© 2010 pearson education canada - sfufriesen/econ103_lecture8a.pdf© 2010 pearson education canada...


Consumption Possibilities

Household consumption choices are constrained by its

income and the prices of the goods and services available.

The budget line describes the limits to the household’s

consumption choices.


Lisa has an income of $40;

the price of movies is $8 and

the price of pop is $4 a case.

How many cases of pop can

she consume if she goes to

zero movies?

How many movies can she

attend if she buys no pop?

What is the rate at which she

can trade off pop for movies?

2 cases of pop will buy her

one movie – slope = 2/1 =

price of movies/price of pop



The budget line is a

constraint on Lisa’s

choices.

Lisa can afford any point

on her budget line or

inside it.

Lisa cannot afford any

point outside her budget

line.



The Budget Equation

The budget equation states that

Expenditure = Income

Call the price of pop PP, the quantity of pop QP, the price

of a movie PM, the quantity of movies QM, and income Y.

Lisa’s budget equation is:

PPQP + PMQM = Y

PPQP = Y - PMQM

QP = Y/PP – (PM /PP)QM




A rise in the price of

movies PM makes the

budget line steeper.

The ―movies‖ intercept

Y/PM gets smaller

The budget line rotates

inward

How does a change in the price of one

good change the budget line?



An change in money

income brings a parallel

shift of the budget line.

The slope of the budget

line doesn’t change

because the relative price

doesn’t change.

How does a change in income change

the budget line?


An indifference curve is

a line that shows

combinations of goods

among which a consumer

is indifferent.

At point C, Lisa sees

2 movies and drinks 6

cases of pop a month.

Preferences and Indifference Curves



Lisa can sort all possible

combinations of goods into

three groups: preferred, not

preferred, and just as good

as point C.

An indifference curve joins

all those points that Lisa

says are just as good as C.

G is such a point. Lisa is

indifferent between point C

and point G.


All the points on the

indifference curve are

preferred to all the points

below the indifference

curve.

And all the points above

the indifference curve

are preferred to all the

points on the

indifference curve.



A preference map is a

series of indifference

curves.

Call the indifference

curve that we’ve just

seen I1.

I0 is an indifference

curve below I1.

Lisa prefers any point

on I1 to any point on I0 .



I2 is an indifference curve above I1.

Lisa prefers any point on I2

to any point on I1 .

For example, Lisa

prefers point J to either

point C or point G.



Marginal Rate of Substitution

The marginal rate of substitution, (MRS) measures the

rate at which a person is willing to give up good y to get an

additional unit of good x while at the same time remain

indifferent (remain on the same indifference curve).

The magnitude of the slope of the indifference curve

measures the marginal rate of substitution.



If the indifference curve is relatively steep, the MRS is

high.

In this case, the person is willing to give up a large

quantity of y to get a bit more x.

If the indifference curve is relatively flat, the MRS is low.

In this case, the person is willing to give up a small

quantity of y to get more x.



A diminishing marginal rate of substitution is the key

assumption of consumer theory.

A diminishing marginal rate of substitution is a general

tendency for a person to be willing to give up less of good

y to get one more unit of good x, while at the same time

remain indifferent as the quantity of good x increases.



At point C, Lisa is

willing to give up 2

cases of pop to see one

more movie—her MRS

is 2.

At point G, Lisa is

willing to give up 1/2

case of pop to see one

more movie—her MRS

is 1/2.



Predicting Consumer Choices

Best Affordable Choice

The consumer’s best affordable choice is

On the highest attainable indifference curve

On the budget line


The highest possible

indifference curve that is

attainable given the budget

line, is at point C.

Point C is at a tangency

between the budget line and

an indifference curve – the

slopes are equal.

At point C, MRS = PM/PP



At point F, Lisa’s MRS is

greater than the relative

price. She is willing to give

up more pop for an

additional movie than she is

required to.

At point H, Lisa’s MRS is

less than the relative price.

She is willing to give up less

pop for an additional movie

than she was required to.

At point C, Lisa’s MRS is

equal to the relative price.



When movies cost $8, she

goes to 2 movies. This is a

point on her demand curve.

Now, the price of a movie

falls to $4. The budget line

rotates outward.

Lisa’s best affordable point is

now J.

Lisa moves to point B, which is

a movement along her

demand curve for movies.

Predicting …


A Change in Income

The effect of a change in

income on the quantity of a

good consumed is called the

income effect.

Initially, Lisa consumes at point

J in part (a) and at point B on

demand curve D0 in part (b).

Predicting …


Lisa’s income decreases and

her budget line shifts leftward

in part (a).

Her new best affordable point

is K in part (a).

Her demand for movies

decreases, shown by a leftward

shift of her demand curve for

movies in part (b).

Predicting …



Substitution Effect and Income Effect

For a normal good, a fall in price always increases the

quantity consumed.

We can prove this assertion by dividing the price effect in

two parts:

Substitution effect

Income effect


Initially, Lisa has an

income of $40, the price of

a movie is $8, and she

consumes at point C.

Lisa’s best affordable point

is now J.

The move from point C to

point J is the price effect.

