This post is 7th in a 7-part series of my personal notes outlining N. Gregory Mankiw’s economics textbook “Principles of Microeconomics” (8th Edition).
Index of Outlines for Principles of Microeconomics:
* Part 1: Introduction (Chapters 1-3)
* Part 2: How Markets Work (Chapters 5-6)
* Part 3: Markets and Welfare (Chapters 7-9)
* Part 4: The Economics of the Public Sector (Chapters 10-12)
* Part 5: Firm Behavior and the Organization of Industry (Chapters 13-17)
* Part 6: The Economics of Labor Markets (Chapters 18-20)
* Part 7: Topics for Further study (Chapters 21-22)
Part 7: Topics for Further Study
Chapter 21: The Theory of Consumer Choice
- The theory of consumer choice examines how consumers make decisions with respect to the trade-offs and in response to their circumstances and environment.
- “People consume less than they desire because their spending is constrained, or limited, by their income.”
21-1 The Budget Constraint: What the Consumer Can Afford
- Budget constraint: The limit on the consumption bundles (a combination of goods) that a consumer can afford.
- Chart showing consumption bundles (as expressed by a downward sloping line). Consumer can afford 5 units of Y or 7 units of X or some combination of the Y and X.
21-2 Preferences: What the Consumer Wants
- Consumer preferences: Goods that best suite a consumer’s tastes.
- Indifference curve: A curve that shows consumption bundles that give the consumer the same level of satisfaction.
- Marginal rate of substitution: The rate at which a consumer is willing to trade one good for another.
Properties of indifference curves:
- Higher indifference curves are preferred to lower ones. Consumers prefer more consumption than less. In the chart above, the consumer will generally prefer the I-3 curve to the I-2 or I-1 curve.
- Indifference curves are downward-sloping. If the quantity of one good is reduced, the quantity for the other good must increase for the consumer to remain equally satisfied.
- Indifference curves do not cross: In order to be true, this would contradict the assumption that a consumer always prefers more of both goods than less.
- Indifference curves are bowed inward: Reflects the consumer’s relative willingness to give up a good that she already has a large quantity of.
- Perfect substitutes: Two goods with straight-line indifference curves. Example: Bundles of nickels and dimes are interchangeable so long as the value of each is the same. The marginal rate of substitution is constant.
- Perfect complements: Two goods with right-angle indifference curves. Example: Left shoes and right shoes. Consumer only cares about pairs of shoes.
21-3 Optimization: What the Consumer Chooses
- Consumer optimum: The best combination of two goods on the highest possible indifference curve that meets the consumer’s budget constraint (as represented by the straight line in the chart below).
If the consumer’s income increases, the consumer will find a new optimum as the budget constraint shifts up and to the right.
- Normal good: A good for which an increase in income raises the quantity demanded.
- Inferior good: A good for which an increase in income reduces the quantity demanded (example: bus rides which can be replaced by car rides when income increases).
Change in the price of goods will similarly change the consumer optimum.
The impact of a change in the price of a good on consumption:
- Income effect: The change in consumption that results when a price change moves the consumer to a higher or lower indifference curve.
- Substitution effect: The change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution.
- In the illustration the point at Qy, Qx represents the consumer optimum. The consumer might prefer a point on the I-3 curve but that quantity exceeds her budget.
21-4 Three Applications
Giffen good: A good for which an increase in the price raises the quantity demanded.
- This is a violation of the law of demand (where consumers buy less of a good when the price increases).
- Giffen goods are inferior goods for which the income effect dominates the substitution effect.
- Table illustrates why this is possible (using consumer preference curves). In the example below, price of potatoes increases causing optimum for potatoes to shift from point C to point E.
How wages affect labor supply.
Backward bending supply curve of labor: When wages increase beyond a certain level, people will substitute leisure for paid work time.
Higher wages lead to a decrease in the labor supply.
- In the 1910s people worked 6-days/week.
- Present day people work 5-days/week.
- Work hours have fallen over that time but wages (adjusted for inflation) have risen.
As wages rise, so does the reward for working. “Yet rather than…working more, most workers choose to take part of their greater prosperity in the form of more leisure…the income effect of higher wages dominates the substitution effect.”
How interest rates affect household savings.
- The impact of interest rates on savings depends on the income and substitution effects.
- If the substitution effect of a higher interest rate is greater than the income effect, an individual will save more.
- If the income effect is greater than the substitution effect, the individual will save less.
- The theory of consumer choice presents an ambiguous outcome: the increase in interest rate could either encourage or discourage saving.
21-5 Conclusion: Do People Really Think This Way?
- The theory of consumer choice does not describe, in a literal sense, the way real humans make purchasing decisions.
- Theory is an economic construct for explaining consumer behavior.
- Consumers are constrained by their financial means and do the best, within those constraints, to maximize their satisfaction.
Chapter 19: Frontiers of Microeconomics
22-1 Asymmetric Information
Asymmetric information: Situations in which one group or individual is better informed than others. The imbalance of information affects the choices each group can make, how they interact, and relative advantages of one group over another.
Examples of asymmetric information:
- A worker knows more than his employer about how much effort he puts into his job (example of a hidden action).
- A seller of a used car knows more than the buyer about the car’s condition/history (example of a hidden characteristic).
Uninformed party wants to know the relevant information. Informed party may have incentives to conceal this information.
Moral hazard: A problem that arises when one person, the “agent”, performs a task on behalf of another person, the “principal.”
Agent: A person performing a task for another person.
