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3.4 End-of-Chapter Material

In Conclusion

We all make economic decisions every day, often without giving them very much thought. In this chapter, we highlighted two fundamental decisions: allocating income and allocating time. You (and everyone else) generally make choices over income and time allocations in a manner that makes you happy. Thus we predict that you will not throw income away. Further, whatever combinations of goods and services and time allocations you choose, economic theory presumes that these are the best ones available to you. Remember also that even though it is usually easier to focus on one decision at a time, your spending and time allocation decisions are interconnected. Changes in the prices of goods and services affect how you spend your time, and changes in the real wage affect your consumption choices.Chapter 7 "Why Do Prices Change?" has more to say on the connections among different markets in the economy.

Economics is often defined as the study of how we allocate scarce resources that have alternative uses. In this chapter, we saw this idea at work at the individual level. Your income is a scarce resource; you don’t have enough income to buy everything that you would like. Your income has alternative uses because there are lots of things you might want to buy.

Perhaps the most fundamental idea of this chapter is that of opportunity cost. Given that you have limited income to allocate across goods and services, the opportunity cost of consuming one good or service is the amount of another good or service you give up. Given that you have limited time to allocate across activities, the opportunity cost of spending time on one activity is the value of the time you could have spent on another. The budget and time budget constraints are graphical representations of this central economic principle. And the interaction between these budget constraints and people’s wants and desires is at the heart of the economic analysis of decision making.

Exercises

  1. Which statements are prescriptive? Which statements are descriptive?

    1. The government should take care of the poor.
    2. If the real wage increases, households will be willing to supply more labor.
    3. When people’s incomes decrease, they consume more cheap cuts of meat.
    4. We ought to consume fewer resources to protect the planet.
    5. Young people should purchase medical insurance because it is cheaper for young people than for old people.
  2. Draw a budget line assuming disposable income equals $100, the price of a music download is $1, and the price of a chocolate bar is $5. On the same graph, draw another budget line assuming the same level of income but with the price of a music download equal to $2 and the price of a chocolate bar equal to $1. Explain how the budget sets differ. If you liked downloads but hated chocolate bars, which budget set would you prefer?
  3. Consider a bundle consisting of 4 chocolate bars and 30 downloads (call it bundle A). Using the assumption that “more is better,” what bundles can we say are definitely preferred to bundle A? What bundles are definitely worse than bundle A? Show your answers on our usual kind of diagram (that is, a budget set diagram with chocolate bars and downloads on the axes).
  4. If we observe that a household buys bundle A but not bundle B and we know that bundle B has more of every good than does bundle A, what can we say about the household’s preferences for bundle A and bundle B? What can we say about the household’s budget set?
  5. (Advanced) Look at Table 3.7 "Preferences over Downloads and Chocolate Bars". The top part of the table lists four different bundles of downloads and chocolate bars. The bottom part of the table shows which bundle is preferred when we compare any two bundles. Look at bundle 1. The top part of the table tells us it contains 0 downloads and 20 chocolate bars. The first row of the bottom part of the table shows how this bundle compares to the other bundles. So this individual prefers bundle 1 to bundle 2 but also prefers both bundle 3 and bundle 4 to bundle 1. Do these preferences satisfy “more is better”? Are they consistent or can you find some contradictions?

