Unit- 2.. offs that people face. Budget Constraint (What consumer can afford) Budget constraint represents all possible combinations of goods and services that an individual can purchase given the prices of goods and services and the individual's income. For example: Let us suppose that consumer has a budget of 8200 to be spent on two commodities: Burger and Coke (for sake of simplicity we assume that the consumer buys only two goods) The price of burger is 840 each and the price of coke is %20 each. 2 & Money spent = Income (40 x 5) + (20 x 0) (40x 4) + (20 x 2) (40 x 3) + (20x 4) (40 x 2) + (20 x6) (40 x 1) + (20 x8) = Jo|rs|r fun] afer] (1)The combinations of goods and services which cost exactly the consumer's total income lie on the budget constraint (A, B, C). (2)The combinations of goods and services which cost less than the consumer's total income lie inside the budget line point D) {3)The combinations of goods and services which cost more than the consumer's total income are not available to the consumer and hence they lie outside the budget constraint (like point E). [(40 x0) + (20% 10) )- Slope of Budget Constraint The slope of budget line measures the rate at which consumer can trade one good for another. It is simply the ratio of prices of two goods, known as the price ratio (relative price). Slope of budget lin Price Therefore the consumer needs to give two cokes each time in order to gain one burger. A slope of 2 represents the trade-off that market is offering to the consumer i.e, 1 burger for 2 litres of coke. ‘oFeoke 326 4 “units of burgers willing to gain (change In x-axis) (29) ties CONSUMER CHOICE Consumer theory is the study of how people decide to spend their money based on their individual preferences and budget constraints. It examines how individuals make choices subject to how much income they have available to spend and the market prices of goods and services. It analyses the trade- y rice of burger =249 = 2 =units of coke willing to sacrifice(change in y-axis)ne ‘© Budget constraint slopes downwards as more units of one good can only be purchased by reducing the units of another good. ‘¢ The slope of budget constraint is a straight line as it is the ratio of price of two goods, which remains constant Preferences ( What the consumers want) Analysis of preferences is important because a consumer's decision is based not only on his budget constraint but also on his preferences regarding two goods. Indifference curve is a graphical representation of various combinations of two goods with which the consumer is equally satisfied. The consumer is equally satisfied with combination A (1 burger, 15 cokes), B (2 burgers ,10 cokes) , C (4 burgers, 3 cokes) because they all lie on the same curve. Properties of Indifference Curves 1) Higher Indifference curves are preferred to lower ones ‘A higher Indifference curve represents larger quantities of goods and services as compared to a lower indifference curve and more goods and services offer more satisfaction (utility) to the consumers. As a result of which rational consumers always prefer a higher indifference curve. 2) Indifference Curves are downward sloping The slope of Indifference curve reflects the rate at which the consumer is willing to substitute one good for another (Marginal rate of substitution). It slopes downwards because as a consumer increases quantity of one good then he must reduce the quantity of other good so that his total satisfaction remains same. y 3) Indifference Curves do not cross each other Let us assume that two curves intersect each other at {A (refer to the figure). The satisfaction from point A and point B will be the same as they lie on the same curve. Similarly, the satisfaction derived from points A and C will be the same. This implies that B and C will also give provide same satisfaction to the consumer however this is not possible as a higher indifference curve always represents 8 more satisfaction. This contradicts our assumption and therefore indifference curves do not intersect. > y Cerne. (30)4) Indifference curves are convex to the origin (bowed inwards, The slope of indifference curve is marginal rate of substitution-the rate at which the consumer is. willing to trade off one good for another. 