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Usman Hannan

Chapter 21 – The Theory of Consumer Choice  Budget Constraint – the limit on the consumption bundles that a consumer can afford  Slope of budget constraint measures the rate at which the consume can trade one good for the other  Indifference Curve – a curve that shows consumption bundles that give the consumer the same level of satisfaction  Marginal Rate of Substitution (MRS) – the rate at which a consumer is willing to trade one good for another o Slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other  4 Properties of Indifference Curve: o High indifference curves are preferred to lower ones - people prefer more than less o Indifference curves are downward sloping – one item increase and the other one increase o Indifference curves do not cross – contradicts the assumption that consumers prefer more of both goods o Indifference curves are bowed inward – reflects the consumer’s greater willingness to give up a good that he already has in large quantity  When goods are easy to substitute for each other, the indifference curves are less bowed  When goods are hard to substitute, the indifference curves are very bowed  Perfect Substitutes – two goods with straight-line indifference curves (nickels and dimes)  Perfect Complements – tow goods with right-angle indifference curves (left and right shoes)  Optimum – the point at which this indifference curve and the budget constraint touch  At optimum – slope of indifference curves equal to the slope of budget constraint o Indifference curve is tangent to the budget constraint o Slope of indifference curve = marginal rate of substitution o Slope of budge constraint = relative price of the two goods o Consumer choses consumption of the two goods so that the marginal rate of substitution equals the relative price  Relative price – rate at which the market is willing to trade one good for the other  MRS – rate at which the consumer is willing to trade one good for the other  Consumer’s optimum (consumer’s valuation of the 2 good measured by MRS) = Market’s valuation (measured by relative price)  Utility – an abstract measure of the satisfaction or happiness that a consumer receives from a bundle of goods o Consumers prefers bundles with more utility  Indifference curve – “equal-utility” curve  Marginal Utility – any good that increase in utility that the consumer gets from an additional unit of that good o Most goods are assumed to diminishing marginal utility - the more of the good the consumer already has, the lower the marginal utility provided by an extra unit of that good  Marginal rate of substitution = ratio of prices  ⁄  Marginal rate of substitution = ratio of marginal utilities  ⁄ ⁄  Rearranged expression becomes  ⁄ ⁄ Income Affecting Consumer’s Choices  Increase in income  budget constraint to shift outward o Prices of items stay the same – increase in income creates a parallel shift in the budget constraint o More income allow consumers to choose a better combination  indifference curve goes up  Normal good – a good for which, other things equal, an increase in income leads to an increase in demand  Inferior good – a good for which, other things equal, an increase in income leads to a decrease in demand (Bus rides) How Changes in Price Affect Consumer’s Choices  A fall in price of any good shifts the budget constraint outward o Outward shift from budget constraint changes its slope because price is changed  Income Effect – the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve o Eg. Pepsi price dropped o Consumer is richer so he buys more Pepsi because it is relatively cheaper o Consumer is richer so he buys more Pizza because he has more purchasing power  Substitution Effect – the change in consumption that results when a price change moves the consumer along a given indifference curve to appoint with a new marginal rate of substitution o Pepsi is relative cheaper so consumer buys more Pepsi o Pizza is relatively more expensive so consumer buys less pizza  Pepsi: income and substitution effects act in same direction – consumer buys more Pepsi  Pizza: income and substitution effects act in opposite directs so total effect on pizza consumption is AMBIGUOUS 3 Applications 1. Do All Demand Curve Slope Downward?  Law of Demand – reflected in downward slope of demand curve  A strong inferior good will have an increase in quantity demanded even though its price increase (e.g. potatoes) o When price of potatoes rises, consumer is poorer o Income effect - people will buy less meat and more potatoes o Substitution effect – people will buy less potatoes and more meat o Potato is crucial in diet, therefore people will eat less meat but still remain the amount of potato required  Giffen Good – a good for which an increase in price raises the quantity demanded 2. How Do Wages Affect Labour Supply?  When wages increase – consumption rises and leisure falls, resulting in a labour supply curve that slopes upward  When wages increase – both consumption and leisure rises, resulting in a labour supply curve that slopes backward 3. How Do Interest Rates Affect Household?  E.g. Saving interest rate rises  Substitution effect: consumption when old becomes less costly relative to consumption when young, therefore induce consumer to save more when old and less when young  Income effect: interest rate rises, consumer moves to higher indifference curve and is better off. He wants to have a better life in both period, inducing him to save less Chapter 19 – Earnings and Discrimination  Compensating Differential – a difference in wages that arises to offset the nonmonetary characteristics of different jobs  Capital usually refers to the economy’s stock of equipment and structures  Human Capital – the accumulation of investments in people, such as education and on-the-job training o Education* - represents expenditure of resources at one point in time to raise productivity in the future o An investment in education is tied to a specific person – linkage is what makes it human capital o Firms (demand labour) are willing to pay more for the highly educated because highly educated workers have higher marginal products  Natural Ability – heredity upbringing, people differ in their physical and mental attributes  Effort – working hard  productive and earn more wages  Chance – opportunity  learning the right skill to use them in the job market  Signaling theory of education – schooling has no real productivity benefit but the worker signals his innate productivity to employers by his willingness to spend years at school  Superstar Phenomenon – singers (millions of CDS over the world) o 1. Every customer in the market wants to enjoy the good supplied by the best producer o 2. The good is produced with a technology that makes it possible for the best producer to supply every customer at low cost  Above-Equilibrium Wages o Minimum-wage laws o Union – a worker association that bargains with employers over wages and working conditions  Strike – the organized withdrawal of labour form a firm by a union o Efficiency wages – above-equilibrium wages paid by firms in order to increase worker productivity  Discrimination – the offering of different opportunities to similar individuals who differ only by race, ethnic group, sex, age or other personal characteristics o Different people earn different wages o People differ in the amount of human capital they have and in the kinds of work they are able and extent to which that experience is continuous or uninterrupted o Pre-market differences – schooling o Job experience – women have less job experience on average than men o Because of the differences in average wages among groups in part reflect difference in human capital and job characteristics, they do not by themselves say anything about how much discrimination there is in the labour market.  Discrimination by Employers o Profit Motive – competitive market economies provide a atural antidote to employer discrimination  Discriminated group with lower wages attract company because they don’t need to spend that much  As more firms hire more discriminated workers, the demand for cheap labour will rise and everything will even out  Discrimination by Customers and Governments o Customer Preferences – firms that hire discriminated workers can sell goods/services for cheaper prices  If customers only cared about the quality and price – they can buy from firms like that  If customers do mind – they can pay extra for their preferences o Government Policies – government can pass laws to help persist/ eliminate discrimination  Apartheid – South African government banned blacks from working some jobs  Suppress the normal equalizing force of free and competitive markets o Competitive markets contain a natural remedy for employer discrimination. The entry into the market of firms that care only about profit tends to eliminate discriminatory wa
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