Principles of Microeconomics Scarcity and Social Provisioning Chapter 7 Consumer Choices

CHAPTER . CONSUMER CHOICES INTRODUCTION TO CONSUMER CHOICES Figure . Investment Choices . Higher education is generally viewed as a good investment , if one can afford it , regardless of the state of the economy . Credit modification of work Creative Commons ) EENY , MEENY , MINEY , MOE CHOICES The Great Recession of touched families around the globe . In too many countries , Workers found themselves out of a job . In developed countries , unemployment compensation provided a safety net , but families still saw a marked decrease in disposable income and had to make tough spending decisions . Of course , discretionary spending was the first to go . Even so , there was one particular category that saw a universal increase in spending during that 18 uptick in the United States , specifically . You might guess that consumers began eating more meals at home , increasing spending at the grocery store . But the Bureau of Labor Statistics Consumer Expenditure Survey , which tracks food spending over time , showed real total food spending by households declined five percent between 2006 and 2009 . So , it was not groceries . just what product would people around the world demand more of during tough economic times , and more importantly , why ?

Find out at chapter end . That question leads us to this chapter how consumers make choices . For most consumers , using eeny , PRINCIPLES or ECONOMICS 205 meeny , miney , moe is not how they make decisions their processes have been educated far beyond a children rhyme . CHAPTER Introduction to Consumer Choices In this chapter , you will learn about Consumption Choices How Changes in Income and Prices Affect Consumption Choices Choices Choices in Financial Capital Markets seeks to understand the behavior of individual economic agents such as and businesses . Economists believe that individuals decisions , such as what goods and services to buy , can be analyzed as choices made within certain budget constraints . consumers are trying to get the most for their limited budget . In economic terms they are ing to maximize total utility , or satisfaction , given their budget constraint . Everyone has their own personal tastes and preferences . The French say ( son goat , or Each to his own An old Latin saying states , De non est or Theres no disputing about If people decisions are based on their own tastes and personal preferences , however , then how can economists hope to analyze the choices consumers make ?

An economic explanation for why people make different choices begins with accepting the proverbial wisdom that tastes are a matter of personal preference . But economists also believe that the choices people make are by their incomes , by the prices of goods and services they consume , and by factors like where they live . This chapter introduces the economic theory of how consumers make choices about what to buy , how much to work , and how much to save . The analysis in this chapter will build on the three budget constraints introduced in the Choice in a World of Scarcity chapter . These were the consumption choice budget constraint , the budget constraint , and the budget constraint . This chapter will also illustrate how nomic theory provides a tool to systematically look at the full range of possible consumption choices to predict how consumption responds to changes in prices or incomes . After reading this chapter , consult the appendix Indifference Curves to learn more about representing utility and choice through indifference curves .

CONSUMPTION CHOICES LEARNING By the end of this section , you will be able to Calculate total utility Propose decisions that maximize utility Explain marginal utility and the significance of diminishing marginal utility on the consumption choices of Americans is available from the Consumer ture Survey carried out by the Bureau of Labor Statistics . Table shows spending patterns for the average household . The first row shows income and , after taxes and personal savings are subtracted , it shows that , in 2015 , the average household spent on consumption . The table then breaks down consumption into various categories . The average household spent roughly of its consumption on shelter and other housing expenses , another on food and vehicle expenses , and the rest on a variety of items , as shown . Of course , these patterns will vary for specific households by differing levels of family income , by geography , and by preferences . Average Household Income before Taxes Average Annual Expenditures Food at home Food away from home Housing Apparel and services Transportation Healthcare Entertainment Education Personal insurance and pensions All else alcohol , tobacco , reading , personal care , cash contributions , miscellaneous Table . US . Consumption Choices in 2015 ( Source )

PRINCIPLES OF ECONOMICS 207 TOTAL UTILITY AND DIMINISHING MARGINAL UTILITY To understand how a household will make its choices , economists look at what consumers can afford , as shown in a budget constraint line , and the total utility or satisfaction derived from those choices . In a budget constraint line , the quantity of one good is measured on the horizontal axis and the of the other good is measured on the vertical axis . The budget constraint line shows the various combinations of two goods that are affordable given consumer income . Consider the situation , shown in Figure . likes to collect and watch movies . In Figure , the quantity of is shown on the horizontal axis , while the quantity of movies is shown on the vertical axis . If Jose had unlimited income or goods were free , then he could consume without limit . But , like all of us , faces a budget . has a total of 56 to spend . The price of is 14 and the price of movies is . Notice that the vertical intercept of the budget constraint line is at eight movies and zero ( The horizontal intercept of the budget constraint is four , where Jose spends of all of his money on and no movies ( The slope of the budget constraint line is or . The specific choices along the budget straint line show the combinations of and movies that are affordable . I , Figure . A Choice between Consumption Goods . has income of 56 . Movies cost and ' shirts cost 14 . The points on the budget constraint line show the combinations of movies and shirts that are affordable . wishes to choose the combination that will provide him with the greatest utility , which is the term economists use to describe a persons level of satisfaction or happiness with his or her choices . Let begin with an assumption , which will be discussed in more detail later , that Jose can measure his own utility with something called . It is important to note that you can not make comparisons between the of individuals if one person gets 20 from a cup of coffee and another gets 10 , this does not mean than the first person gets more enjoyment from the coffee than the other or that they enjoy the coffee twice as much . Table shows how utility is connected with his consumption of or movies . The first column of the table shows the quantity of . The second column shows the total utility , or total amount of satisfaction , that receives

203 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER from consuming that number of . The most common pattern of total utility , as shown here , is that consuming additional goods leads to greater total utility , but at a decreasing rate . The third shows marginal utility , which is the additional utility provided by one additional unit of sumption . This equation for marginal utility is change in total utility MU change 171 quantity Notice that marginal utility diminishes as additional units are consumed , which means that each sequent unit of a good consumed provides less additional utility . For example , the first picks is his favorite and it gives him an addition of 22 . The fourth is just to something to wear when all his other clothes are in the wash and yields only 18 additional . This is an ple of the law of diminishing marginal utility , which holds that the additional utility decreases with each unit added . The rest of Table shows the quantity of movies that attends , and his total and marginal utility from seeing each movie . Total utility follows the expected pattern it increases as the number of movies seen rises . Marginal utility also follows the expected pattern each additional movie brings a smaller gain in utility than the previous one . The first movie Jose attends is the one he wanted to see the most , and thus provides him with the highest level of utility or satisfaction . The fifth movie he attends is just to kill time . Notice that total utility is also the sum of the marginal utilities . Read the next Work It Out feature for instructions on how to calculate total utility . Quantity ) Movies ( Quantity ) Total Utility 22 22 16 16 43 21 31 15 63 20 45 14 81 18 58 13 97 16 70 12 111 14 81 11 123 12 91 10 133 10 100 Table . Total and Marginal Utility Table looks at each point on the budget constraint in Figure , and adds up total utility for five possible combinations of and movies . Point Movies Total Utility Table . Finding the Choice with the Highest Utility

PRINCIPLES OF ECONOMICS 209 CALCULATING TOTAL UTILITY Let look at makes his decision in more detail . Step . Observe that , at point ( for example ) consumes three and two movies . Step . Look at Table . You can see from the fourth second column that three are worth 63 . Similarly , the second fifth column shows that two movies are worth 31 . Step . From this information , you can calculate that point has a total utility of 94 ( 63 31 ) Step . You can repeat the same calculations for each point on Table , in which the total utility numbers are shown in the last column . For , the highest total utility for all possible combinations of goods occurs at point , with a total utility of 103 from consuming one and six movies . CHOOSING WITH MARGINAL UTILITY Most people approach their combination of choices in a way . This approach is based on looking at the , measured in terms of marginal utility , of consuming less of one good and more of another . For example , say that Jose starts off thinking about spending all his money on and choosing point , which corresponds to four and no movies , as illustrated in Figure . Jose chooses this starting point randomly he has to start somewhere . Then he considers giving up the last , the one that provides him the least marginal utility , and using the money he saves to buy two movies instead . Table tracks the series of decisions Jose needs to make ( Key are 14 , movies are , and income is 56 ) The following Work It Out feature explains how marginal utility can effect decision making . Try Which Has Total Utility i ' i Utility Conclusion Choice 81 from and movies from movies Choice 63 from 31 Loss of 18 from less , but gain of 31 from and movies from movies 94 more movies , for a net utility gain of 13 Ever Choice 43 from 58 Loss of 20 from less , but gain of 27 from two and movies from movies 101 more movies for a net utility gain of Choice and 22 from 81 Loss of 21 from less , but gain of 23 from two movies from movies 103 more movies , for a net utility gain of Ever Choice from 100 Loss of 22 from less , but gain of 19 from two and movies from movies 100 more movies , for a net utility loss of rI Table . A Approach to Maximizing Utility