4 MRS = units of coke willing to sacrifice : 6 » units of burger willing to gain Consider the example. Combination P has only one burger and therefore the consumer is willing to give up five litres of coke but as 4 he increases his consumption of burgers his marginal utility declines( Law of Diminishing Marginal utility) 6 and he is then willing to sacrifice less and less quantity of burger. Also, people are willing to trade away the good they have in abundance and less willing to trade es the good they have in less quantity. Diminishing MRS is the primary reason why the Indifference curve is downward sloping. eur Law of diminishing utility: The law of diminishing Marginal utility states that as we consume more and more units of a commodity the utility (satisfaction) derived from each successive unit goes on decreasing. need Perfect substitutes A substitute is a product or service that can be easily replaced with another by consumers, Perfect substitutes nit Freee are identical goods. If two goods X and Y are perfect =i AULWE substitutes, the indifference curve is a straight line with negative slope and MRS is constant. When you are always willing to give up the same number of Ys for one more X. ’ For example-Butter from two different producers are considered perfect substitutes; the producers may be different, but their purpose and usage are the same. | nA are used together to satisfy a given want. Two products are perfect complements when you always want to consume X and Y together in the same proportion. The indifference curves for perfect complements will always be right angles. Perfect Complements Complementary goods are products which a] neliff eae Ue Fe : 6 Apoodix Faeanbe ate Fight shoe and left shoe. You need exactly one right shoe with every left shoe. If you Bht shoe and 5 left shoes you are still on the same indifference curve because those extra 4 left shoes will just go to waste. The best point to be at is on the corner of each indifference curve (least int to be at ( In the real I it world, most goods are neither perfect substitutes nor perfect complements. (31)Optimization (What consumer chooses) After analyzing what consumer prefers (indifference curve) and what consumer can afford (budget constraint) we will discuss how the consumer put these together to decide what to buy. The Consumer's Optimal Choice The consumer would like to maximize his satisfaction by choosing the combination of two goods that falls on the highest indifference curve subject to the constraint of his budget line. The consumer chooses the point on his budget constraint that lies on the highest Indifference curve. At this point, called the optimum (equilibrium), the marginal rate of substitution equals the price ratio i.e. the relative price of two goods. Thus consumer buys goods at the point where MRS is equal to the rela- tive price of two goods. The consumer would prefer point A which lies on the highest indifference curve but that is beyond his, budget constraint. By contrast point C is affordable but because it lies ona lower indifference curve, the consumer does not prefer it. He would end up buying the bundle of goods at point B which lies on the highest indifference curve given his limited budget. oo Note: At the optimum, the slope of the indifference curve (marginal rate of substitution) equals the slope of budget constraint (relative price or the price ratio). The indifference curve is tangent to the budget line. The relative price (price ratio) is the rate at which the market trades one good for another whereas MRS is the rate at which is the consumer is willing to trade one good for another. ‘At equilibrium i.e., consumer's optimum, the consumer’s valuation of goods (MRS) equals the market's valuation of goods (Relative price). Utility Analysis: An alternative way to describe Consumer Preference and Optimization Another way to represent preferences is through the concept of Utility. Utility is an abstract measure of satisfaction that an individual derives by consumption of goods and services. Itis the ability of a good to satisfy a want. Consumer prefers goods and services that provide more utility than others. Note: Utility is not a quality inherent in the good or service itself. Marginal utili 4 eel Utility is the additional utility derived from consumption of one more unit of a commodity. assumed that the goods follow the Law of Diminishing Marginal Utility. (As a consumer consumes pare more of a good or service, its marginal utility falls) pen eae Ha of substitution between two goods depends upon their marginal utilities. For example, ginal utility of a good X is twice the marginal utility of good Y then the consumer would require 2 units of ¥ to compensate for the loss of 1 unit of X and MRS = 2. (32)MRS = marginal utility of good X = MUx marginal utility of good Y MU, Consumer Optimization under Utility Analysis MRS = Px ‘As MRS is equal to the price ratio of two goods Py MRS = MUx Also MRS equals the marginal utility of two goods Muy Px = MUx Py My Or Px Py It means that at equilibrium, the marginal utility per rupee spent on good X must equal the marginal utility per rupee spent on good V. If, for example, the marginal utility per rupee spent on good X were higher than the marginal utility per rupee spent on good Y, then it would make sense for the