CHAPTER 3 Consumer Preferences and Choice

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03-Salvatore-Chap03.qxd 08-08-2008 12:41 PM Page 78 78 PART TWO Theory of Consumer Behavior and Demand EXAMPLE 3–6 Q Y 12 10 Water Rationing in the West Rationing Quantitative restrictions. 8 6 0 J 2 B 5 U 2 U 1 U 0 K Q X Q Y 10 8 0 J U0 L 1 U 1 3 optimization is true only when indifference curves assume their usual convex shape and are neither everywhere flatter nor steeper than the budget line. Finally, although a consumer in the real world does not spend all of his or her income on one or a few goods, there are many more goods that he or she does not purchase because they are too expensive for the utility they provide. For example, few people purchase a $2,000 watch because the utility that most people get from the watch does not justify its $2,000 price. The nonconsumption of many goods in the real world can be explained by indifference curves which, though convex to the origin, are everywhere either flatter or steeper than the budget line, yielding corner rather than interior solutions. Corner solutions can also arise with rationing, as Example 3–6 shows. U 2 5 K Q X Q Y 10 8 6 J U 0 B U 1 0 2 3.5 FIGURE 3.10 Corner Solutions In the left panel, indifference curves are everywhere flatter than the budget line, and U1 is the highest indifference curve that the consumer can reach by purchasing 10Y only (point J). The middle panel shows indifference curves everywhere steeper than the budget line, and U1 is the highest indifference curve that the consumer can reach by spending all income to purchase 5X (point K). In the right panel, concave indifference curve U1 is tangent to the budget line at point B, but this is not the optimum point because the consumer can reach higher indifference curve U2 by consuming only good Y (point J). Because goods are scarce, some method of allocating them among individuals is required. In a free-enterprise economy such as our own, the price system accomplishes this for the most part. Sometimes, however, the government rations goods, such as water in the West of the United States (as a result of recurrent droughts) and gasoline in 1974 and 1979 (at the height of the petroleum crisis). If the maximum amount of the good that the government allows is less than the individual would have purchased or used, the rationing will reduce the individual’s level of satisfaction. K 5 6 U 2 Q X
03-Salvatore-Chap03.qxd 08-08-2008 12:41 PM Page 79 FIGURE 3.11 Rationing In the absence of rationing, the individual maximizes satisfaction at point B, where indifference curve U1 is tangent to budget line JK, and consumes 2X and 6Y (as in Figure 3.8). If the government did not allow the individual to purchase more than 1X per week, the budget line becomes JLK ′ , with a kink at point L. The highest indifference curve that the individual can reach with budget line JLK ′ , is now U0 at point L, by consuming 1X and 8Y. ✓ Concept Check Can rationing lead to a black market? CHAPTER 3 Consumer Preferences and Choice 79 The effect of rationing on utility maximization and consumption can be examined with Figure 3.11. In the absence of rationing, the individual maximizes satisfaction at point B, where indifference curve U1 is tangent to budget line JK, by consuming 2X and 6Y (as in Figure 3.8). Good X could refer to hours per week of lawn watering (in absence of an automatic water sprinkler system), while good Y could refer to hours per week of TV viewing. If the government did not allow the individual to use more than 1X per week, the budget line becomes JLK ′ , with a kink at point L. Thus, rationing changes the constraints under which utility maximization occurs. The highest indifference curve that the individual can reach with budget line JLK ′ is now U0 at point L,by consuming 1X and 8Y. In our water rationing case, this refers to one hour of lawn watering and eight hours of TV viewing per week. With water rationing, the incentive arises to illegally water lawns at night under the cover of darkness. On the other hand, gasoline rationing during 1974 and 1979 led to long lines at the gas pump and to black markets where gasoline could be purchased illegally at a higher price without waiting. Thus, rationing leads to price distortions and inefficiencies. If rations were 2X or more per week, the rationing system would not affect this consumer since he or she maximizes utility by purchasing 2X and 6Y (point B in the figure). Rationing is more likely to be binding or restrictive on high-income people than on low-income people (who may not have sufficient income to purchase even the allowed quantity of the rationed commodity). Thus, our model predicts that highincome people are more likely to make black-market purchases than low-income people. Effective rationing leads not only to black markets but also to “spillover” of consumer purchases on other goods not subject to rationing (or into savings). Both occurred in the United States during the 1974 and 1979 gasoline rationing periods. As pointed out in Section 2.7, allowing the market to operate (i.e., letting the price of the commodity reach its equilibrium level) eliminates the inefficiency of price controls and leads to much better results. Sources: “Trickle-Down Economics,” Wall Street Journal, August 23, 1999, p. A14; “Water Rights May Become More Liquid,” Wall Street Journal, February 15, 1996, p. A2; W. C. Lee, “The Welfare Cost of Rationing-by-Queuing Across Markets,” Quarterly Journal of Economics, July 1987; J. Brewer, et al., “Water Markets in the West: Prices, Trading, and Contractual Forms,” NBER Working Paper No. 13002, March 2007, and M. Greenstone, “Tradable Water Rights,” Democracy Journal, No. 8, Spring 2008, pp. 1–2. Quantity of Y Q Y 10 8 6 3 0 J L 1 K 9 2 B K U 1 U 0 5 8 Q X Quantity of X
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CHAPTER 3 Consumer Preferences and Choice

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