210 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER DECISION MAKING BY COMPARING MARGINAL UTILITY Jose could use the following thought process ( if he thought in ) to make his decision regarding how many and movies to purchase Step . From Table , Jose can see that the marginal utility of the fourth is 18 . gives up the fourth , then he loses 18 . Step . Giving up the fourth , however , frees up 14 ( the price of a ) to buy the first two movies ( at each ) Step . knows that the marginal utility of the first movie is 16 and the marginal utility of the second movie is 15 . Thus , moves from point to point , he gives up 18 ( from the ) but gains 31 ( from the movies ) Step . Gaining 31 and losing 18 is a net gain of 13 . This is just another way of saying that the total utility at ( 94 according to the last column in Table ) is 13 more than the total utility at ( 81 ) Step . So , it makes sense to give up the fourth in order to buy two movies . clearly prefers point to point Now repeat this process of decision making with marginal utilities . thinks about giving up the third and surrendering a marginal utility of 20 , in exchange for purchasing two more movies that promise a combined marginal utility of 27 . prefers point to point . What if Jose thinks about going beyond to point ?

Giving up the ond means a marginal utility loss of 21 , and the marginal utility gain from the fifth and sixth movies would combine to make a marginal utility gain of 23 , so prefers point to However , if seeks to go beyond point to point , he finds that the loss of marginal utility from giving up the first is 22 , while the marginal utility gain from the last two movies is only a total of 19 . If Jose were to choose point , his utility would fall to 100 . Through these stages of thinking about marginal , again concludes that , with one and six movies , is the choice that will provide him with the highest level of total utility . This approach will reach the same conclusion regardless of starting point . Another way to look at this is by focusing on satisfaction per dollar . Marginal utility per dollar is the amount of additional utility Jose receives given the price of the product . For and movies , the marginal utility per dollar is shown in Table marginal utility marginal utility per dollar , price first purchase will be a movie . Why ?

Because it gives him the highest marginal utility per dollar and it is affordable . will continue to purchase the good which gives him the highest marginal ity per dollar until he exhausts the budget . will keep purchasing movies because they give him a greater bang or the buck until the sixth movie is equivalent to a purchase . can afford to purchase that . will choose to purchase six movies and one .

PRINCIPLES or ECONOMICS 211 Quantity of Total Marginal Marginal Utility Quantity of Total Marginal Marginal Utility Utility Utility per Dollar Movies Utility Utility per Dollar 22 22 16 16 43 21 31 15 63 20 45 14 81 18 58 13 97 16 70 12 14 81 12 91 10 Table . Marginal Utility per Dollar A RULE FOR MAXIMIZING UTILITY This process of decision making suggests a rule to follow when maximizing utility . Since the price of is twice as high as the price of movies , to maximize utility the last chosen needs to provide exactly twice the marginal utility ( MU ) of the last movie . If the last provides less than twice the marginal utility of the last movie , then the is providing less bang for the buck ( marginal utility per dollar spent ) than if the same money were spent on movies . If this is so , should trade the for more movies to increase his total utility . Marginal utility per dollar sures the additional utility will enjoy given what he has to pay for the good . If the last provides more than twice the marginal utility of the last movie , then the is providing more bang for the buck or marginal utility per dollar , than if the money were spent on movies . As a result , should buy more . Notice that at optimal choice of point , the marginal utility from the first , of 22 is exactly twice the marginal utility of the sixth movie , which is . At this choice , the marginal utility per dollar is the same for both goods . This is a signal has found the point with highest total utility . This argument can be written as a general rule the choice between consumption goods occurs where the marginal utility per dollar is the same for both goods . MU A sensible economizer will pay twice as much for something only if , in the marginal comparison , the item confers twice as much utility . Notice that the formula for the table above is 22 11 14 The following Work It Out feature provides step by step guidance for this concept of ing choices .

212 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER MAXIMIZING UTILITY The general rule , means that the last dollar spent on each good provides exactly the same marginal utility . So Step . If we traded a dollar more of movies for a dollar more of , the marginal utility gained from would exactly offset the marginal utility lost from fewer movies . In other words , the net gain would be zero . Step . Products , however , usually cost more than a dollar , so we can not trade a dollars worth of movies . The best we can do is trade two movies for another , since in this example cost twice what a movie does . Step . If we trade two movies for one , we would end up at point ( two and four movies ) Step . Choice in Table shows that if we move to point , we would lose 21 from one less , but gain 23 from two more movies , so we would end up with more total utility at point In short , the general rule shows us the choice . There is another , equivalent way to think about this . The general rule can also be expressed as the ratio of the prices of the two goods should be equal to the ratio of the marginal utilities . When the price of good is divided by the price of good , at the point this will equal the marginal utility of good divided by the marginal utility of good . This rule , known as the consumer equilibrium , can be written in algebraic form Along the budget constraint , the total price of the two goods remains the same , so the ratio of the prices does not change . However , the marginal utility of the two goods changes with the quantities consumed . At the optimal choice of one and six movies , point , the ratio of marginal utility to price for ( 22 14 ) matches the ratio of marginal utility to price for movies ( of ) MEASURING UTILITY WITH NUMBERS This discussion of utility started off with an assumption that it is possible to place numerical values on utility , an assumption that may seem questionable . You can buy a thermometer for measuring at the hardware store , but what store sells an for measuring utility ?

However , while measuring utility with numbers is a convenient assumption to clarify the explanation , the key assumption is not that utility can be measured by an outside party , but only that individuals can decide which of two alternatives they prefer . To understand this point , think back to the process of finding the choice with highest total utility by comparing the marginal utility that is gained and lost from different choices along the budget constraint . As compares each choice along his budget constraint to the previous choice , what matters is not the specific numbers that he places on his whether he uses any at only that he personally can identify which choices he prefers . In this way , the process of choosing the highest level of utility resembles rather closely how many people make consumption decisions . We think about what will make us the happiest we think about what things cost we think about buying a little more of one item and giving up a little

PRINCIPLES OF ECONOMICS 213 of something else we choose what provides us with the greatest level of satisfaction . The vocabulary of comparing the points along a budget constraint and total and marginal utility is just a set of tools for discussing this everyday process in a clear and specific manner . It is welcome news that specific utility numbers are not central to the argument , since a good is hard to find . Do not we can not measure , by the end of the next module , we will have transformed our analysis into something we can . KEY CONCEPTS AND SUMMARY Economic analysis of household behavior is based on the assumption that people seek the highest level of utility or satisfaction . Individuals are the only judge of their own utility . In general , greater consumption of a good brings higher total utility . However , the additional utility received from each unit of greater consumption tends to decline in a pattern of diminishing marginal utility . The choice on a consumption budget constraint can be found in several ways . You can add up total utility of each choice on the budget line and choose the highest total . You can choose a starting point at random and compare the marginal utility gains and losses of moving to neighboring thus eventually seek out the preferred choice . Alternatively , you can compare the ratio of the marginal utility to price of good with the marginal utility to price of good and apply the rule that at the optimal choice , the two ratios should be equal SELF CHECK QUESTIONS . Jeremy is deeply in love lives where cell phone coverage is poor , so he can either call her on the phone for five cents per minute or he can drive to see her , at a cost of in gasoline money . He has a total of 10 per week to spend on staying in touch . To make his preferred choice , Jeremy uses a handy that measures his total utility from personal visits and from phone minutes . Using the values given in Table , figure out the points on consumption choice budget constraint ( it may be helpful to do a sketch ) and identify his point .