The price of a movie falls

from $8 to $4 and her

budget line rotates outward.



We’re going to break the

move from point C to

point J into two parts.

The first part is the

substitution effect and

the second is the

income effect.



Substitution Effect

The substitution effect is

the effect of a change in

price on the quantity

bought when the

consumer remains on the

same indifferent curve.



The direction of the

substitution effect never

varies:

When the relative price

falls, the consumer always

substitutes more of that

good for other goods.

The substitution effect is

the first reason why the

demand curve slopes

downward.



Income Effect

To isolate the income effect, we reverse the hypothetical pay cut and restore Lisa’s income to its original level (its actual level).

Lisa is now back on indifference curve I2 and her best affordable point is J.

The move from K to J is the income effect.



For Lisa, movies are a

normal good.

With more income to spend,

she sees more movies—the

income effect is positive.

For a normal good, the

income effect reinforces the

substitution effect and is the

second reason why the

demand curve slopes

downward.



Inferior Goods

For an inferior good, when income increases, the

quantity bought decreases.

The income effect is negative and works against the

substitution effect.

So long as the substitution effect dominates, the

demand curve still slopes downward.



If the negative income effect is stronger than the

substitution effect, a lower price for inferior goods brings a

decrease in the quantity demanded—the demand curve

slopes upward!

This case does not appear to occur in the real world.



Externalities in Our Lives

An externality is a cost or benefit that arises from

production and falls on someone other than the producer,

or a cost or benefit that arises from consumption and falls

on someone other than the consumer.

A negative externality imposes a cost and a positive

externality creates a benefit.


The four types of externality are

Negative production externalities

Positive production externalities

Negative consumption externalities

Positive consumption externalities



Negative Production Externalities

Negative production externalities are common.

Some examples are noise from aircraft and trucks,

polluted rivers and lakes, the destruction of animal habitat,

and air pollution in major cities from auto exhaust.



Positive Production Externalities

Positive production externalities are less common that

negative externalities.

Two examples arise in honey and fruit production. By

locating honeybees next to a fruit orchard, fruit production

gets an external benefit from the bees, which pollinate the

fruit orchards and boost fruit output; and honey production

gets an external benefit from the orchards.



Negative Consumption Externalities

Negative consumption externalities are a common part of

everyday life.

Smoking in a confined space poses a health risk to others;

noisy parties or loud car stereos disturb others.



Positive Consumption Externalities

Positive consumption externalities are also common.

When you get a flue vaccination, everyone you come into

contact with benefits.

When the owner of an historic building restores it,

everyone who sees the building gets pleasure.



Private Costs and Social Costs

A private cost of production is a cost that is borne by the

producer, and marginal private cost (MC) is the private

cost of producing one more unit of a good or service.

An external cost of production is a cost that is not borne by

the producer but is borne by others.

Marginal external cost is the cost of producing one more

unit of a good or service that falls on people other than the

producer.

Production Externalities


Marginal social cost is the marginal cost incurred by the

entire society—by the producer and by everyone else on

whom the cost falls—and is the sum of marginal private

cost and marginal external cost.

That is,

MSC = MC + Marginal external cost.

We express costs in dollars but must remember that the

dollars represent the value of a forgone opportunity.

Marginal private cost, marginal external cost, and marginal

social cost increase with output.

Negative Externalities: Pollution


Negative Production Externalities


Production and Pollution: How Much?

In the market for a good with an externality that is

unregulated, the amount of pollution created depends on

the equilibrium quantity of the good produced.

Negative Production Externalities:

Pollution


Figure 16.2 shows the

equilibrium in an

unregulated market with

an external cost.

The quantity produced is

where marginal private

cost equals marginal

social benefit.



At the market equilibrium,

MSB is less than MSC,

so the market produces

an inefficient quantity.

At the efficient quantity,

marginal social cost equals

marginal social benefit.

With no regulation, the

market overproduces and

creates a deadweight loss.



Consumption Externalities

Knowledge comes from education and research and

creates external benefits.

Private Benefits and Social Benefits

A private benefit is a benefit that the consumer of a good

or service receives, and marginal private benefit (MB) is

the private benefit from consuming one more unit of a

good or service.

An external benefit is a benefit that someone other than

the consumer receives. Marginal external benefit is the

benefit from consuming one more unit of a good or service

that people other than the consumer enjoy.


Marginal social benefit is the marginal benefit enjoyed by

the entire society—by the consumer and by everyone else

on whom the benefit falls.

Marginal social benefit is the sum of marginal private

benefit and marginal external benefit. That is:

MSB = MB + Marginal external benefit.

Consumption Externalities


Figure 16.5 illustrates the marginal private benefit,

marginal external benefit,

and marginal social benefit.

It identifies marginal external benefit as the vertical

distance between the MB and MSB curves.

Positive Consumption Externalities:

Knowledge


Figure 16.6 shows how

a private market

underproduces an item

that generates an

external benefit

and creates a

deadweight loss.

Positive Externalities: Knowledge

© 2010 pearson education canada - sfufriesen/econ103_lecture8a.pdf© 2010 pearson education canada...

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