This Document Contains Chapters 9 to 10 Chapter 9: Decision Making by Individuals and Firms What’s New in the Fifth Edition? • Updated Teaching Tips • Updated Business Cases • Handouts for use in class Chapter Objectives • Explain why implicit costs are just as important as explicit costs in decision making. • Explain the difference between accounting profit and economic profit. • Explain the principle of either-or decision making. • Discuss the principle of marginal analysis when making “how much” decisions. • Explain the concept of a sunk cost. • Explain why people sometimes behave irrationally in predictable ways. Teaching Tips Costs, Benefits, and Profits Creating Student Interest • Use Handout 9-1 to have students brainstorm the costs of going to college or Handout 9-7 to consider the implicit and explicit costs of raising children. Presenting the Material • Use Handout 9-2 or 9-5 to have students consider the costs, both implicit and explicit, of operating a business. Making “How Much” Decisions: The Role of Marginal Analysis Creating Student Interest • Ask students to estimate how long they plan to spend studying for their next economics exam. You can have them write their estimates on a small slip of paper and collect them. Look at the estimates and determine a rough estimate of the average. Have them consider whether this is the optimal number of hours (minutes?) to study. Why wouldn’t they want to study longer? Why not stop studying earlier? Ask for suggestions of what they would need to consider to determine the optimal number of hours to study. They need to know their goal for the class, the benefits of studying (which are decreased if all the studying is “crammed” into the night before the exam), and their opportunity costs. You might also want to point out that since many of the costs are experienced before the exam and the benefits received after the exam, sometimes students study less than the optimal amount of time! They should make an optimal decision beforehand, set up a study schedule early, and stick to it for optimal results. Presenting the Material • Use Handout 9-3 for students to think about the marginal decision involved in the optimal choice of output for a business. Sunk Costs Creating Student Interest • Have students consider the following scenario. Two friends have purchased memberships to a fitness center. They have agreed to work out together every Monday, Thursday, and Saturday. Leslie paid $600 for her annual membership; Amy, who waited for a special membership promotion, paid $100. In both cases, the fee was paid in full, in advance, and is nonrefundable. After the first few months of their agreement, Leslie and Amy’s school starts having a special concert every Saturday so Amy decides she is only going to work out twice a week. Leslie tells Amy that because she paid $600 for her membership, she is going to continue going to the gym every Saturday, even though it means missing the concert. Ask the students if they think the friends made the best decision and why. Presenting the Material • Give the class the following additional information about Leslie and Amy (from the preceding scenario). Leslie and Amy both love to attend concerts. They are music majors and get great enjoyment from listening to all kinds of music. Both of the friends stay very fit carrying around their instruments and neither much enjoys working out. Leslie especially hates working out if her best friend Amy isn’t with her. Now have the students think about the following questions: 1. If Leslie continues going to the gym every Saturday, how much does the gym membership cost her for the year? ($600.) 2. If Leslie stops going to the gym every Saturday, how much does the gym membership cost her for the year? ($600.) 3. What does Leslie gain from going to the gym alone on Saturday? (Nothing—she is actually less happy because she hates to go without Amy.) 4. What does Leslie gain from going to the concert with Amy on Saturday? (A great deal of enjoyment.) 5. Since the $600 is a sunk cost (Leslie cannot get it back no matter what she does), she should look at the benefit of each of her choices and do the one that makes her happiest. The $600 gym membership should not figure into her decision. The sunk costs should be ignored! 6. Make sure students see the difference between sunk costs and explicit costs. Explicit costs (the amount paid for wages and materials) also cannot be recovered, but these are normal ongoing costs associated with producing output. Sunk costs are better thought of as one-time costs. Behavioral Economics Creating Student Interest • Ask students if they think of themselves as rational decision makers. Remind them that a rational decision maker chooses the outcome that leads to the most preferred outcome. When they decide not to study until one day before the exam, is this rational? Are they making the decision that gives them the most preferred outcome? They should argue yes here. Now point out that they could have earned a higher grade if they had chosen to begin studying earlier. Was the decision to wait rational even though they ended up with a B or C instead of an A? They could still argue yes because the action you prefer is not always the same as the action that gives you the highest payoff. Other examples to introduce at this time are charitable contributions and the decision to take a lower-paying job over a higher-paying job. Now ask students if they think they ever make decisions that leave them worse off than if they had chosen another option. These are the irrational decisions. Going back to the example of when to start studying for the exam, waiting until the last day could also have been an irrational decision. Suppose for example the students were overconfident about what they thought they knew, and then once they started studying they realized they would never have enough time to master what they needed to know. Being overconfident can lead people to make irrational decisions. Presenting the Material • This is a topic that you can really have fun with. Use a variety of examples to explain the difference between a rational and an irrational decision. Discuss reasons why a decision may be rational but still result in a lower economic payoff. Next, discuss the common reasons why people make irrational decisions. The use of examples is sure to stimulate some interesting class discussion. One approach would be to make a list of decisions and then have students discuss whether the decision was rational or irrational. • Use Handout 9-4 to help students think through rational and irrational decisions. Understanding Present Value • The appendix to Chapter 9 introduces the concept of present value. Often when a decision is made, the costs and benefits occur across several periods, or the costs and benefits can each occur in different periods. For example, you pay for college today in order to earn future benefits in terms of a higher salary. Explain the idea that a dollar earned or spent today is not equivalent to a dollar earned or spent in a future period. Common Student Pitfalls • Explicit versus implicit costs. Students may have forgotten that opportunity cost includes both explicit and implicit costs. Implicit costs are easy to ignore because no money is changing hands, but they are part of opportunity cost. Many students will be used to thinking about accounting profit rather than economic profit. Make sure they understand that an economic profit of zero corresponds to a positive accounting profit because of the implicit costs. • Why are there only two choices? Students may wonder why in either-or decision making there are only two choices. Tell them that there can be three or more choices. If there were more than two choices, you would compare two at a time, and discard the choice with the lowest return. The choice with the highest return will remain. • Total cost versus marginal cost. Students may be inclined to think that if marginal cost is decreasing, then so is total cost. Remind them that marginal cost is extra cost so that as long as marginal cost is positive, total cost will increase. • Muddled at the margin. Students may confuse the idea of setting marginal benefit equal to marginal cost with the idea of maximizing the difference between total benefit and total cost. The difference between total benefit and total cost is total profit. As long as marginal benefit is greater than marginal cost, doing more of an activity will increase total profit. Chapter Outline Opening Example: The opening story discusses a choice faced by many people every year, namely the choice of getting a job or continuing on with school. The decision-making concepts learned in this chapter will allow students to better understand this important choice. I. Costs, Benefits, and Profits A. Explicit versus implicit costs 1. The true cost of anything (its opportunity cost) is what you must give up to get it. Opportunity cost can be divided into explicit cost and implicit cost. 2. In considering the cost of an activity, you should include the cost of using any of your own resources for that activity. B. Accounting profit versus economic profit 1. Companies report their accounting profit, which is not necessarily equal to their economic profit. 