consumer to purchase more of good X rather than purchasing any more of good Y. After purchasing more and more of good X, the marginal utility of good X will eventually fall due to the law of diminishing marginal utility such that the marginal utility per rupee spent on good X will eventually be equal to the marginal utility of good ¥. ice of good Y= %1, Budget = 85 ILLUSTRATION: Price of good X= %2, Unit of good X | MU of good X MU/Px Unit of good Y | MU of good Y Mu/P, af 1 _{[s {200 | 18 _ 2 8 a 3 12 3 _ [5 (4 6 — 4 i yy comparing the marginal utility per rupee spent (the ratio of the .ds X and Y, subject to the constraint that the consumer | utility per rupee spent on the first unit of good X is greater than the marginal utility per rupee spent on the first unit of good Y (12 utis > 9 utils). Because the price of good Xis 82 per unit, the consumer can afford to purchase this first unit of good % and so she does, She now has 85 ~ X2 = €3 remaining in her budget. The consumer's next step is to compare the marginal utility per rupee spent on the second unit of good X with the marginal utlity per dollar spent on the first unit of good Y. Because these ratios are both equal to 9 utis, the consumer is indif- ferent between purchasing the second unit of good X and the first unit of good Y, so she purchases both, She can afford to do so because the second unit of good X costs &2 and the first unit of good ¥ costs 21, for a total of 3. At this point, the consumer has exhausted her budget of %5 and has arrived at the consumer equilibrium, where the marginal utilities per rupee spent are equal. The consumer equilibrium is found bj marginal utility to the price of a good) for goo does not exceed her budget of %5. The marginal (33)Effect of change in Income on Consumer’s choice An increase in income shifts the budget constraint assuming that there is no change in the prices of goods under consideration. The increase in income allows consumer to buy more of the two goods and have a better combination of goods and services which is on a higher indifference curve. Notice that the slope of budget constraint does not change as there is no change in the prices of two goods. An increase in income leads to a parallel shift in budget constraint. In case of Normal goods (goods for which quantity demanded increases with an increase in income), with an increase in income the consumer responds by buying more quantities of both the goods. In case of Inferior goods (goods for which quantity demanded decreases with an increase in income), with an increase in income the consumer buys more of one good but less of other good which is considered inferior. Opposite happens in case of decrease in income. Effect of change in prices on consumer's choice A decrease in prices increase consumer's purchasing power and he is able to enjoy more quantity of goods and services. An increase in prices of goods limits consumer's purchasing opportunities. Notice in this case the slope of new budget constraint is different from slope of initial budget constraint as prices of the goods change. How such a change in budget constraint alters consumption dependsupon the consumer's preferences. Income Effect Vs the Substitution Effect These are the two components of the effect of the change in the price of a good on the consumption pattern Income effect When price of a good decreases the purchasing power (real income) of the consumer increases, As a result, he can purchase more goods with the same income. It is change in demand for a commodity caused by the change in consumer's real income. For example, let us suppose that the price of burgers deereages without any change in price of Coke, As a result of which he can buy more of both~burgers and Coke. The effect doesn't dictate the kinds of goods consumers will buy. They may opt to purchase more expensive good in higher quantities and cheaper good in lower quantities or vice versa, depending on their preferences, It results in movement to a new indifference curve. (34)Substitution Effect When the price of a good falls, it becomes comparatively cheaper than another good, as a result of which the customer replaces the good whose price has been decreased for another good that is relatively expensive now. It is an effect due to the change in the price of a good or service, leading the consumer to replace higher-priced items with lower- priced ones. For example, suppose the price of burgers decreases. The consumer will now substitute coke (more expensive) with burgers (less expensive). Therefore with a decrease in price of burgers, the consumer will increase the demand for burgers. As a result of this, the aggregate demand for the good whose price has been reduced, increases and vice versa. It results in movement to a new point on the same