214 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Round Trips Total Utility Phone Minutes Total Utility 80 20 40 60 80 Table . Take Jeremy total utility information in Question , and use the marginal utility approach to confirm the choice of phone minutes and round trips that maximize utility . REVIEW QUESTIONS Who determines how much utility an individual will receive from consuming a good ?

Would you expect total utility to rise or fall with additional consumption of a good ?

Why ?

Would you expect marginal utility to rise or fall with additional consumption of a good ?

Why ?

Is it possible for total utility to increase while marginal utility diminishes ?

Explain . If people do not have a complete mental picture of total utility for every level of consumption , how can they find their consumption choice ?

What is the rule relating the ratio of marginal utility to prices of two goods at the optimal choice ?

Explain Why , if this rule does not hold , the choice can not be . CRITICAL THINKING QUESTIONS Think back to a purchase that you made recently . How would you describe your thinking before you made that purchase ?

The rules of politics are not always the same as the rules of economics . In discussions of setting budgets for government agencies , there is a strategy called closing the Washington monument . When an agency faces the unwelcome prospect of a budget cut , it may decide to close a attraction enjoyed by many people ( like the Washington monument ) Explain in terms of diminishing marginal utility why the Washington monument strategy is so misleading . Hint If you are really trying to make the best of a budget cut , should you cut the items in your budget with the highest marginal utility or the lowest marginal utility ?

PRINCIPLES OF ECONOMICS 215 Does the Washington monument strategy cut the items with the highest marginal utility or the lowest marginal utility ?

PROBLEMS , who lived in ancient Greece , derives utility from reading poems and from eating cucumbers . gets 30 units of marginal utility from her first poem , 27 units of marginal utility from her second poem , 24 units of marginal utility from her third poem , and so on , with marginal utility declining by three units for each additional poem . illa gets six units of marginal utility for each of her first three cucumbers consumed , five units of marginal utility for each of her next three cucumbers consumed , four units of marginal utility for each of the following three cucumbers consumed , and so on , with marginal utility declining by one for every three cucumbers consumed . A poem costs three bronze coins but a cucumber costs only one bronze coin . has 18 bronze coins . Sketch budget set between poems and cucumbers , placing poems on the vertical axis and cucumbers on the horizontal axis . Start off with the choice of zero poems and 18 cucumbers , and calculate the changes in marginal utility of moving along the budget line to the next choice of one poem and 15 cucumbers . Using this process based on marginal utility , create a table and identify choice . Compare the marginal utility of the two goods and the tive prices at the optimal choice to see if the expected relationship holds . Hint Label the table columns ) Choice , Marginal Gain from More Poems , Marginal Loss from Fewer Cucumbers , Overall Gain or Loss , Is the previous choice optimal ?

Label the table rows ) Poems and 18 Cucumbers , Poem and 15 Cucumbers , Poems and 12 Cucumbers , Poems and Cucumbers , Poems and Cucumbers , Poems and Cucumbers , Poems and Cucumbers . REFERENCES Bureau of Labor Statistics . 2015 . Consumer Expenditures in Accessed March 11 , Bureau of Labor Statistics . 2015 . Employer Costs for Employee Accessed March 11 , Bureau of Labor Statistics . 2015 . Labor Force Statistics from the Current Population Accessed March , budget constraint line shows the possible combinations of two goods that are affordable given a consumer limited income consumer equilibrium when the ratio of the prices of goods is equal to the ratio of the marginal utilities ( point at which the consumer can get the most satisfaction ) diminishing marginal utility the common pattern that each marginal unit of a good consumed provides less of an addition to utility than the previous unit marginal utility the additional utility provided by one additional unit of consumption marginal utility per dollar the additional satisfaction gained from purchasing a good given the price of the product Price

216 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER total utility satisfaction derived from consumer choices SOLUTIONS Answers to Questions . The rows of the table in the problem do not represent the actual choices available on the budget set that is , the combinations of round trips and phone minutes can afford with his budget . One of the choices listed in the problem , the six round trips , is not even available on the budget set . has only 10 to spend and a round trip costs and phone calls cost per minute , he could spend his entire budget on five round trips but no phone calls or 200 minutes of phone calls , but no round trips or any combination of the two in between . It is easy to see all of his budget options with a little algebra . The equation for a budget line is where and are price and quantity of round trips ( and phone calls ( per minute ) case the equation for the budget line is 10 10 200 200 If we choose zero through five round trips ( column ) the table below shows how many phone minutes can be afforded with the budget ( column ) The total utility figures are given in the table below . Round Trips Total Utility for Trips Phone Minutes Total Utility for Minutes Utility 200 100 100 80 160 1040 120 150 120 900 1050 210 30 630 890 260 40 330 640 300 300 Table . Adding up total utility for round trips and phone minutes at different points on the budget line gives total utility at each point on the budget line . The highest possible utility is at the combination of one trip and 160 minutes of phone time , with a total utility of 120 . The first step is to use the total utility figures , shown in the table below , to calculate marginal utility , remembering that marginal utility is equal to the change in total utility divided by the change in trips or minutes .

PRINCIPLES or ECONOMICS 217 Round Trips Total Utility Marginal Utility ( per trip ) Phone Minutes Total Utility Marginal Utility ( per minute ) 200 100 80 80 160 1040 70 120 900 60 680 50 40 380 40 Table . Note that We can not directly compare marginal utilities , since the units are trips versus phone minutes . We need a common denominator for comparison , which is price . Dividing MU by the price , yields columns and in the table below . Round Total Marginal Utility ( per Total Marginal utility ( per Trips Utility ) Utility minute ) 1100 30 1040 005 900 11 530 150 330 190 Table . Start at the bottom of the table Where the combination of round trips and phone minutes is ( This ing point is arbitrary , but the numbers in this example work best starting from the bottom . Suppose We sider moving to the next point up . At ( 40 ) the marginal utility per dollar spent on a round trip is 25 . The marginal utility per dollar spent on phone minutes is 190 . Since 25 190 , We are getting much more utility per dollar spent on phone minutes , so lets choose more of those . At ( 80 ) is 30 150 ( the ) but notice that the difference is narrowing . We keep trading round trips for phone minutes until we get to ( 160 ) which is the best we can do . The parison is as close as it is going to get ( 40 70 ) Often in the real world , it is not possible to get exactly equal for both products , so you get as close as you can .

HOW CHANGES IN INCOME AND PRICES AFFECT CONSUMPTION CHOICES LEARNING By the end of this section , you will be able to Explain how income , prices , and preferences affect consumer choices Contrast the substitution effect and the income effect Utilize concepts of demand to analyze consumer choices Apply choices to governments and businesses ust as utility and marginal utility can be used to discuss making consumer choices along a budget constraint , these ideas can also be used to think about how consumer choices change when the budget constraint shifts in response to changes in income or price . Indeed , because the budget constraint framework can be used to analyze how quantities demanded change because of price movements , the budget constraint model can illustrate the underlying logic behind demand curves . HOW CHANGES IN INCOME AFFECT CONSUMER CHOICES Let begin with a concrete example illustrating how changes in income level affect consumer choices . Figure shows a budget constraint that represents Kimberly choice between concert tickets at 50 each and getting away overnight to a for 200 per night . Kimberly has per year to spend between these two choices . After thinking about her total utility and marginal utility and applying the decision rule that the ratio of the marginal utilities to the prices should be equal between the two products , Kimberly chooses point , with eight concerts and three overnight aways as her choice . Now , assume that the income Kimberly has to spend on these two items rises to per year , ing her budget constraint to shift out to the right . How does this rise in income alter her choice ?

Kimberly will again consider the utility and marginal utility that she receives from concert tickets and overnight getaways and seek her choice on the new budget line . But how will her new choice relate to her original choice ?