2. Businesses can face implicit costs for two reasons. First, a business’s capital could have been put to use in some other way. Second, the owner devotes time and energy to the business that could have been used elsewhere. 3. Forgone interest earnings from financial assets used to pay for college are used to illustrate implicit cost of capital. C. Making “either-or” decisions 1. An either-or decision requires you to choose between two projects. II. Making “How Much” Decisions: The Role of Marginal Analysis A. Marginal analysis involves comparing the benefit of doing a little bit more of some activity (marginal benefit) with the cost of doing a little bit more of that activity (marginal cost). B. Marginal cost 1. For the production of some goods, the shape of the marginal cost curve changes as more output is produced. Marginal cost may first decrease, then become constant, then increase. 2. The simple case is to assume increasing marginal cost. C. Marginal benefit 1. In some cases marginal benefit is constant, such as when the perfectly competitive firm takes market price as given. Each unit sold yields the same price, or marginal benefit. 2. The example in this chapter assumes decreasing marginal benefit. D. Marginal analysis 1. The profit of an activity is the difference between the marginal benefit and the marginal cost. Profit can be calculated for each unit of a good produced. 2. The optimal quantity is the quantity that generates the highest possible profit. 3. Total profit is the sum of the profit earned in each individual year for the schooling example, or for all of the units of the good produced. 4. Text Figure 9-3 illustrates the optimal quantity as the quantity whose marginal benefit is equal to marginal cost. 5. According to the profit-maximizing principle of marginal analysis, when faced with a profit-maximizing “how much” decision, the optimal quantity is the largest quantity at which the marginal benefit is greater than or equal to marginal cost. E. A principle with many uses 1. The principle of marginal analysis can be applied to a variety of “how much” decisions, including those whose benefits and costs are not measured in dollars. 2. Some examples: a. A consumer has to decide how to allocate a weekly budget between restaurant meals and mocha lattes. b. A producer has to decide on the size of a new store. c. A physician has to decide on the optimal dosage of a drug by considering the marginal cost in terms of side effects versus the marginal benefit in terms of fighting the disease. III. Sunk Costs A. A sunk cost should be ignored in decisions about future actions. B. The choice between replacing parts on a car or selling the car and buying another car is used in the text to illustrate sunk costs. IV. Behavioral Economics A. Behavioral economics studies why it is rational for people to sometimes make less-than-perfect choices. B. Rational, but human, too 1. People sometimes make less-than-optimal choices because they are concerned about fairness. 2. A decision maker operating with bounded rationality makes a choice that is close to but not exactly the one that leads to the best possible economic outcome. A person makes a less-than-perfect choice because the effort of finding the best payoff is too costly. 3. People are sometimes risk averse and will sacrifice some economic payoff in order to avoid a potential loss. C. Irrationality: an economist’s view 1. An irrational decision maker chooses an option that leaves him worse off than if he had chosen another available option. 2. People’s irrational behavior stems from six mistakes: a. Misperceptions of opportunity cost—for example, including a sunk cost or ignoring an implicit cost. b. Overconfidence—for example, assuming your finances are better than they actually are. c. Unrealistic expectations about future behavior—for example, assuming you will study twice as hard tomorrow. d. Mental accounting, or the habit of making some dollars’ worth more than other dollars. For example, people often spend more if they use a credit card. e. An oversensitivity to loss (or loss aversion), leading to unwillingness to recognize a loss and move on; for example, refusing to sell a stock that is not performing well. f. Status quo bias, or the tendency to avoid making a decision and to stick with the status quo. D. Rational models for irrational people? 1. Models based on rational behavior still provide good predictions for most markets. 2. People sometimes behave more rationally over time, justifying the use of models based on rational behavior. 3. Models based on rational behavior are much simpler to work with. Case Studies in the Text Economics in Action Airbnb and the Rising Cost of Privacy—This EIA looks at the increasing market for short-term rentals and the space-sharing websites that make it easy to rent extra space. Ask students the following questions: 1. What are the implicit costs of renting out space in your home? (Loss of privacy, need to keep it clean, uncomfortable to have strangers in your home.) 2. What will happen to the prices received for renting out space as more space is available? (An increase in the supply of space will drive down prices.) The Cost of a Life—This EIA considers the “marginal cost of a life” and the role it can or does play in policy decisions. Ask students the following questions: 1. Why do we have to put a value on saving a life? (Resources are scarce; we must decide how much to spend on saving lives because we cannot spend infinite amounts.) 2. Can we make an efficient decision about using our resources for a particular policy (like improving rail safety) without calculating the value of saving a life? Explain. (There is an implicit value of a life in any decision to implement a potentially life-saving policy or not, whether we calculate it explicitly or not.) Biotech: The World’s Biggest Loser— This EIA looks at sunk costs and the biotech industry. Ask students the following questions: 1. What makes a cost “sunk”? (It cannot be recovered.) 2. Why are investors willing to continue to provide funds to the biotech industry? (Investors know that many experimental drugs will fail, but when a drug succeeds, the returns will be enormous.) The Jingle Mail Blues—This EIA discusses the increase in the number of people choosing to default on their mortgages, despite being capable of paying the mortgage. Ask students the following questions: 1. What is a strategic default? (This is default by a homeowner who is capable of paying the mortgage but instead chooses not to.) 2. Why has there been such a large increase in the number of strategic defaults? (The fall in housing prices that began in 2008 has left many homeowners “underwater.”) For Inquiring Minds In Praise of Hard Deadlines—This FIM describes the results of an experiment wherein three classes were given assignment schedules with different deadlines. The grades were then compared in order to learn more about the decisions the students made under each assignment schedule. Global Comparison House Sizes Around the World—This comparison shows that the average size of new homes in the world is directly related to the land mass available in the country (with the exception of China). Business Case J.C. Penney’s One-Price Strategy Upsets Its Customers—This business case discusses J.C. Penney’s experiment with a one-price strategy. The one-price strategy is compared with the more typical strategy of marking prices up and then posting a SALE sign, or offering a 20%-off coupon. Psychologically, buyers like