indifference curve. The total change in consumption due to the price change is called price effect. Price Effect = Income Effect + Substitution Effect Example: When the price of burgers fall [Good | Incomeeffect____—_—_—_| Substitution effect [Price effect | | Burgers | Consumers rcher, so she buys | Burgers are relatively | Income and } | rove Burgers. cheaper, so the | Substitution are in consumer buys more | same direction, 0 Burgers consumer buys more | a | Burgers. | Coke Consumer is richer, so she buys | Coke is relatively | Income and | more coke expensive, so substitution are in | consumer buys less | opposite directions, of it. so total effect on | demand for coke is | | _[ ambiguous. | ANAM & Swottituriort F freer Bey- rastiol Budget Constraime AH Iyihiak @peimum Be,- New Budget Aencinaint| c ne t B-shOwls SUbstitUbion epreck supsritution, % \ ec -chone iron eff eet N\ AMOUgh CONMUNEA newer Bui hy pothetical * : wre 9 Tue vation Fr point 20 show Manity beren. > rome byork me epee. ee (3s)Deriving the Demand Curve The demand curve shows quantity demanded of a good at different prices ie. it reflects the consumption decisions of individuals. In this way theory of consumer choice provides the theoretical foundation of Demand Curve Suppose that price of good x decreases. As a result of which the budget line rotates, fixed at y-axis and optimum changes. Demand curve derived from different optimum levels shows the relationship between price and quantity demanded, (36)Application of Consumer Theory (1) Do all demand Curves slope upwards? / the case of Giffen Goods: A Giffen good is @ low-income, non-luxury product for which demand increases as the price increases and vice versa, ‘A Giffen good has an upward- sloping demand curve which is contrary to the fundamental laws of demand. The term "eiffen goods" was coined in the late 1800s, named after Scottish economist, and statistician Sir Robert Giffen. These goods generally form 2 large percentage of consumers’ ture and do not have close substitutes. potatoes and meat. Say that potatoes are f potatoes has been increased and therefore in total expendi For example, let us consider two goods- considered inferior (giffen) goods, the price of that case with a decrease in the consumer ‘s real income, he can buy fewer goods. The income effect makes the consumer buy less meat and more potatoes (As demand for inferior goods increases when income decreases). At the same time as potato is relatively expensive to meat, the substitution effect makes consumer buy more meat (less expensive) and fewer potatoes (more expensive). In the case of giffen goods income effect is much larger than the substitution effect and therefore consumer ends up buying more potatoes and less meat. Since an increase in prices of such goods increases their demand, that is why they have an upward sloping demand curve. Agiffen good When prices of potatoes rise the optimum goraroes shifts from A to B , the consumer responds by buying less meat and more potatoes. ial budget constraint ew budget constraint (37){2)How do wages affect Labour Supply ? ry of Consumer choice to determine how a person allocates time. people spend some of their time working to afford consumption of goods and services and rest oft enjoying leisure .The essence of time allocation problem Is the trade-off between leisure snd consumption. Wages reflect the trade-off between leisure and consumption.People always prefer more and more of leisure and consumption ie. they always try to be on higher praiference curve. Since people have limited working hours, their preferences are limited by Budget Constraint, Now we shall apply the theo The two panels show how people respond to an increase in wage. The graphs on left shows consumer's initial budget constraint BC, and BC;, his new budget constraint as well as her optimal choices over consumption and leisure The graph on right show resulting labour-supply . Since working hours equal total hours available minus hours of leisure , an increase in leisure implies a decrease in quantity of labour supplied and vice versa peers pe consumption rises and leisure falls, resulting in labour-supply th Paral eywhen igher wage in this case, induces individual to work more and enjoy ne at pe eee both consumption and leisure rises, resulting in a labour-supply pes downward. A higher wage in this case induces individual t supply work less and so the labour supply curve slopes downward, (0 enjoy more and (38)Substitution Effect: When wages rise, consumption becomes relatively cheaper and leisure becomes more expensive. Therefore the worker substitutes leisure (more expensive) with ). As a result of which the substitution effect makes individuals consumption (less expe! work more and enjoy less. : if consumption and leisure