The possible choices along the new budget constraint can be divided into three groups , which are divided up by the dashed horizontal and vertical lines that pass through the original choice in the figure . All choices on the upper left of the new budget constraint that are to the left of the vertical dashed line , like choice with two overnight stays and 32 concert tickets , involve less of the good

PRINCIPLES OF ECONOMICS 219 Concert Tickets ) I Overnight Stays Figure . How a Change in Income Affects Consumption Choices . The choice on the original budget constraint is The dashed horizontal and vertical lines extending through point allow you to see at a glance whether the quantity consumed of goods on the new budget constraint is higher or lower than on the original budget constraint . On the new budget constraint , a choice like will be made if both goods are normal goods . If overnight stays is an inferior good , a choice like will be made . If concert tickets are an inferior good , a choice like will be made . on the horizontal axis but much more of the good on the Vertical axis . All choices to the right of the vertical dashed line and above the horizontal dashed choice with five overnight getaways and 20 concert more consumption of both goods . Finally , all choices that are to the right of the vertical dashed line but below the horizontal dashed line , like choice with four concerts and nine overnight getaways , involve less of the good on the vertical axis but much more of the good on the horizontal axis . All of these choices are theoretically possible , depending on Kimberly personal preferences as expressed through the total and marginal utility she would receive from consuming these two goods . When income rises , the most common reaction is to purchase more of both goods , like choice , which is to the upper right relative to Kimberly original choice , although exactly how much more of each good will vary according to personal taste . Conversely , when income falls , the most typical reaction is to purchase less of both goods . As defined in the chapter on Demand and Supply and again in the chapter on Elasticity , goods and services are called normal goods when a rise in income leads to a rise in the quantity consumed of that good and a fall in income leads to a fall in quantity . However , depending on Kimberly preferences , a rise in income could cause consumption of one good to increase while consumption of the other good declines . A choice like means that a rise in

220 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER income caused her quantity consumed of overnight stays to decline , while a choice like would mean that a rise in income caused her quantity of concerts to decline . Goods where demand declines as income rises ( or conversely , where the demand rises as income falls ) are called inferior An inferior good occurs when people trim back on a good as income rises , because they can now afford the more expensive choices that they prefer . For example , a household might eat fewer hamburgers or be less likely to buy a used car , and instead eat more steak and buy a new car . HOW PRICE CHANGES AFFECT CONSUMER CHOICES For analyzing the possible effect of a change in price on consumption , let again use a concrete ple . Figure represents the consumer choice of Sergei , who chooses between purchasing baseball bats and cameras . A price increase for baseball bats would have no effect on the ability to purchase eras , but it would reduce the number of bats Sergei could afford to buy . Thus a price increase for baseball bats , the good on the horizontal axis , causes the budget constraint to rotate inward , as if on a hinge , from the vertical axis . As in the previous section , the point labeled represents the originally preferred point on the original budget constraint , which Sergei has chosen after contemplating his total utility and marginal utility and the involved along the budget constraint . In this ple , the units along the horizontal and vertical axes are not numbered , so the discussion must focus on whether more or less of certain goods will be consumed , not on numerical amounts . Cameras Baseball Bats Figure . How a Change in Price Affects Consumption Choices . The original choice is When the price rises , the budget constraint shifts in to the left . The dashed lines make it possible to see at a glance whether the new consumption choice involves less of both goods , or less of one good and more of the other . The new possible choices would be fewer baseball bats and more cameras , like point , or less of both goods , as at point . Choice would mean that the higher price of bats led to exactly the same quantity of bats being consumed , but fewer cameras . Choices like are ruled out as theoretically possible but highly unlikely in the real world , because they would mean that a higher price for baseball bats means a greater quantity consumed of baseball bats . After the price increase , Sergei will make a choice along the new budget constraint . Again , his choices can be divided into three segments by the dashed vertical and horizontal lines . In the upper left

PRINCIPLES or ECONOMICS 221 tion of the new budget constraint , at a choice like , Sergei consumes more cameras and fewer bats . In the central portion of the new budget constraint , at a choice like , he consumes less of both goods . At the end , at a choice like , he consumes more bats but fewer cameras . The typical response to higher prices is that a person chooses to consume less of the product with the higher price . This occurs for two reasons , and both effects can occur simultaneously . The tion effect occurs when a price changes and consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price . The income effect is that a higher price means , in effect , the buying power of income has been reduced ( even though actual income has not changed ) which leads to buying less of the good ( when the good is normal ) In this example , the higher price for baseball bats would cause Sergei to buy a fewer bats for both reasons . Exactly how much will a higher price for bats cause Sergei consumption of bats to fall ?

Figure a range of possibilities . Sergei might react to a higher price for baseball bats by purchasing the same quantity of bats , but cutting his consumption of cameras . This choice is the point on the new budget constraint , straight below the original choice Alternatively , Sergei might react by cally reducing his purchases of bats and instead buy more cameras . The key is that it would be imprudent to assume that a change in the price of baseball bats will only or primarily affect the good whose price is changed , while the quantity consumed of other goods remains the same . Since Sergei purchases all his products out of the same budget , a change in the price of one good can also have a range of effects , either positive or negative , on the quantity consumed of other goods . In short , a higher price typically causes reduced consumption of the good in question , but it can affect the consumption of other goods as well . Read this article about the potential of variable prices in vending machines . El ?

53 THE FOUNDATIONS OF DEMAND CURVES Changes in the price of a good lead the budget constraint to shift . A shift in the budget constraint means that when individuals are seeking their highest utility , the quantity that is demanded of that good will change . In this way , the logical foundations of demand show a tion between prices and quantity based on the underlying idea of individuals seeking utility . Figure ( a ) shows a budget constraint with a choice between housing and everything ( Putting everything else on the vertical axis can be a useful approach in some cases , especially when the focus of the analysis is on one particular good . The preferred choice on the original budget straint that provides the highest possible utility is labeled . The other three budget constraints

222 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER resent successively higher prices for housing of , and . As the budget constraint rotates in , and in , and in again , the choices are labeled , and , and the quantity demanded of housing falls from to to to . So , as the price of housing rises , the budget constraint shifts to the left , and the quantity consumed of housing falls , meaning , with all other things being the same ) This price of housing rising from to to to , while the quantity of housing demanded falls from to to to on the demand curve in Figure ( Indeed , the vertical dashed lines stretching between the top and bottom of Figure show that the quantity of housing demanded at each point is the same in both ( a ) and ( The shape of a demand curve is ultimately determined by the underlying choices about maximizing utility subject to a budget constraint . And while economists may not be able to measure , they can certainly measure price and quantity demanded . APPLICATIONS IN GOVERNMENT AND BUSINESS The budget constraint framework for making choices offers a reminder that ple can react to a change in price or income in a range of different ways . For example , in the winter months of 2005 , costs for heating homes increased significantly in many parts of the country as prices for natural gas and electricity soared , due in large part to the disruption caused by Hurricanes Katrina and Rita . Some people reacted by reducing the quantity demanded of energy for example , by turning down the thermostats in their homes by a few degrees and wearing a heavier sweater inside . Even so , many home heating bills rose , so people adjusted their consumption in other ways , too . As you learned in the chapter on Elasticity , the short run demand for home heating is generally inelastic . Each hold cut back on what it valued least on the margin for some it might have been some dinners out , or a vacation , or postponing buying a new refrigerator or a new car . Indeed , sharply higher energy prices can have effects beyond the energy market , leading to a widespread reduction in purchasing throughout the rest of the economy . A similar issue arises when the government imposes taxes on certain products , like it does on gasoline , cigarettes , and alcohol . Say that a tax on alcohol leads to a higher price at the liquor store , the higher price of alcohol causes the budget constraint to pivot left , and consumption of alcoholic beverages is likely to decrease . However , people may also react to the higher price of alcoholic beverages by ting back on other purchases . For example , they might cut back on snacks at restaurants like chicken wings and nachos . It would be unwise to assume that the liquor industry is the only one affected by the tax on alcoholic beverages . Read the next Clear It Up to learn about how buying decisions are by who controls the household income . DOES WHO CONTROLS HOUSEHOLD INCOME MAKE A DIFFERENCE ?

In the , the United Kingdom made an interesting policy change in its child allowance policy . This program provides a fixed amount of money per child to every family , regardless of family income . Traditionally , the child allowance had been distributed to families by withholding less in taxes from the paycheck of the family wage the father in this time period . The new policy instead provided the child allowance as a cash payment to the mother . As a result of this change , households have the same level of income and face the same prices in the market , but the money is more likely to be in the purse of the mother than in the wallet of the father . Should this change in policy alter household consumption patterns ?