the idea of a sale even though in reality they are not paying any less for goods than they would under a one-price strategy. Web Resources The following site will take you to a video of behavioral economist Dan Ariely. His research findings show how we’re not as rational as we think when we make decisions. http://www.ted.com/talks/dan_ariely_asks_are_we_in_control_of_our_own_decisions . Handout 9-1 Date _________ Name ____________________________ Class________ Professor ________________ College Opportunity Costs? Consider the costs of attending college. Write the costs in the appropriate column and estimate the amount of each cost. Sum the implicit costs. Sum the explicit costs. Then, calculate the opportunity cost of attending college. Implicit cost Estimate Explicit cost Estimate Total implicit costs Total explicit costs Handout 9-2 Date _________ Name ____________________ Class ________ Professor ________________ Explicit and Implicit Costs Consider the following scenario and answer the questions that follow. Larry has decided to quit his job working at Quickie-lube and become an entrepreneur. He had been earning $2,500 per month performing oil changes. Since he has his own garage, which he had been renting out for $400 per month, he has decided to open his own oil-changing business. His monthly costs and revenue are shown in the following list. Note: we are assuming no depreciation. Price of oil change = $25 Oil changes per month = 200 Cost of oil = $5 per oil change Equipment rental = $200 per month Other expenses = $1,000 per month 1. What is Larry’s total revenue for the month? 2. What are Larry’s explicit costs for the month? 3. If an accountant figured Larry’s profit, what would it equal? 4. What costs does Larry have that are not considered by the accountant? 5. If an economist calculated Larry’s profit, what would it equal? 6. What does the negative economic profit signal to Larry? Answers: Larry has decided to quit his job working at Quickie-lube and become an entrepreneur. He had been earning $2,500 per month performing oil changes. Since he has his own garage, which he had been renting out for $400 per month, he has decided to open his own oil-changing business. His monthly costs and revenue are shown in the following list. Note: we are assuming no depreciation. Price of oil change = $25 Oil changes per month = 200 Cost of oil = $5 per oil change Equipment rental = $200 per month Other expenses = $1,000 per month Have the class work through the answers to each of the following questions: 1. What is Larry’s total revenue for the month? (P × Q = $25 × 200 = $5,000.) 2. What are Larry’s explicit costs for the month? (Oil = $1,000, rental = $200, other = $1,000; TOTAL = $2,200.) 3. If an accountant figured Larry’s profit, what would it equal? (TR – TC [explicit] = $5,000 – $2,200 = $2,800.) 4. What costs does Larry have that are not considered by the accountant? (He has implicit [opportunity] costs. His forgone earnings = $2,500 and his forgone garage rental = $400 for total implicit costs = $2,900.) 5. If an economist calculated Larry’s profit, what would it equal? (TR – TC [implicit and explicit] = $5,000 – [$2,200 + $2,900] = $5,000 – $5,100 = –$100.) 6. What does the negative economic profit signal to Larry? (His accounting profit is $2,800. If he hadn’t opened his own business, he could have earned $2,500 working for Quickie-lube and $400 for renting out his garage [$2,900]. He would have made $100 more if he had stayed at Quickie-lube. The negative economic profit means that he could do better in his next-best alternative. An economic profit of zero means that he would earn the same in his next-best alternative. A positive economic profit tells him he is earning more than he could in his next-best alternative. For Larry to choose to open his own business in this case, he must be getting more than $100 worth of satisfaction each month from owning his own business.) (When Larry evaluates whether he should keep his business open or not, this is an example of an either-or decision. A person deciding to pursue activity A or activity B will pick the activity with the positive economic profit. Note that keeping the business open yields an economic profit of –$100. Closing the business will yield an economic profit of $100. Make sure the students are clear about the difference between either-or decisions and “how much” decisions.) Handout 9-3 Date _________ Name _____________________ Class ________ Professor ________________ Carpet Cleaning Sam begins to clean carpets for family and friends. He is trying to determine the optimal quantity of carpets to clean. In the table below, calculate Sam’s marginal costs and marginal benefits. Also, calculate his total gain at each quantity of carpets cleaned. Quantity of carpets cleaned Total cost Marginal cost Total benefit (price) Marginal benefit Total net gain 0 $ 0 $— $ 0 $— $— 1 20 60 2 42 110 3 68 150 4 100 180 5 140 200 What is Sam’s optimal number of carpets cleaned? Is this the point of maximum total net gain? What is happening to marginal benefits as the number of carpets cleaned increases? Why is this happening? What is happening to marginal costs as the number of carpets cleaned increases? Why is this happening? Answers: Sam begins to clean carpets for family and friends. He is trying to determine the optimal quantity of carpets to clean. In the table below, calculate Sam’s marginal costs and marginal benefits. Also, calculate his total gain at each quantity of carpets cleaned. Quantity of carpets cleaned Total cost Marginal cost Total benefit (price) Marginal benefit Total net gain 0 $ 0 $— $ 0 $— $— 1 20 20 60 60 30 2 42 22 110 50 68 3 68 26 150 40 82 4 100 32 180 30 80 5 140 40 200 20 60 What is Sam’s optimal number of carpets cleaned? Is this the point of maximum total net gain? The optimal number of carpets cleaned is 3. That is the maximum net gain of $82. What is happening to marginal benefits as the number of carpets cleaned increases? Why is this happening? Marginal benefits are diminishing in this example based on the assumption that price must be lowered in order to attract more customers. It would not be reasonable to assume there exists an unlimited number of customers willing to pay the same price for a carpet cleaning. What is happening to marginal costs as the number of carpets cleaned increases? Why is this happening? Cleaning marginal cost in this case is increasing because as more carpets are cleaned per day, the opportunity cost of Sam’s time will increase. He may even have to hire a helper. More carpets per day also increases the depreciation and maintenance on his equipment. Handout 9-4 Date_________ Name ______________________ Class ________ Professor ________________ Rational or Irrational? Explain why a person might make each of the following rational choices: 1. Fred needs to buy a new computer, compares the prices at the two stores close to his house, and picks the store with the lower price. Fred does not check the price at any other store that sells the same computer. 2. Jane gives $1,000 to the local food bank each year. 3. Bob thinks that if he quit his current job and moved to New York City, there is a good chance he would be able to find a job that pays twice his current salary. Bob decides to stay with his current job. Explain why a person might make each of the following irrational choices: 1. Ben lost his job as a construction worker, and although he has been offered jobs as a maintenance worker, he is still looking for a new construction job. 2. George owns 10 houses that he bought because he thought it was a good investment. Although he has observed housing prices declining, he refuses to sell any of his houses. 3. Bill refuses to go back and get a second degree because he has already paid for one college degree. 4. Jack has not yet reduced his spending despite the fact that his wealth has declined and people at his place of employment are being laid off. 5. Mary wants a new car but does not want to spend her savings. After an unexpected bonus at work, she decides to buy the car. 6. Mark knows he could get a better job if he moves to another city, but he has not sent off any résumés. Answers Rational: 1. Fred is operating with bounded rationality. It is too costly to search all the stores and find the lowest price. 2. Jane is concerned about fairness. 3. Bob is risk averse. Irrational: 1. Ben is overconfident. 