    Table 3.7 Preferences over Downloads and Chocolate Bars

    Bundle Downloads Consumption Chocolate Bar Consumption
    1 0 20
    2 100 0
    3 50 10
    4 110 30
    Bundle Which Bundle Is Preferred When Comparing Bundles?
    Bundle 1 Bundle 2 Bundle 3 Bundle 4
    1 1 3 4
    2 1 2 4
    3 3 2 3
    4 4 4 3
  6. Suppose income increases by 10 percent, but the price of a chocolate bar and the price of downloads both increase by 5 percent. Will the budget line shift inward or outward? Will the slope of the budget line change?
  7. We explained the household demand curve and the law of demand by focusing on how a change in the price of a chocolate bar influences the quantity of chocolate bars demanded. Redo this discussion and the figures to illustrate how a change in the price of downloads will affect the demand for downloads and the demand for chocolate bars.
  8. In our example, we noted that it was not possible for both chocolate bars and music downloads to be inferior goods. Suppose there were three goods: chocolate bars, music downloads, and tuna sushi. Is it possible now that chocolate bars and music downloads are both inferior goods? Could all three be inferior goods?
  9. (Advanced) Suppose the government imposes a tax on chocolate bars. Draw a diagram that shows what happens to the budget set. If chocolate bars and downloads are both normal goods, can you say whether the consumption of chocolate bars will increase or decrease? What about the consumption of downloads?
  10. Explain why a price increase in movie tickets causes the demand curve for chocolate bars to shift.
  11. Suppose you are thinking of buying chocolate bars. Your marginal valuation of the seventh chocolate bar is $3. The price of a chocolate bar is $4. Should you buy more or fewer than seven bars?
  12. Explain how the law of demand works in the case of a unit demand curve.
  13. Can preferences include altruism or a regard for fairness and still exhibit rationality?
  14. Using the data in Table 3.5 "United Kingdom Budget Study", create a pie graph of expenditure shares. How might you explain the differences in spending between younger households in the United States and the United Kingdom? How might you explain the differences in spending in 2005 between younger households and average households?
  15. (Advanced) In discussing labor supply, we did not allow an individual to decide not to work. Yet we observe many individuals who could work but choose not to. How would you have to amend the discussion to include the choice of working or not working?
  16. If you face a big exam this week, how might this influence your time allocation choice in Figure 3.14 "The Time Budget Constraint"?
  17. (Advanced) If there is a reduction in the price of a chocolate bar, what does our theory predict will happen to labor supply?
  18. (Advanced) Suppose the government imposes a tax on labor. What will that tax do to the labor supply of a household and its demands for downloads and chocolate bars?
  19. (Advanced) If one member of a two-person household gets a raise, what will that do to the hours worked by that person and to the other household member? Explain this using income and substitution effects. Could this raise cause the other household member not to work at all?

Economics Detective

  1. Search the Internet to find the level of spending by Japanese households on food in a recent year. Convert this figure to dollars.
  2. The data in Table 3.4 "Budget Shares in the United States" come from a survey. Who was surveyed? How frequently?
  3. Go to the web page of the Office for National Statistics in the United Kingdom (http://www.statistics.gov.uk/CCI/Nscl.asp?ID=5407&Pos=1&ColRank=1&Rank=16UK) and create a version of Table 3.5 "United Kingdom Budget Study" for different income groups. What differences do you see in spending patterns across income groups? How would you explain the differences in spending patterns as income changes?
  4. Go to http://www.bls.gov/tus. Pick two years. Prepare a table to illustrate how the allocation of time has changed for one of two age groups over these two years. How might you explain these changes?

Spreadsheet Exercise

  1. (Advanced) Create a spreadsheet to reproduce the graph of a budget constraint with two goods (chocolate bars and downloads) in Figure 3.4 "The Budget Line". In column A, put the quantity of chocolate bars (from 0 to 20). In column B, put the price of a chocolate bar (that is, each cell should contain a 5).This is the simplest but not the most elegant way to create this spreadsheet. If you are an experienced user of spreadsheets, you may know tricks that will allow you to create the spreadsheet in a more compact way. In column C, put the price of downloads. In column D, put income. Then write an equation to enter in each cell of column E, based on the budget line. This equation should calculate the quantity of downloads in terms of the prices, income, and the quantity of chocolate bars. Make sure that you allow only nonnegative quantities of the goods. Use this to graph the budget line. Now try changing the prices and the level of income and make sure you can explain how the budget line shifts as income and prices change.