Basic models of consumption decisions , of the sort PRINCIPLES or ECONOMICS Original housing price Housing price rises for the time to , Housing prices rises for the second time to Housing rises for the third time to , Everything Else I I In Housing ( a ) A budget constraint diagram ! I I . I . EI ' I , Quantity of Housing ( Deriving a demand curve Figure . The Foundations of a Demand Curve An Example of Housing . a ) As the price increases from to to to , the budget constraint on the upper part of the diagram shifts to the left . The choice changes from Mo to to to . As a result , the quantity demanded of housing shifts from to to to , The demand curve graphs each combination of the price of housing and the quantity of housing demanded , Indeed , the quantities of housing are the same at the points on both ( a ) and ( Thus , the original price of housing ( Po ) and the original quantity of housing ( appear on the demand curve as point . The higher price of 223

224 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER housing ( and the corresponding lower quantity demanded of housing ( appear on the demand curve as point . examined in this chapter , assume that it does not matter whether the mother or the father receives the money , because both parents seek to maximize the utility of the family as a whole . In effect , this model assumes that everyone in the family has the same preferences . In reality , the share of income controlled by the father or the mother does affect what the household consumes . When the mother controls a larger share of family income a number of studies , in the United Kingdom and in a Wide variety of other countries , have found that the family tends to spend more on restaurant meals , child care , and women clothing , and less on alcohol and tobacco . As the mother controls a larger share of household resources , children health improves , too . These findings suggest that when providing assistance to poor families , in countries and tries alike , the monetary amount of assistance is not all that matters it also matters which member of the family actually receives the money . The budget constraint framework serves as a constant reminder to think about the full range of effects that can arise from changes in income or price , not just effects on the one product that might seem most immediately affected . KEY CONCEPTS AND SUMMARY The budget constraint framework suggest that when income or price changes , a range of responses are possible . When income rises , households will demand a higher quantity of normal goods , but a lower quantity of inferior goods . When the price of a good rises , households will typically demand less of that whether they will demand a much lower quantity or only a slightly lower quantity will depend on personal preferences . Also , a higher price for one good can lead to more or less of the other good being demanded . SELF ' QUESTIONS . Explain all the reasons Why a decrease in the price of a product would lead to an increase in purchases of the product . As a college student you work at a job , but your parents also send you a monthly Suppose one month your parents forgot to send the check . Show graphically how your budget constraint is affected . Assuming you only buy normal goods , what would happen to your purchases of goods ?

REVIEW QUESTIONS . As a general rule , is it safe to assume that a change in the price of a good will always have its most significant impact on the quantity demanded of that good , rather than on the quantity demanded of other goods ?

Explain . Why does a change in income cause a parallel shift in the budget constraint ?

PRINCIPLES OF ECONOMICS 225 CRITICAL THINKING QUESTIONS Income effects depend on the income elasticity of demand for each good that you buy . If one of the goods you buy has a negative income elasticity , that is , it is an inferior good , what must be true of the income elasticity of the other good you buy ?

PROBLEMS If a 10 decrease in the price of one product that you buy causes an increase in quantity demanded of that product , will another 10 decrease in the price cause another increase ( no more and no less ) in quantity demanded ?

income effect a higher price means that , in effect , the buying power of income has been reduced , even though actual income has not changed always happens simultaneously with a substitution effect substitution effect when a price changes , consumers have an incentive to consume less of the good with a relatively higher price and more of the good with a relatively lower price always happens simultaneously with an income effect SOLUTIONS Answers to Questions . This is the opposite of the example explained in the text A decrease in price has a substitution effect and an income effect . The substitution effect says that because the product is cheaper relative to other things the consumer purchases , he or she will tend to buy more of the product ( and less of the other things ) The income effect says that after the price decline , the consumer could purchase the same goods as before , and still have money left over to purchase more . For both reasons , a decrease in price causes an increase in quantity demanded . This is a negative income effect . Because your parents check failed to arrive , your monthly income is less than normal and your budget constraint shifts in toward the origin . If you only buy normal goods , the decrease in your income means you will buy less of every product .

CHOICES LEARNING OBJECTIVES By the end of this section , you will be able to Interpret budget constraint graphs Predict consumer choices based on Wages and other compensation Explain the bacl supply curve of labor do not obtain utility just from products they purchase . They also obtain utility from leisure time . Leisure time is time not spent at work . The process of a maximizing household applies to what quantity of hours to work in much the same way that it applies to purchases of goods and services . Choices made along the budget constraint , as wages shift , provide the logical underpinning for the labor supply curve . The discussion also offers some insights about the range of possible reactions when people receive higher wages , and specifically about the claim that if people are paid higher wages , they will Work a greater quantity of that they have a say in the matter . According to the Bureau of Labor Statistics , workers averaged hours per week on the job in 2014 . This average includes workers for workers only , the average was hours per week . Table 10 shows that more than half of all workers are on the job 35 to 48 hours per week , but significant proportions work more or less than this amount . Table breaks down the average hourly compensation received by private industry workers , ing wages and benefits . Wages and salaries are about of total compensation received by workers the rest is in the form of health insurance , vacation pay , and other benefits . The tion workers receive differs for many reasons , including experience , education , skill , talent , ship in a labor union , and the presence of discrimination against certain groups in the labor market . Issues surrounding the inequality of incomes in a economy are explored in the on Poverty and Economic Inequality and Issues in Labor Markets Unions , Discrimination ,

PRINCIPLES or ECONOMICS 227 Hours Worked per Week Number of Workers Percentage of Workforce hours million hours million hours million hours million hours million 60 hours and over million Table 10 . Persons at Work , by Average Hours Worked per Week in 2013 ( Total number of workers million ) Source ) Compensation , Wage , Salary , and Benefits per hour Wages and Salaries Vacation Supplemental Pay Insurance Health Benefits Retirement and Savings Defined Benefit Defined Contribution Legally Required Table 11 . Hourly Compensation Wages , Benefits , and Taxes in 2014 . Source ) THE BUDGET CONSTRAINT How do workers make decisions about the number of hours to work ?

Again , let proceed with a example . The economic logic is precisely the same as in the case of a consumption choice get constraint , but the labels are different on a budget constraint . Vivian has 70 hours per week that she could devote either to work or to leisure , and her wage is hour . The lower budget constraint in Figure shows Vivian possible choices . The horizontal axis of this diagram measures both leisure and labor , by showing how Vivian time is divided between leisure and labor . Hours of leisure are measured from left to right on the horizontal axis , while hours of labor are measured from right to left . Vivian will compare choices along this budget constraint , ranging from 70 hours of leisure and no income at point to zero hours of leisure and 700 of income at point She will choose the point that provides her with the highest total utility . For this example , let assume that Vivian choice occurs at , with 30 hours of leisure , 40 hours of work , and 400 in weekly income . For Vivian to discover the choice that will maximize her utility , she does not have to place numerical values on the total and marginal utility that she would receive from every level of income and leisure . All that really matters is that Vivian can compare , in her own mind , whether she would prefer more leisure or more income , given the she faces . If Vivian can say to herself

223 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER 8800 , 3700 8600 ( 300 ) 5500 . I . 400 3300 ( 50 240 200 ' 100 so I I I 20 30 40 so so 70 Labor ( hours ) Leisure ( hours ) Figure . How a Rise in Wages Alters the Choice . Vivian original choice is point on the lower opportunity set . A rise in her wage causes her opportunity set to swing upward . In response to the increase in wages , Vivian can make a range of different choices available to her a choice like , which involves less work and a choice like , which involves the same amount of work but more income or a choice like A , which involves more work and considerably more income . personal preferences will determine which choice she makes . really rather work a little less and have more leisure , even if it means less income , or be ing to work more hours to make some extra income , then as she gradually moves in the direction of her preferences , she will seek out the choice on her budget straint . Now imagine that Vivian wage level increases to hour . A higher wage will mean a new budget constraint that tilts up more steeply conversely , a lower wage would have led to a new budget straint that was . How will a change in the wage and the corresponding shift in the budget straint affect Vivian decisions about how many hours to work ?