2. George is experiencing loss aversion. 3. Bill has misperceptions about opportunity cost. 4. Jack has unrealistic expectations about future behavior. 5. Mary is counting her dollars unequally. 6. Mark has status quo bias. Handout 9-5 Date_________ Name _________________________ Class ________ Professor ________________ Ski Rental Costs Calculate the accounting profit and economic profit for the following case study. The owner of Crested Butte Ski Rentals purchased $150,000 worth of skis for rentals. The revenue from the rentals is $300,000. Utilities are $20,000 per year and wages are $50,000. There is an outstanding loan, and the interest owing per year is $12,000. If the skis had not been purchased, the owner could earn $11,500 in annual interest income on the $150,000 otherwise used to buy the skis. The owner was offered a managerial position at another ski shop for $40,000 a year. Accounting profit Accounting profit Economic profit Accounting profit Revenues: Revenues: Costs: Costs: Total cost: Total cost: Total accounting profit: Total economic profit: Should the owner continue in business? Why? Answers Accounting profit Accounting profit Economic profit Accounting profit Revenues: +$300,000 Revenues: +$300,000 Costs: Costs: Cost of skis –150,000 Cost of skis –150,000 Cost of utilities –20,000 Cost of utilities –20,000 Wages –50,000 Wages –50,000 Interest owed –12,000 Interest owed –12,000 Forgone interest on money used to buy skis –11,500 Forgone salary opportunity –40,000 Total cost: –232,000 Total cost: –283,500 Total accounting profit: +68,000 Total economic profit: 16,500 Should the owner continue in business? Why? Yes, he is earning an economic profit. Handout 9-6 Date _________ Name _______________________ Class ________ Professor ________________ Expensive Babies In her book The Price of Motherhood, Ann Crittenden claims the total cost for a college-educated couple to have a child is $1 million over the child’s lifetime. She discusses the following items as the costs of an educated woman having a child. Classify these as explicit or implicit costs of having a child. 1. Unearned social security credits 2. Forgone promotions 3. Salary while not working 4. Expenses for baby’s room 5. Loss of experience at work 6. Depreciation of work skills 7. Food and clothing for the child 8. Loss of pension benefits 9. Awards given for excellence in your paid job 10. Babysitting fees 11. Preschool expenses 12. Earnings from paid work contributed by an employer to a retirement account 13. Doctor visits/medical expenses 14. Costs of decorating child’s room 15. Lost training opportunities at work Answers 1. Unearned social security credits (implicit cost) 2. Forgone promotions (implicit cost) 3. Salary while not working (implicit cost) 4. Expenses for baby’s room (explicit cost) 5. Loss of experience at work (implicit cost) 6. Depreciation of work skills (implicit cost) 7. Food and clothing for the child (explicit cost) 8. Loss of pension benefits (implicit cost) 9. Awards given for excellence in your paid job (implicit cost) 10. Babysitting fees (explicit cost) 11. Preschool expenses (explicit cost) 12. Earnings from paid work contributed by an employer to a retirement account (implicit cost) 13. Doctor visits/medical expenses (explicit cost) 14. Costs of decorating child’s room (explicit cost) 15. Lost training opportunities at work (implicit cost) Chapter 10: The Rational Consumer What’s New in the Fifth Edition? • Updated business cases • Updated Teaching Tips • Handouts for in-class use Chapter Objectives • Explain the concept of utility as a measure of the satisfaction from consumption. • Explain why the principle of diminishing marginal utility applies to the consumption of most goods and services. • Explain how the budget constraint determines what a consumer can afford to buy. • Explain how marginal analysis can be used to determine the consumption choice that maximizes utility. • Define the income and substitution effects in order to better understand the law of demand. Teaching Tips Utility: Getting Satisfaction Creating Student Interest • Bring a supply of small treats to class (e.g., a box of “donut holes” works well in a morning class). Ask for a volunteer who enjoys the treat you have brought. Tell them that you will give them the treats in return for data you can use in the class. Give them a treat and let them eat it. Then ask the student for your data—“How much did you like the donut hole?” The student will probably ask you for more information, such as “compared with what?” or “on what scale?” Tell them that they agreed to give you the data in return for the donut hole and press them to give you the answer. After making the student squirm for a bit, explain that the satisfaction received from consuming a good is measured in “utils,” or units of utility. Then ask the student “how many units of utility did you receive from eating the donut hole?” Still, the student may not want to answer. Encourage them by pointing out that they are the only one who knows the answer and they have promised to give you the data. Eventually you should be able to get a number from them. Record the data on the board and then give them another donut hole. Repeat the process. The number they give will decline eventually. At some point, the student will refuse an additional donut. Coax them to eat as many as they will. When they won’t eat any more, ask them why. Eventually you will get at the idea that their utility is 0 (or negative). Sometimes students will say they don’t want to eat more because they are thirsty from the donut holes. If you’d like, bring something for them to drink (say, orange juice), but don’t let them have it (violating the premise of ceteris paribus) and then discuss complements! Once your final data is recorded, calculate total utility and graph total and marginal utility. • If you don’t want to bring food to class, or if you have no volunteers for the exercise, talk about what happens when you are really hungry and you order a pizza. Do you eat more than one slice? Do you get the same satisfaction from each slice? Is it possible that the last slice actually gave you negative satisfaction (after the fact)? • Presenting the Material • Use Worksheet 10-1 to introduce the calculation of marginal utility and to discuss diminishing marginal utility. • Students often are mystified by the whole concept of attaching a number to how much they like something. Explain that the numbers are useful for explaining how consumers make decisions. Point out that the number itself does not matter, just the ranking. As long as they can tell you that bundle A is preferred to bundle B, then bundle A must have a higher utility number. The relative value of the numbers matters also. If you like brand A twice as much as brand B, then the marginal utility from brand A should be twice that of brand B. Ask them what happens if you like the two brands equally. Which one do you buy? Budgets and Optimal Consumption Creating Student Interest • Ask students if they have a budget constraint. What determines their budget constraint? Does everyone have a budget constraint? Is it possible to consume beyond your budget constraint? If so, for how long? Students may say that credit cards or other sources of credit can allow them to consume beyond their budget constraint. If that is the case, point out that this can’t go on forever and ask them what it does to their budget constraint in the future if they run up their credit card today. (It will decrease their budget constraint when the credit card must be paid off or they suffer the effects of defaulting.) Spending the Marginal Dollar Creating Student Interest • Present the class with the following scenario: Each student has $10 to spend on either Oreos or Chips Ahoy cookies. Ask them which they would buy and why. There will probably be a discussion about the different characteristics of the cookies (the tastiness of the creamy center filling versus the chocolate chips) and who likes which kind of cookie and why. If during the discussion no one asks how much each type of cookie costs, announce to the class, “Oh, I forgot, Oreos cost 50 cents each and Chips Ahoy cookies cost $5 each.” Ask if this information changes their decision. If anyone hates Oreos, they will not change their decision. However, anyone who is willing to substitute Oreos for Chips