes nothing when he is young, he will be able to consume

$110,000 when he is old.

5. Saul’s optimum occurs where his highest possible indifference curve is tangent to his budget

constraint.

6. If the interest rate rises to 20 percent, two possible outcomes could occur.

b. Because the increase in the interest rate means an increase in purchasing power, the

income effect suggests that Saul increase his consumption of normal goods. Because

c. Thus, the end result will depend on whether the income effect or the substitution effect

dominates. If the substitution effect is larger than the income effect, Saul will save more

when young.

7. Because of this ambiguity, it is not clear how changing the way interest income is taxed will

affect overall savings rates.

SOLUTIONS TO TEXT PROBLEMS:

Quick Quizzes

1. A person with an income of $1,000 could purchase $1,000/$5 = 200 liters of Pepsi if she

spent all of her income on Pepsi or she could purchase $1,000/$10 = 100 pizzas if she spent

all of her income on pizza. Thus, the point representing 200 liters of Pepsi and no pizzas is

the vertical intercept and the point representing 100 pizzas and no Pepsi is the horizontal

intercept of the budget constraint, as shown in Figure 1. The slope of the budget constraint

is the rise over the run, or –200/100 = –2.

Figure 16

Chapter 21/The Theory of Consumer Choice ❖ 377

Figure 1

2. Figure 2 shows indifference curves between Pepsi and pizza. The four properties of these

indifference curves are: (1) higher indifference curves are preferred to lower ones because

consumers prefer more of a good to less of it; (2) indifference curves are downward sloping

because if the quantity of one good is reduced, the quantity of the other good must increase

for the consumer to be equally happy; (3) indifference curves do not cross because if they

did, the assumption that more is preferred to less would be violated; and (4) indifference

curves are bowed inward because people are more willing to trade away goods that they

have in abundance and less willing to trade away goods of which they have little.

Figure 2

3. Figure 3 shows the budget constraint (

BC

1) and two indifference curves. The consumer is

point C where the new budget constraint is tangent to a lower indifference curve. To break

this move down into income and substitution effects requires drawing the dashed budget line

shown, which is parallel to the new budget constraint and tangent to the original indifference

378 ❖ Chapter 21/The Theory of Consumer Choice

curve at point B. The movement from A to B represents the substitution effect, while the

movement from B to C represents the income effect.

Figure 3

the income effect.

Questions for Review

of -1,000/500 = -2.

Chapter 21/The Theory of Consumer Choice ❖ 379

Figure 4

away wine if she has a lot of it and less willing to trade away wine if she has little of it.

Figure 5

380 ❖ Chapter 21/The Theory of Consumer Choice

Figure 6

marginal rate of substitution is $6/$3 = 2.

Figure 7

constraint out from

BC

1 to

BC

2. If both wine and cheese are normal goods, consumption of

Chapter 21/The Theory of Consumer Choice ❖ 381

Figure 8

Figure 9

shifts from

BC

1 to

BC

2 and her optimal choice changes from point A (

c

1 cheese,

w

1 wine) to

we draw in budget constraint

BC

3, which is parallel to

BC

2 but tangent to the consumer’s