Vivian choices of quantity of hours to work and income along her new budget constraint can be divided into several categories , using the dashed horizontal and vertical lines in Figure that go through her original choice ( One set of choices in the portion of the new budget straint involves more hours of work ( that is , less leisure ) and more income , at a point like A with 20 hours of leisure , 50 hours of work , and 600 of income ( that is , 50 hours of work multiplied by the new wage of 12 per hour ) A second choice would be to work exactly the same 40 hours , and to take the benefits of the higher wage in the form of income that would now be 480 , at choice . A third choice would involve more leisure and the same income at point ( that is , hours of work by the new wage of 12 per hour equals 400 of total income ) A fourth choice would involve

PRINCIPLES OF ECONOMICS 229 less income and much more leisure at a point like , with a choice like 50 hours of leisure , 20 hours of work , and 240 in income . In effect , Vivian can choose whether to receive the benefits of her wage increase in the form of more income , or more leisure , or some mixture of these two . With this range of possibilities , it would be unwise to assume that Vivian ( or anyone else ) will necessarily react to a wage increase by working substantially more hours . Maybe they will maybe they will not . APPLICATIONS OF UTILITY MAXIMIZING WITH THE BUDGET CONSTRAINT The theoretical insight that higher wages will sometimes cause an increase in hours worked , times cause hours worked not to change by much , and sometimes cause hours worked to decline , has led to labor supply curves that look like the one in Figure . The portion of the labor supply curve slopes upward , which the situation of a person who reacts to a higher wage by supplying a greater quantity of labor . The middle , portion of the labor supply curve the situation of a person who reacts to a higher wage by supplying about the same quantity of labor . The very top portion of the labor supply curve is called a supply curve for labor , which is the situation of people who can earn so much that they respond to a higher wage by working fewer hours . Read the following Clear It Up feature for more on the number of hours the average person works each year . Higher wages Fewer hours worked wages a Nearly the same hours worked Wage , wages a More hours worked Hours of Labor Figure . A Supply Curve of Labor . The bottom portion of the labor supply curve shows that as wages increase over this range , the quantity of hours worked also increases . The middle , nearly vertical portion of the labor supply curve shows that as wages increase over this range , the quantity of hours worked changes very little . The portion of the labor supply curve at the top shows that as wages increase over this range , the quantity of hours worked actually decreases . All three of these possibilities can be derived from how a change in wages causes movement in the budget constraint , and thus different choices by individuals .

230 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER IS AMERICA A NATION OF WORKAHOLICS ?

Americans work a lot . Table 12 shows average hours worked per year in the United States , Canada , and several pean countries , with data from 2013 . To get a perspective on these numbers , someone who works 40 hours per week for 50 weeks per year , with two weeks off , would work hours per year . The gap in hours worked is a little astonishing the 250 to 300 hour gap between how much Americans work and how much Germans or the French Work amounts to roughly six to seven weeks less of Work per year . Economists who study these international patterns debate the extent to which average Americans and Japanese have a preference for working more than , say , Germans , or whether German workers and employers face particular kinds of taxes and regulations that lead to fewer hours worked . Many countries have laws that regulate the Work week and dictate holidays and the standards of normal vacation time vary from country to country . It is also interesting to take the amount of time spent working in context it is estimated that in the late nineteenth century in the United States , the average work week was over 60 hours per little to no time for leisure . Country Average Annual Hours Actually Worked per Employed Person United States Spain japan 59 Canada United Kingdom Sweden Germany France Table 12 . Average Hours Worked Per Year in Select Countries . Source ?

The different responses to a rise in hours worked , the same hours worked , or fewer hours patterns exhibited by different groups of workers in the economy . Many time workers have jobs where the number of hours is held relatively fixed , partly by their own choice and partly by their employers practices . These workers do not much change their hours worked as wages rise or fall , so their supply curve of labor is inelastic . However , workers and younger workers tend to be more in their hours , and more ready to increase hours worked when wages are high or cut back when wages fall . The supply curve for labor , when workers react to higher wages by working fewer hours and having more income , is not observed often in the short run . However , some , like dentists or accountants , may react to higher wages by choosing to limit the number of hours , perhaps by taking especially long vacations , or taking every other Friday off . Over a perspective , the supply curve for labor is common . Over the last century , have reacted to gradually rising wages by working fewer hours for example , the length of the average has fallen from about 60 hours per week in 1900 to the present average of less than 40 hours per week . Recognizing that workers have a range of possible reactions to a change in wages casts some fresh insight on a perennial political debate the claim that a reduction in income would , in effect , allow people to earn more per encourage people to work more . The budget set points out that this connection will not hold true for all workers . Some people , especially , may react to higher wages by working more . Many will work the same number of hours .

PRINCIPLES or ECONOMICS 231 Some people , especially those whose incomes are already high , may react to the tax cut by working fewer hours . Of course , cutting taxes may be a good or a bad idea for a variety of reasons , not just because of its impact on Work incentives , but the specific claim that tax cuts will lead people to work more hours is only likely to hold for specific groups of workers and will depend on how and for whom taxes are cut . KEY CONCEPTS AND SUMMARY When making a choice along the budget constraint , a household will choose the bination of labor , leisure , and income that provides the most utility . The result of a change in wage levels can be higher work hours , the same work hours , or lower work hours . SELF CHECK QUESTIONS . has 50 hours per Week to devote to Work or leisure . He has been working for per hour . Based on the information in Table 13 , calculate his choice of labor and leisure time . Leisure Hours Total Utility from Leisure Work Hours Income Total Utility from Income 10 10 80 20 20 30 30 40 40 50 50 Table 13 . In problem , calculate marginal utility for income and for leisure . Now , start off at the choice with 50 hours of leisure and zero income , and a wage of per hour , and explain , in terms of marginal utility how could reason his way to the optimal choice , using marginal thinking only . REVIEW QUESTIONS How will a find the choice of leisure and income that provides the greatest utility ?

As a general rule , is it safe to assume that a higher Wage will encourage significantly more hours Worked for all individuals ?

Explain . CRITICAL THINKING QUESTIONS . In the choice model , What is the price of leisure ?

Think about the part of the labor supply curve . Why would someone work less as a result of a higher Wage rate ?

232 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER . What would be the substitution effect and the income effect of a Wage increase ?

Visit the Website and determine if education level , ethnicity , or gender appear to impact labor Versus leisure choices . GLOSSARY supply curve for labor the situation when people can earn so much that they respond to a wage by working fewer hours SOLUTIONS Answers to Questions This problem is straightforward if you remember leisure hours plus Work hours are limited to 50 hours total . If you reverse the order of the last three columns so that more leisure corresponds to less work and income , you can add up columns two and five to find utility is maximized at 10 leisure hours and 40 work hours Leisure Hours Total Utility from Leisure Work Hours Income Total Utility from Income Total Utility from 50 400 10 40 320 20 30 240 30 20 160 300 , 50 40 10 80 500 50 530 Table 14 . Begin from the last table and compute marginal utility from leisure and Work Leisure Total Utility from MU from Work Total Utility from . Hours Leisure Leisure Hours Income 50 400 10 40 320 20 30 240 30 20 160 300 40 10 80 500 50 Table 15 . Suppose Sid starts with 50 hours of leisure and hours of work . As Sid moves up the table , he trades 10 hours of leisure for 10 hours of Work at each step . At ( 40 , 10 ) his , 50 , which is substantially less than his of 500 . This shortfall signals Sid to keep trading leisure for until at ( 10 , 40 ) the marginal utility of both is equal at 200 . This is the sign that he should stop here , confirming the answer in question .