Ahoy cookies will change their decision. Presenting the Material • Return to the Handout 10-1 to see how marginal utility per dollar is calculated. From Utility to the Demand Curve Creating Student Interest • Ask students how they have responded to increases in the price of gasoline over the past few years. Ask them how they would respond if the price of gasoline doubled over the next two years. What alternatives do they have for buying gasoline? Could they change to zero consumption of gasoline in the short run? In the long run? In the short run, when the price of gasoline increases, what happens to the income they have to spend on other goods? Presenting the Material • Review the law of demand and the downward-sloping individual and market demand curves. The law of diminishing marginal utility is behind the law of demand. Use the following examples: ○ The substitution effect: The change in quantity consumed as the consumer substitutes the relatively cheaper good for the more expensive good. • As the price of gasoline rose from $1.50 to $2.00, the marginal utility per dollar of a gallon of gasoline fell. Consumers could increase their utility by purchasing fewer gallons. • If the price of computer peripherals falls, the marginal utility per dollar has risen and consumers will buy more. Again, consumers can increase their utility by buying more computer accessories. • The substitution effect dominates when items purchased are a small portion of the consumer’s total budget. ○ The income effect: The change in purchasing power due to the higher price of a good. • College tuition has risen steadily over the past 10 years. The result is that tuition payments take a bigger portion of a consumer’s income, and consumers have less purchasing power for other goods. In contrast, if the price of newspapers rises, there is less of an impact on consumer incomes. • Use Handout 10-2 to discuss substitution and income effects. Common Student Pitfalls • All income is spent. Students may ask why a consumer cannot choose a consumption bundle within the budget constraint. Explain that in these exercises we assume that the consumer maximizes utility but receives zero utility from saving money. • The “right” marginal comparison—marginal utility versus marginal utility per dollar. Students often say that a consumer will buy the good with the highest marginal utility rather than the highest marginal utility per dollar. Remind them that consumers look at two things: how much extra utility they will receive from consuming a good and the price of the product. The marginal utility per dollar incorporates both of these factors. • Understanding the income effect. Students have a harder time understanding the income effect than they do the substitution effect of a price increase. Explain that in reality the consumer has not lost “income” but rather has lost purchasing power when on a fixed budget. Chapter Outline Opening Example: The opening example discusses maximizing utility at an all-you-can-eat buffet. When does a consumer stop eating? I. Utility: Getting Satisfaction A. Utility and consumption 1. The utility of a consumer is a measure of the satisfaction the consumer derives from consumption of goods and services, or their consumption bundle. 2. An individual’s utility function gives the total utility generated by their consumption bundle, measured in utils. B. The principle of diminishing marginal utility 1. The principle of diminishing marginal utility says that each successive unit of a good or service consumed adds less to total utility than the previous unit. II. Budgets and Optimal Consumption A. Budget constraints and budget lines 1. A consumer’s budget constraint defines the consumption possibilities for the consumer and depends on the consumer’s income and the prices of the goods and services as illustrated in Figure 10-2, shown next. 2. Every consumption bundle on or inside the budget line is affordable, whereas every bundle outside the budget line is unaffordable. B. Optimal consumption choice 1. An individual’s optimal consumption bundle is the one that maximizes total utility and so puts the individual at the top of their total utility curve. III. Spending the Marginal Dollar A. Marginal utility per dollar 1. When deciding to purchase a good, a consumer weighs the additional utility to be derived from the good against the additional cost (price) of the good. 2. MUc and MUp indicate the marginal utility of clams and potatoes, respectively. 3. The marginal utility per dollar of clams = MUc/Pc, and the marginal utility per dollar of potatoes = MUp/Pp. B. Optimal consumption 1. According to the utility-maximizing principle of marginal analysis, the marginal utility per dollar spent must be the same for all goods and services in the optimal consumption bundle. 2. In equation form, the optimal consumption rule for two goods C and P is: MUC / PC = MUP / PP 3. If the ratios of the marginal utility per dollar for the two goods are not equal, consumers will adjust their choices until the marginal utilities per dollar spent for each and every good or service in that bundle are equal. IV. From Utility to the Demand Curve A. Marginal utility, the substitution effect, and the law of demand 1. If the price of a good rises (falls), the marginal utility per dollar of that good falls (rises) and gives the consumer an incentive to consume fewer (more) units. 2. Point 1 confirms the law of demand: The individual’s demand curve, which relates an individual’s consumption of a good to the price of that good, is normally downward sloping. 3. When a good absorbs a small share of the consumer’s budget, the substitution effect is essentially the entire reason that the demand curve slopes downward. B. The income effect 1. For the great majority of goods and services, the income effect is not important and has no significant effect on individual consumption because the good absorbs a small share of a consumer’s budget. 2. When the income effect matters at all (when a good absorbs a large share of a consumer’s budget), the income effect usually reinforces the substitution effect. When the price of a good that constitutes a large share of income rises, consumers of that good are poorer because their purchasing power falls. This effective reduction in income causes the consumer to demand less of that good. 3. In the case of an inferior good, the income and substitution effects work in opposite directions. An increase in price that reduces purchasing power will increase quantity demanded. Case Studies in the Text Economics in Action Is Salmon a Luxury? It Depends—This EIA looks at the change in salmon consumption between Colonial times and today. Salmon was a common food in Colonial times. Over time, pollution and overfishing threatened salmon and it became a delicacy. This EIA explains why. Ask students the following questions: 1. Why in the past was salmon considered a luxury dish? (The quantity of salmon produced was low due to overfishing and pollution.) 2. Why did the marginal utility of salmon fall for most consumers? (New technology increased the mass production of salmon, making salmon easier to obtain. The result: lower additional satisfaction from eating salmon.) The Great Condiment Craze—This EIA discusses the change in the market for condiments, from a market with only a few choices to a market with a vast array of choices. Ask students the following questions: 1. How did a change in preferences result in more choices on the condiment aisle? (Consumers have been more exposed to gourmet and ethnic cuisine over the years and want to spice up their home cooking.) 2. How does the cost of production help explain more choices on the condiment aisle? (It is relatively easy to make bottled condiments, so small companies can experiment and find the flavors that consumers prefer.) Buying Your Way Out of Temptation—Consumers will pay more to get less when they gain utility from smaller portions. (They are removed from the temptation to overeat.) Ask students the following questions: 1. Why are consumers willing to pay more for a smaller portion of a product? (They are paying for help in restraining their tendency to overeat.) 