Principal: A person for whom another person is performing some act.
Some refer to this problem as the “Principal-Agent Problem.”
Example: Employee-worker relationship.
The employee is the agent.
The employer is the principal.
The moral-hazard problem is that imperfectly monitored workers may be tempted to “slack off.”
Employers can manage this problem in various ways:
- Better monitoring of workers (e.g. hidden cameras).
- High wages (per efficiency-wages in Chapter 19) which creates stronger incentives to perform.
- Delayed payment (e.g. end-of-year bonuses).
- Home-owners with fire insurance who buys too few fire extinguishers. Home-owner bears the cost of the extinguishers while the insurance company receives too much of the benefit.
- Family living near a river with a high risk of flooding because they enjoy the scenic views. Government bears the cost of disaster relief after a flood.
Adverse selection: The tendency for the mix of unobserved attributes to become undesirable from the standpoint of an uninformed party.
Examples of adverse selection:
- Used-cars: Sellers know the defects of their cars. Owners of the worst cars are more likely to sell defective cars than are the owners of good-quality cars. Buyers are worried about buying lemons.
- Labor market: If a firm cuts wages, talented workers are more likely to quit and find work elsewhere (leaving the less desirable workers still employed).
- Health insurance: Buyers know more about their health problems than the insurance company. People with bigger, hidden health problems are more likely to buy health insurance than healthy people. The price of health insurance reflects the costs of sicker customers. People with average health may decide not to buy the insurance.
Signaling: An action taken by an informed party to reveal private information to an uninformed party.
Examples of signaling:
- Advertising is a form of signaling to customers that the product is of high-quality if the seller is willing to spend/invest to advertise.
- A college degree is a way to signal to employers that a prospective worker is of high-quality and high-ability.
What is needed for an effective signal:
- Something costly: If the signal were free, anyone could use it. The signal must differentiate in some way.
- The signal must benefit the person using the signal: The signal-user expects that the return on investment for acquiring the signal will be worth it.
Screening: An action taken by an uninformed party to induce an informed party to reveal information.
Examples of screening:
Buyer of a used car asking to have the car checked by a mechanic. If the seller refuses this request they may be hiding important private information.
Insurance company offering different policies that help sort safe drivers from riskier drivers:
- Policy with low premiums but a high deductible: May attract safe drivers.
- Policy with high premium but no deductible: May attract riskier drivers.
Complications for government intervention in addressing economic problems arising from asymmetric information:
- Private market can already address the asymmetries with signaling and screening.
- Government doesn’t always have more information than private parties.
- Government is an imperfect institution.
22-2 Political Economy
Political economy: The study of government using the analytic methods of economics.
Condorcet paradox: The failure of majority rule to produce transitive preferences for society.
Arrow’s impossibility theorem: A mathematical result showing that, under certain assumed conditions, there is no scheme for aggregating individual preferences into a valid set of social preferences.
- “No matter what voting system society adopts for aggregating the preferences of its members, it will in some way be flawed as a mechanism for social choice.”
Median voter theorem: A mathematical result showing that if voters are choosing a point along a line and each voter wants the point closest to his most preferred point, then majority rule will pick the most preferred point of the median voter.
- “If two political parties are each trying to maximize their chance of election, they will both move their positions toward the median voter.”
- “This theory can explain why the parties in a two-party system are similar to each other: They are both moving toward the median voter.”
- Minority views don’t carry much weight. Example: 40% of the population want a lot of money spent on parks and 60% want nothing spent. Median voter preference is zero in the example.
Politicians are individuals and carry their own set of self-interests, biases and agendas into their policy-making activities.
22-3 Behavioral Economics
Behavioral economics: The subfield of economics that integrates the insights of psychology.
Homo economicus: The “rational” humans that economic theory makes frequent use of.
Real people are irrational and complex: forgetful, impulsive, confused, emotional, shortsighted, imperfect.
Satisficers: Idea promoted by Herbert Simon that humans are not rational maximizers but instead make decisions that are “good enough.”
Systematic mistakes (some call these cognitive biases):
- People are overconfident and too sure of their own abilities.
- People give too much weight to a small number of vivid observations.
- People are reluctant to change their minds (confirmation bias).
The ultimatum game:
Premise: Two individuals are told they will play a game to win $100. Game begins with a coin toss which assigns the players a role. Role A is to propose a division of the $100 prize between himself and the other player. Role B decides whether to accept or reject the proposal.
- If B accepts A’s proposal both players are paid per the proposal.
- If B rejects A’s proposal both players walk away with nothing.
Conventional economic theory assumes people are rational wealth maximizers:
- Player A should propose that he gets $99 and Player B gets $1 (and Player B accepts).
- Assumptions is that Player B gets something out of the situation and should take that deal.
- The 99-1 split is the Nash equilibrium.
When experimental economists test the game with real people the results are different:
- Player B individuals usually reject the $1 proposal.
- Anticipating this rejection, Player A typically offers a 60:40 or 60:30 split (the smaller amount offered to B).
Conclusion from real-world test:
- 99-1 appears unfair to most people and they reject it to their own detriment.
- 70-30, while still unfair, is not so unfair that people ignore their self-interest.
- Some economists suggest that firms should consider this perceived fairness when setting wages (even when equilibrium prices don’t dictate it).
- “The study of asymmetric information should make you more wary of market outcomes.”
- “The study of political economy should make you more wary of government solutions.”
- “the study of behavioral economics should make you wary of any institution that relies on human decision making, including both the market and the government.”