CHOICES IN FINANCIAL CAPITAL MARKETS LEARNING OBJECTIVES By the end of this section , you will be able to Evaluate the reasons for making choices Interpret an budget constraint Analyze why people in America tend to save such a small percentage of their income ates of saving in America have never been especially high , but they seem to have dipped even lower in recent years , as the data from the Bureau of Economic Analysis in Figure show . A decision about how much to save can be represented using an budget straint . Household decisions about the quantity of financial savings show the same underlying tern of logic as the consumption choice decision and the decision . 120 , 80 as on 60 , 40 20 00 , 588 70 . Year Figure . Personal Savings as 21 Percentage of Personal Income . Personal savings were about to 11 of personal income for most of the years from the late up to the early . Since then , the rate of personal savings has fallen substantially , although it seems to have bounced back a bit since 2008 . Source ) The discussion of financial saving here will not focus on the specific financial investment choices , like bank accounts , stocks , bonds , mutual funds , or owning a house or gold coins . The characteristics of

234 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER these specific financial investments , along with the risks and they pose , are detailed in the Labor and Financial Markets chapter . Here , the focus is saving in is , on how a household determines how much to consume in the present and how much to save , given the expected rate of return ( or interest rate ) and how the quantity of saving alters when the rate of return changes . USING MARGINAL UTILITY TO MAKE IN CHOICES Savings behavior varies considerably across households . One factor is that households with higher incomes tend to save a larger percentage of their income . This pattern makes intuitive sense a family has the in its budget to save of income , while a poor family struggling to keep food on the table will find it harder to put money aside . Another factor that causes personal saving to vary is personal preferences . Some people may prefer to consume more now , and let the future look after itself . Others may wish to enjoy a lavish ment , complete with expensive vacations , or to pile up money that they can pass along to their children . There are savers and among the young , and old , and among those with high , middle , and low income levels . Consider this example is a young man starting off at his first job . He thinks of the present as his working life and the future as after retirement . plan is to save money from ages 30 to 60 , retire at age 60 , and then live off his retirement money from ages 60 to 85 . On average , fore , he will be saving for 30 years . If the rate of return that he can receive is per year , then saved in the present would build up to after 30 years ( using the formula for compound interest , 30 ) Say that will earn over the 30 years from age 30 to age 60 ( this amount is approximately an annual salary of multiplied by 30 years ) The question for is how much of those lifetime earnings to consume during his working life , and how much to put aside until after retirement . This example is obviously built on simplifying assumptions , but it does convey the basic choice of saving during working life for future consumption after retirement . Figure and Table 16 show budget constraint . choice involves comparing the utility of present consumption during his working life and future consumption after retirement . The rate of return that determines the slope of the budget line between sent consumption and future consumption in this example is the annual interest rate that he would earn on his savings , compounded over the 30 years of his working life . For simplicity , we are ing that any savings from current income will compound for 30 years . Thus , in the lower budget straint line on the figure , future consumption grows by increments of , because each time is saved in the present , it compounds to after 30 years at a interest rate . If some of the numbers on the future consumption axis look bizarrely large , remember that this occurs because of the power of compound interest over substantial periods of time , and because the figure is grouping together all of saving for retirement over his lifetime .

PRINCIPLES OF ECONOMICS ( 000 A EL 59 000 000 A , I Present Consumption Figure . Choice The Budget Set . will make a choice between present and future consumption . With an annual rate of return of , he decides that his utility will be highest at point , which represents a choice of in present consumption and in future consumption . When the annual rate of return rises to , the budget constraint pivots up . could choose to take the gains from this higher rate of return in several forms more present saving and much higher future consumption ) the same present saving and higher future consumption ( more present consumption and more future consumption ( or more present consumption and the same future consumption ( 235

236 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Present Present Future Consumption ( annual Future Consumption ( annual Consumption Savings return ) return ) Table 16 . Budget Constraint will compare the different choices along the budget constraint and choose the one that provides him with the highest utility . For example , he will compare the utility he would receive from a choice like point A , with consumption of million in the present , zero savings , and zero future consumption point , with present consumption of , savings of , and future sumption of point , with present consumption of , savings of , and future consumption of or even choice , with present consumption of zero , savings of , and future consumption of . will also ask himself questions like these Would I prefer to consume a little less in the present , save more , and have more future sumption ?

or Would I prefer to consume a little more in the present , save less , and have less future consumption ?

By considering marginal changes toward more or less consumption , he can seek out the choice that will provide him with the highest level of utility . Let us say that preferred choice is . Imagine that annual rate of return raises from to . In this case , each time he saves in the present , it will be worth in 30 years from now ( using the formula for compound interest that ( A change in rate of return alters the slope of the budget constraint a higher rate of return or interest rate will cause the budget line to pivot upward , while a lower rate of return will cause it to pivot downward . If were to consume nothing in the present and save all , with a rate of return , his future consumption would be , as shown on ure . As the rate of return rises , considers a range of choices on the new budget constraint . The dashed vertical and horizontal lines running through the original choice help to illustrate his range of options . One choice is to reduce present consumption ( that is , to save more ) and to have considerably higher future consumption at a point like above and to the left of his original choice . A second choice would be to keep the level of present consumption and savings the same , and to receive the benefits of the higher rate of return entirely in the form of higher future tion , which would be choice As a third choice could have both more present is , less still have higher future consumption because of the higher interest rate , which would be choice like , above and to the right of his original choice . Thus , the higher rate of return might cause to save more , or less , or the same amount , depending on his own preferences . A fourth choice would be that could react to the higher rate of return by increasing his current consumption and

PRINCIPLES or ECONOMICS 237 leaving his future consumption unchanged , as at point directly to the right of his original choice . The actual choice of what quantity to save and how saving will respond to changes in the rate of return will vary from person to person , according to the choice that will maximize each person ity . APPLICATIONS OF THE MODEL OF CHOICE The theoretical model of the budget constraint suggests that when the rate of return rises , the quantity of saving may rise , fall , or remain the same , depending on the preferences of . For the economy as a whole , the most common pattern seems to be that the quantity of savings does not adjust much to changes in the rate of return . As a practical matter , many households either save at a fairly steady pace , by putting regular contributions into a retirement account or by making regular payments as they buy a house , or they do not save much at all . Of course , some people will have preferences that cause them to react to a higher rate of return by increasing their quantity of saving others will react to a higher rate of return by noticing that with a higher rate of return , they can save less in the present and still have higher future consumption . One prominent example in which a higher rate of return leads to a lower savings rate occurs when firms save money because they have promised to pay workers a certain fixed level of pension benefits after retirement . When rates of return rise , those companies can save less money in the present in their pension fund and still have enough to pay the promised retirement benefits in the future . This insight suggests some skepticism about political proposals to encourage higher savings by savers with a higher rate of return . For example , Individual Retirement Accounts ( and 401 ( accounts are special savings accounts where the money going into the account is not taxed until it is taken out many years later , after retirement . The main difference between these accounts is that an IRA is usually set up by an individual , while a 401 ( needs to be set up through an employer . By not taxing savings in the present , the effect of an IRA or a 401 ( is to increase the return to saving in these accounts . IRA and 401 ( accounts have attracted a large quantity of savings since they became common in the late and early . In fact , the amount of rose from 239 million in 1992 to billion in 2005 to over billion in 2012 , as per the Investment Company Institute , a national association of investment companies . However , overall personal savings , as discussed earlier , actually dropped from low to lower in the late and into the 20005 . Evidently , the larger amounts in these retirement accounts are being offset , in the economy as a whole , either by less savings in other kinds of accounts , or by a larger amount of borrowing ( that is , negative savings ) The following Clear It Up further explores America saving rates . A rise in interest rates makes it easier for people to enjoy higher future consumption . But it also allows them to enjoy higher present consumption , if that is what these individuals desire . Again , a change in this case , in interest to a range of possible outcomes . HOW DOES AMERICA SAVING RATES COMPARE TO OTHER COUNTRIES ?