2. Why don’t consumers simply save money by buying the larger packages and separating them into smaller portions placed in Ziploc bags? (They are willing to pay to save the effort required to separate the portions—the convenience is worth the higher price.) Lower Gasoline Prices and the Urge to Splurge—This EIA discusses gasoline prices and how the recent lower prices increase consumer spending, using the income and substitution effects. Ask students the following questions: 1. Gasoline prices fell in the 2014 to 2015 period. In what way did the income effect prevail? (People saw an increase in their effective income, allowing them to buy more. In fact, people spent 80% of their windfall.) 2. How did the substitution effect play out when gasoline prices fell? (People bought not only more gasoline, but also higher grades of gasoline.) For Inquiring Minds Food for Thought on Budget Constraints—This FIM explains that budget constraints are not just about money. Business Case Freedom from Fries—This business case discusses recent declines in sales at the nation’s largest restaurant chain. Web Resources The following websites may provide useful information for students: MyMoney.gov: https://www.mymoney.gov/Pages/default.aspx Money Instructor web page on budgeting (including information and curriculum): http://www.moneyinstructor.com/budgeting.asp Handout 10-1 Date _________ Name _______________________ Class ________ Professor ________________ Maximizing Utility Use the following table to determine Sergio’s utility maximizing bundle of bags of peanuts and quantity of Cokes. Sergio has a budget of $12. Follow the steps below. (1) Quantity of bags of peanuts (2) Total utility (3) Marginal utility (4) Marginal utility per dollar (5) Quantity of Cokes (6) Total utility (7) Marginal utility (8) Marginal utility per dollar 0 0 — — 0 0 — — 1 10 1 8 2 19 2 14 3 27 3 18 4 34 4 21 5 40 5 23 1. Calculate the marginal utility (MU) of peanuts and the MU of Cokes. Record those numbers in columns (3) and (6). What is happening to MU as the number of bags of peanuts consumed increases? 2. Calculate the MU per dollar spent for each quantity of each good. Record those in columns (4) and (7). 3. Now have Sergio choose among different combinations of bags of peanuts and Cokes. He has only $12 to spend; the price of peanuts is $2, and the price of a Coke is $1. What is the optimal number of bags of peanuts and Cokes that Sergio should purchase to maximize his utility? 4. What is the optimal consumption bundle when Sergio’s income is $9? Answers (1) Quantity of bags of peanuts (2) Total utility (3) Marginal utility (4) Marginal utility per dollar (5) Quantity of Cokes (6) Total utility (7) Marginal utility (8) Marginal utility per dollar 0 0 — — 0 0 — — 1 10 10 (∆TU/∆Q) 10/2 = 5 (will buy 3rd) 1 8 8 8 (will buy 1st) 2 19 9 9/2 = 4.5 will buy 4th) 2 14 6 6 (will buy 2nd) 3 27 8 8/2 = 4 (will buy 5th or 6th) 3 18 4 4 (will buy 5th or 6th) 4 34 7 7/2 = 3.5 (will buy 7th) 4 21 3 3 (will buy 8th) 5 40 6 6/2 = 3 5 23 2 2 1. Calculate the marginal utility (MU) of peanuts and the MU of Cokes. Record those numbers in columns (3) and (6). What is happening to MU as the number of bags of peanuts consumed increases? See table above. 2. Calculate the MU per dollar spent for each quantity of each good. Record those in columns (4) and (7). See table above. 3. Now have Sergio choose among different combinations of bags of peanuts and Cokes. He has only $12 to spend; the price of peanuts is $2, and the price of a Coke is $1. What is the optimal number of bags of peanuts and Cokes that Sergio should purchase to maximize his utility? The optimal bundle at which Sergio spends the entire $12 budget will be four Cokes and four bags of peanuts. 4. What is the optimal consumption bundle when Sergio’s income is $9? The optimal consumption bundle is 3 bags of peanuts and 3 Cokes. Handout 10-2 Date _________ Name ____________________ Class ________ Professor ________________ Substitution and Income Effects Describe the substitution effect and (if it is significant) the income effect of the following cases. Situation Substitution effect Income effect 1. The price of college tuition rises. 2. The price of gasoline rises. 3. Prices at Walmart are consistently lower than those of other local retailers. 4. The price of weddings has skyrocketed. 5. The price of buying private medical insurance has climbed. Answers Describe the substitution effect and (if it is significant) the income effect of the following cases. Situation Substitution effect Income effect 1. The price of college tuition rises. Students may substitute community colleges for more expensive universities. 2. The price of gasoline rises. Buyers cut driving to less essential destinations. 3. Prices at Walmart are consistently lower than those of other local retailers. Buyers shop more at Walmart. Shoppers have more purchasing power for other goods after shopping at Walmart. 4. The price of weddings has skyrocketed. Couples opt for smaller weddings. Couples may forgo or cut back on the honeymoon. 5. The price of buying private medical insurance has climbed. Individuals may go without health insurance. Families who purchase private insurance have less money to spend on other goods. Chapter 10A: Appendix: Consumer Preferences and Consumer Choice What’s New in the Fifth Edition? Appendix Objectives • Explain how indifference curves can be used to illustrate a person’s preferences. • Explain how to find the optimal consumption bundle using indifference curves and the budget line. • Explain how indifference curves and the budget line can be used to illustrate the income and substitution effects of a price change. Teaching Tips Mapping the Utility Function Creating Student Interest • Start with a discussion of the meaning of the term indifference. Ask students for their definitions of the term. Present the definitions: not making a difference; lack of sufficient importance to constitute a difference. Make sure students understand that “indifference curves” illustrate various combinations of goods that don’t make a difference to your utility; that is, changing from one to the other does not change your utility. Another way of expressing this idea: There is a lack of sufficient importance in the difference between the combinations of goods to make a difference in the utility they give you. Or, the combinations of goods on an indifference curve are all the same to you (you are indifferent between them)! • Present the following scenario: A group of friends are getting into a car to drive to dinner. As they start to leave, the driver asks which restaurant they are going to. Everyone in the car says they don’t care. If everyone is truly indifferent as to where they eat, how can they ever decide where to go for dinner at all? Ask the class if anyone thinks it is possible to be truly indifferent, and what that would mean. If everyone is truly indifferent, will the group go to dinner at all? Does it matter where they eventually eat? Would it make sense simply not to go to dinner? How can the group come to a decision? Use the discussion to foreshadow the introduction of prices and income as part of decision making. Presenting the Material • Use Handout 10A-1 to have students work with consumptions bundles and indifference curves. Indifference Curves and Consumer Choice Creating Student Interest • Use this class experiment to illustrate the marginal rate of substitution. Bring in two bags of miniature candy, such as Hershey’s Kisses or Reese’s Pieces. Choose two or three students to participate and give them each a large quantity of one candy and a more modest quantity of the other. Now have them reveal how many pieces of the abundant candy they will trade for a piece of the scarce candy. See if they have a diminishing marginal rate of substitution. Now that they have seen preferences illustrated graphically, ask students which bundle they will choose to consume. At this point, students should remember that they have a budget constraint that limits their possible choices. Ask students under what circumstances they can consume a bundle that lies beyond their budget constraint. (They must borrow, face a lower price of at least one good, or receive a higher income.) Presenting the Material • Continue to use Handout 10A-1 to calculate marginal rates of substitutions and to insert budget constraints. Using Indifference Curves: Substitutes and Complements Creating Student Interest • Divide the class in half. Ask one group of students to think of examples of two goods that are complements and ask the other group to think