both are considered normal goods, an increase in income Effect: J ‘ income will make an individual enjoy both of these i.e. consumption as well as leisure. In other with an increment in wages, the income effect makes him work less and enjoy more, words, which makes the supply curve slope downwards. Therefore, supply curve can be both upward as well as downward-sloping. Shreds of evidence show that over long periods, the labour supply curve slopes downwards i.e., despite of increase in wages workers choose to spend their time enjoying leisure rather than working more. (3)How do Interest Rates affect Household Savings? The Theory of Consumer Choice can help us analyze how people decide how much income should be consumed(money spent) and how much should be saved. Interest Rates that they earn on their savings will affect their decision! Every rupee that an individual saves today, he can consume same the same amount + interest in the future. The income of an individual can be divided into two parts: Current consumption and future consumption (savings). An individual always tries to maximize his consumption in both periods i.e. he always tries to be on a higher indifference curve. But since his income is fixed, his preferences are limited by budget constraint. Now suppose the interest rate increases, the budget constraint will shift outwards. As the interest rate is increased person will get more consumption in future for every rupee of consumption that he sacrifices today. In panel (a) an increase in interest makes the individual save more and consume less. |n panel (b) an increase in interest makes the individual consume more and save less. “) @) june Ne comer omsmprer By, \ " N o << os (39)‘The Substitution Effect: Consider the substitution effect, when interest rises the future consumption becomes less costly relative to current consumption so the consumer substitutes current consumption (more expensive) with future consumption (less expensive). Therefore the substitution effect makes the individual save more. The Income Effect: As long as consumption in both periods consists of Normal goods, the consumer wants to enjoy higher consumption in both periods. In other words, the income effect makes the individual save less and consume more. Ifthe substitution effect is greater than the income effect the individual saves more and if the income effect is greater than the substitution effect, the individual consumes more! Thus an increase in interest rates can either encourage or discourage savings. Diamond-Water Paradox Diamond water paradox (also known as the paradox of value) examines that although water is more essential and useful commodity than diamonds, the latter demands a much higher price than the former. This paradox was first presented by Scottish philosopher and economist, Adam Smith. Many Economists have tried to explain the paradox. Some of them such as Adam Smith, who was a proponent Of the labour theory of value, believed that the paradox of value can be explained by the relationship between the price of an item and the cost to produce or acquire It. The theory states that the economic value of a good or service is determined by the amount of labour required to produce it. Smith denied a necessary relationship between price and utility (how well can a good satisfy @ want). Others believed in the theory of Marginalism (perhaps more accepted) which states that itis not the total usefulness of diamonds or water that determines their prices, but the utility (satisfaction) derived from each additional unit of water or diamonds(marginal utility). The total utility of water to people is indeed tremendous because they need it to survive, However, since water is in such large supply in the world, the marginal utility of water is low. In other words, each additional unit of water that becomes available can be applied to less urgent uses as more urgent uses for water are satisfied. Therefore, any particular unit of water is worth less to people as the supply of water increases. On the other hand, diamonds are in much lower supply. They are of such low supply that the usefulness of one additional diamond is Breater than the usefulness of one additional glass of water, which i in abundant supply, Thus, diamonds are worth more to people. Therefore, those who want diamonds are willing to pay a higher price for one diamond than for one glass of water, and sellers of diamonds ask fora price for one diamond that is higher than for one glass of water. Conversely, a man dying of thirst in a desert would have greater marginal use for water than for diamonds so would pay more for water, ‘A modern-day example can be the vast difference in the wages of essential workers such as nurses and farmers and that of others such as CEOs of companies. (40)