By international standards , Americans do not save a high proportion of their income , as Table 17 shows . The rate of gross national saving includes saving by individuals , businesses , and government . By this measure , US . national savings amount 233 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER to 17 of the size of the US . which measures the size of the US . economy . The comparable world average rate of savings is 22 . Country Gross Domestic Savings as a Percentage of China 51 India 30 Russia 28 Mexico 22 Germany 26 japan 22 Canada 21 France 21 Brazil 15 United States 17 United Kingdom 13 Table 17 . National Savings in Select Countries . Source ) THE UNIFYING POWER OF THE BUDGET SET FRAMEWORK The choices of households are determined by an interaction between prices , budget constraints , and personal preferences . The and powerful terminology of gives economists a vocabulary for bringing these elements together . Not even economists believe that people walk around mumbling about their marginal utilities before they walk into a shopping mall , accept a job , or make a deposit in a savings account . However , do believe that individuals seek their own satisfaction or utility and that people often decide to try a little less of one thing and a little more of another . If these assumptions are accepted , then the idea of households facing budget constraints becomes highly plausible . BEHAVIORAL ECONOMICS AN ALTERNATIVE VIEWPOINT As we know , people sometimes make decisions that seem irrational and not in their own best est . People decisions can seem inconsistent from one day to the next and they even deliberately ignore ways to save money or time . The traditional economic models assume rationality , which means that people take all available information and make consistent and informed decisions that are in their best interest . In fact , economics professors often delight in pointing out irrational each semester to their new students , and present economics as a way to become more rational . But a new group of economists , known as behavioral economists , argue that the traditional method leaves out something important people state of mind . For example , one can think differently about money if one is feeling revenge , optimism , or loss . These are not necessarily irrational states of mind , but part of a range of emotions that can affect anyone on a given day . And whats more , actions under these conditions are indeed predictable , if the underlying environment is better understood . So , behavioral economics seeks to enrich the understanding of by integrating the insights of psychology into economics . It does this by investigating how given dollar amounts can

PRINCIPLES or ECONOMICS 239 mean different things to individuals depending on the situation . This can lead to decisions that appear outwardly inconsistent , or irrational , to the outside observer . The way the mind works , according to this view , may seem inconsistent to traditional economists but is actually far more complex than an unemotional adding machine . For example , a traditional economist would say that if you lost a 10 bill today , and also got an extra 10 in your paycheck , you should feel perfectly neutral . After all , 10 10 . You are the same financially as you were before . However , behavioral economists have done research that shows many people will feel some negative , frustration , and so those two things pen . We tend to focus more on the loss than the gain . This is known as loss aversion , where a loss pains us times more than a gain helps us , according to the economists Daniel and Amos in a famous 1979 article in the journal . This insight has implications for investing , as people tend to overplay the stock market by reacting more to losses than to gains . Indeed , this behavior looks irrational to traditional economists , but is consistent once we understand better how the mind works , these economists argue . Traditional economists also assume human beings have complete . But , for instance , ple will buy cigarettes by the pack instead of the carton even though the carton saves them money , to keep usage down . They purchase locks for their refrigerators and overpay on taxes to force selves to save . In other words , we protect ourselves from our worst temptations but pay a price to do so . One way behavioral economists are responding to this is by setting up ways for people to keep themselves free of these temptations . This includes what are called nudges toward more rational behavior rather than mandatory regulations from government . For example , up to 20 percent of new employees do not enroll in retirement savings plans immediately , because of procrastination or ing overwhelmed by the different choices . Some companies are now moving to a new system , where employees are automatically enrolled unless they opt Almost opts out in this program and employees begin saving at the early years , which are most critical for retirement . Another area that seems illogical is the idea of mental accounting , or putting dollars in different tal categories where they take different values . Economists typically consider dollars to be fungible , or having equal value to the individual , regardless of the situation . You might , for instance , think of the 25 you found in the street differently from the 25 you earned from three hours working in a fast food restaurant . The street money might well be treated as mad money with little rational regard to getting the best value . This is in one sense strange , since it is still equivalent to three hours of hard work in the restaurant . Yet the easy go ity replaces the rational economizer because of the situation , or context , in which the money was attained . In another example of mental accounting that seems inconsistent to a traditional economist , a person could carry a credit card debt of that has a 15 yearly interest cost , and simultaneously have a savings account that pays only per year . That means she pays 150 a year to the credit card company , while collecting only 40 annually in bank interest , so she loses 130 a year . That doesnt seem . The rational decision would be to pay off the debt , since a savings account with in debt is the equivalent net worth , and she would now net 20 per year . But curiously , it is not uncommon for people to ignore this advice , since they will treat a loss to their savings account as higher than the

240 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER benefit of paying off their credit card . The dollars are not being treated as fungible so it looks to traditional economists . Which view is right , the behavioral economists or the traditional view ?

Both have their advantages , but behavioral economists have at least shed a light on trying to describe and explain behavior that has historically been dismissed as irrational . If most of us are engaged in some irrational behavior , perhaps there are deeper underlying reasons for this behavior in the first place . EENY , MEENY , MINEY , MOE CHOICES In what category did consumers worldwide increase their spending during the recession ?

Higher education . According to the United Nations Educational , Scientific , and Cultural Organization ( enrollment in colleges and universities rose in China and almost in Saudi Arabia , nearly doubled in Pakistan , tripled in , and surged by three the United States . Why were consumers willing to spend on education during lean times ?

Both individuals and countries view higher education as the way to prosperity . Many feel that increased earnings are a benefit of attending college . Bureau of Labor Statistics data from May 2012 supports this view , as shown in Figure . They show a positive correlation between earnings and education . The data also indicate that unemployment rates fall with higher levels of education and training . Professional Degree Doctoral Degree Master Degree Bachelors Degree 51 I Median weekly earnings Degree I Unemployment rate Some college High school diploma Less than a High school diploma Figure . The Impact of Education on Earnings and Unemployment Rates , 2012 . Those with the highest degrees in 2012 had substantially lower unemployment rates whereas those with the least formal education suffered from the highest unemployment rates . The national median average weekly income was 815 , and the nation unemployment average in 2012 was . Source Bureau of Labor Statistics , May 22 , 2013 )

PRINCIPLES OF ECONOMICS 241 KEY CONCEPTS AND SUMMARY When making a choice along the budget constraint , a household will choose the bination of present consumption , savings , and future consumption that provides the most utility . The result of a higher rate of return ( or higher interest rates ) can be a higher quantity of saving , the same quantity of saving , or a lower quantity of saving , depending on preferences about present and future consumption . Behavioral economics is a branch of economics that seeks to understand and explain the human factors that drive what traditional economists see as people irrational spending . SELF CHECK QUESTIONS . How would an increase in expected income over one lifetime affect one budget constraint ?

How would it affect one saving decision ?

How would a decrease in expected interest rates over one Working life affect one budget constraint ?

How would it affect one saving decision ?

REVIEW QUESTIONS . According to the model of choice , what are the major factors which determine how much saving an individual will do ?

What factors might a behavioral economist use to explain savings decisions ?

As a general rule , is it safe to assume that a lower interest rate will encourage significantly lower financial savings for all individuals ?

Explain . CRITICAL THINKING QUESTIONS . What do you think accounts for the Wide range of savings rates in different countries ?

What assumptions does the model of choice make that are not likely true in the real world and would make the model harder to use in practice ?

REFERENCES Holden , Sarah , and Daniel . 2012 . The rose of in Households Saving for Retirement , ICI Research Perspective ( 2012 ) Daniel and Amos . Prospect Theory An Analysis of Decision under ( March 1979 ) Thaler , Richard Shifting Our Retirement Savings into The New York Times , April , 20 ?

242 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Institute for Statistics . Statistics in Brief Profiles Accessed August ?

121 . behavioral economics a branch of economics that seeks to enrich the understanding of making by integrating the insights of psychology and by investigating how given dollar amounts can mean different things to individuals depending on the situation . fungible the idea that units of a good , such as dollars , ounces of gold , or barrels of oil are capable of mutual substitution with each other and carry equal value to the individual . SOLUTIONS Answers to Questions . An increase in expected income would cause an outward shift in the budget constraint . This would likely increase both current consumption and saving , but the answer would depend on one time preference , that is , how much one is Willing to wait to forgo current consumption . Children are notoriously bad at this , which is to say they might simply consume more , and not save any . Adults , because they think about the future , are generally better at time is , they are more willing to wait to receive a reward . Lower interest rates would make lending cheaper and saving less rewarding . This would be in a budget line , a rotation around the amount of current income . This would likely cause a decrease in saving and an increase in current consumption , though the results for any individual would depend on time preference .