of two goods that are substitutes. Further challenge them for “bonus points” to think of nonfood complements or substitutes. Make a list of substitutes and a list of complements. Go through the lists and identify any that could be perfect substitutes or complements. (Identify under what conditions they would be considered “perfect.”) Presenting the Material • Use the following example of two goods that are perfect substitutes for Anna: She is completely indifferent to having two scoops of vanilla ice cream and one scoop of chocolate chip, or vice versa. Any combination that adds up to three scoops yields the same utility. If this is true, the marginal rate of substitution along an indifference curve is constant and the indifference curve is a straight, downward-sloping curve. • Another extreme case is perfect complements. Allan wants to buy only four tires and one car, regardless of their relative prices. A car without four tires yields zero utility. The marginal rate of substitution is undefined because Allan’s preferences do not allow any substitution. • Students also can relate to the example of college courses and textbooks as perfect complements. If each course requires one textbook (assume you can’t pass the class without a textbook, and there is no way to get a textbook without buying one), then students will purchase one textbook with each course. Having additional textbooks without taking additional courses provides no additional utility—unless you love reading textbooks on your own; and taking an additional course provides no additional utility without an additional textbook—unless you get utility from paying tuition to sit in on courses that you really can’t follow without a textbook. So students will generally purchase a 1:1 ratio of textbooks to courses. Prices, Income, and Demand Creating Student Interest • Ask students how they would feel if their income was suddenly doubled and why? A higher income will make consumers happier (able to reach a higher level of utility). (This represents the income effect shown by a parallel shift out of the budget line.) Presenting the Material • Use the text example in which Ingrid consumes two goods: rooms in an apartment (R) and restaurant meals (M). Prices of rooms increase from $150 per room to $600 per room. The price of restaurant meals remains unchanged at $30. As a result, her budget line swings inward. See text Figure 10A-17, shown next. Now walk students through the steps of determining how Ingrid responds to this price change. This response is broken down into a substitution effect and an income effect: 1. The higher price of rooms causes her to consume fewer rooms and more restaurant meals. Her budget line rotates inward. (The result is a decline in her purchasing power; it is as if her income has fallen.) 2. To isolate the substitution effect we have to pretend for the moment that her income has gone up enough to compensate for the increase in prices of rooms PR, so that her total utility is the same as before; this is represented on the graph by the dotted line parallel to her new budget line. The slope of the budget line changed but her utility did not. The movement along her original indifference curve from bundle A to B is the pure substitution effect. (This is “pure” because we assume for the moment that she has lost no purchasing power.) She now consumes more meals and fewer rooms. 3. The remainder of the drop in rooms consumed from B to C is the pure income effect. Common Student Pitfalls • Indifference curves. Make sure that students understand the meaning of the term indifferent. When they understand the meaning of the indifference curve (the combinations of goods on a single curve yield equal utility), then move on to the indifference map. Explain that each possible level of utility has its own indifference curve. What gives higher utility? More of one or both goods, so indifference curves farther to the right represent increased levels of utility. • Other things equal, revisited. Recall that the law of demand states that as the price of a good increases, the quantity demanded decreases (and vice versa)—all other things equal. It is easy to forget the “other things equal” assumption that goes along with the law. Among the things that are held equal are the prices of other goods and consumers’ income. Since the position and slope of the budget line are affected by changes in price or income, it is important to emphasize that a change in the price of a good will inversely affect the quantity demanded all other things equal. A change in the price of a good may not change the quantity demanded if other factors (income or the price of other goods) change. • Tangency with the budget line. Students may get confused about what the budget line and indifference curves represent. Explain to students that in order to demand a good, a consumer must be both willing and able to purchase it. Willingness comes from consumer preferences (indifference curves) and ability is determined by price and income (the budget line). To determine demand, we need to represent both willingness and ability. Combinations of goods beyond the budget line are not attainable (we are not able to purchase them). We are able to purchase combinations of goods on an indifference curve that crosses (or lies entirely below) the budget line, but we prefer those on a higher indifference curve. The highest level of utility we can afford is given by the indifference curve that just barely touches the budget line (tangency). • Complements and substitutes shown with indifference curves. Students may need an additional explanation of how complements and substitutes are shown using indifference curves. To explain complements, use the example of a person who drinks coffee with sugar. The person will only drink a cup of coffee with one packet of sugar and will not eat sugar unless it is in a cup of coffee. Therefore, one cup of coffee with no sugar or one packet of sugar with no coffee creates no utility. One sugar and one coffee give the person some utility. Adding a second sugar or a second cup of coffee does not create additional utility, but adding one more cup of coffee AND one more packet of sugar creates more utility than one cup of coffee and one sugar. Use the example to create a table showing the combinations from this example, and then draw the corresponding indifference curves, showing how the right-angle “curves” illustrate perfect complements. To help students understand substitutes, present the example of a person who is completely indifferent between apples and oranges. One apple or one orange— it’s all the same to this person. In this case, the price of the goods will determine whether the person will choose apples or oranges. The text presents an example using chocolate chip and peanut butter cookies as substitutes. Appendix Outline I. Mapping the Utility Function A. Indifference curves 1. Indifference curves graphically express total utility as a function of two goods and show all the consumption bundles that yield the same amount of total utility for an individual. 2. An individual is always indifferent between any two bundles that lie along the same indifference curve. 3. Given a consumer’s tastes, there is an indifference curve corresponding to each possible level of total utility. 4. As indifference curves shift out from the origin, any combination on a higher indifference curve is preferable to that on a lower indifference curve. 5. A collection of indifference curves in which each curve corresponds to a different total utility level is called an indifference curve map and represents the entire utility function of an individual. B. Properties of indifference curves 1. Indifference curves have two properties: a. Indifference curves never cross; each consumption bundle refers to a unique utility level. b. The farther out the indifference curve lies—the farther it is from the origin—the higher the level of total utility it indicates. 2. For most consumption goods, economists add two additional properties of indifference curves. a. Indifference curves are downward sloping—more is better. The only way a consumer can consume more of one good without gaining utility is if he or she gives up some of the other good in return. b. Indifference curves have a convex shape; this feature is due to the law of diminishing marginal utility. II. Indifference Curves and Consumer Choice A. The marginal rate of substitution 1. As we move down an indifference curve, an individual trades more of one good for less of the other good, with the terms of that trade-off—the ratio of one good consumed to the other good sacrificed—chosen to keep a person’s total utility constant. 2. Using the text example, the equation for the slope of an indifference curve is ∆QM/∆QR = –MUR/MUM, where R represents the quantity of rooms (the good on the horizontal axis) and M represents the quantity of restaurant meals (the good on the vertical axis). 3. As we move along an indifference curve, the change in total utility from one good equals the change in total utility from the other good. –MUM × ∆QM = MUR × ∆QR 4. The marginal rate of substitution, or MRS, of good R in place of good M is how much of one good must be given up to gain an additional quantity of another good, maintaining a constant level of total utility. MRS = MUR/MUM, the ratio of the marginal utility of R to the marginal utility of M. 5. The principle of diminishing marginal rate of substitution states that the more of good R a person consumes in proportion to good M, the less M he or she is willing to substitute for another unit of R. 6. Indifference curves get flatter as we move down them to the right. This is because of diminishing marginal utility, which can also be expressed as the principle of diminishing marginal rate of substitution. 7 Ordinary goods, goods that exhibit diminishing marginal rate of substitution, account for the great majority of goods in any consumer’s utility function. B. The tangency condition 1. The goal of an individual is to obtain the highest level of total utility given the budget constraint. Indifference curves illustrate the most preferred bundles. The budget line illustrates the affordable bundles. 2. When the indifference curve and the budget line just touch, the tangency condition is met. This condition determines the optimal consumption bundle when the indifference curves have the typical convex shape. This is illustrated in text Figure 10A-6, shown next. C. The slope of the budget line 1. The slope of the budget constraint line is: where N is income, PM is the price of meals, and PR is the price of rooms, with R on the horizontal axis and M on the vertical axis. 2. The relative price of good R, in terms of good M, is equal to minus the slope of the budget line (or PR/PM), when R is on the horizontal axis and M is on the vertical axis. D. Prices and the marginal rate of substitution 1. The slope of the indifference curve is: –MUR / MUM 2. The relative price rule states that at the optimal consumption bundle, the marginal rate of substitution between two goods is equal to their relative price. 3. We find the same optimal consumption bundle by using either the optimal consumption rule (see Chapter 10) or the relative price rule (discussed in this appendix). E. Preferences and choices 1. When two consumers have different preferences, they have different utility functions. This means that they will have indifference curve maps with different shapes. And those different maps will translate into different consumption choices, even among consumers with the same income who face the same prices. III. Using Indifference Curves: Substitutes and Complements A. Perfect substitutes 1. Two goods are perfect substitutes if the marginal rate of substitution of one good in place of the other good is constant, regardless of how much of each an individual consumes. a. Graphically, indifference curves for perfect substitutes are shown as downward-sloping straight lines. 2. Unless the relative price ratio equals the marginal rate of substitution, the optimal consumption bundle will be at either the horizontal or vertical intercept of an indifference curve. B. Perfect complements 1. Two goods are perfect complements when a consumer wants to consume the goods in the same ratio, regardless of their relative price. a. Graphically, indifference curves for perfect complements take the form of right angles. 2. The optimal consumption bundle will always occur at the corner of the right angle. C. Less extreme cases 1. In most cases, the possibility for substitution between most goods lies between perfect substitutes and perfect complements. 2. In some cases, it is difficult to tell whether two goods are substitutes or complements. IV. Prices, Income, and Demand A. The effects of a price increase 1. When the price of one good changes, the relative price of the good in terms of the other good changes. This rotates the budget line. 2. This change in the budget line leads to the choice of a new consumption bundle. 3. An increase in the price of one good reduces a consumer’s purchasing power. B. Income and consumption 1. If income falls, holding relative price constant, the consumer must reduce consumption of one of the goods, or both. 2. When income falls, the budget line shifts inward but the slope does not change. When income rises, the budget line shifts out. 3. Reducing consumption in this way puts the consumer at a lower level of total utility, represented by a lower indifference curve. C. Income and substitution effects 1. The substitution effect of a price change is the change in consumption that arises from the substitution of the good that is now relatively cheaper for the good that is now relatively more expensive. 2. The income effect of a price change is the change in consumption caused by the change in purchasing power arising from the price change. 3. People substitute between goods because the increase in the price of a good raises its opportunity cost. 4. The income effect occurs because a decrease in purchasing power makes consumers feel poorer. 5. For normal goods, the income effect and the substitution effect work in the same direction: A price increase induces a fall in the quantity consumed by the substitution effect and a fall in the quantity consumed by the income effect. 6. For an inferior good, the income effect and the substitution effect work in opposite directions. Web Resources The following websites provide information that may be useful to students as they study this material. About.com presents indifference curves using a production example: https://www.thoughtco.com/using-and-understanding-indifference-curves-1147588 Handout 10A-1 Date _________ Name ______________________ Class ________ Professor ________________ Indifference Curves For Jim, the following combinations of goods give him equal satisfaction. Consumption bundle Quantity of concerts per month Quantity of videos rented per month Total utility A 2 15 30 B 3 10 30 C 4 7 30 D 5 6 30 E 6 5 30 Plot each of these consumption bundles on a graph to illustrate the indifference curve. Plot a bundle that has lower utility than the above bundles and label it F. Plot a bundle that has lower utility than the above bundles and label it G. Calculate the MRS between bundles A and B. Calculate the MRS between bundles C and D. Why is the MRS between A and B different than the MRS between C and D? If Jim has an income of $35 and the price of concert tickets is $5 and the price of videos is $2, what is the budget constraint? Draw the budget constraint on the graph above. Answers For Jim, the following combinations of goods give him equal satisfaction. Consumption bundle Quantity of concerts per month Quantity of videos rented per month Total utility A 2 15 30 B 3 10 30 C 4 7 30 D 5 6 30 E 6 5 30 Plot each of these consumption bundles on a graph to illustrate the indifference curve. Plot a bundle that has lower utility than the above bundles and label it F. Plot a bundle that has lower utility than the above bundles and label it G. Calculate the MRS between bundles A and B. MRS = 1/4 Calculate the MRS between bundles C and D. MRS = 1 Why is the MRS between A and B different than the MRS between C and D? Because the person attends less concerts, he or she will need more videos to compensate for taking away another concert. If Jim has an income of $34 and the price of concert tickets is $5 and the price of videos is $2, what is the budget constraint? Draw the budget constraint on the graph above. What is the utility maximizing bundle of concerts and videos? 7C + 2V = 34 or C = 2V/5 + 6.8 (See blue line) 7 videos and 4 concerts Instructor Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780
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