Mankiw.2003.Principles.of.Economics

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 465

PINTS OF PEPSI NUMBER SPENDING SPENDING TOTAL Table 21-1
OF PIZZAS ON PEPSI ON PIZZA SPENDING
0 THE CONSUMER’S
50 100 $0 $1,000 $1,000 OPPORTUNITIES. This table
100 90 100 900 1,000 shows what the consumer can
150 80 200 800 1,000 afford if his income is $1,000, the
200 70 300 700 1,000 price of Pepsi is $2, and the price
250 60 400 600 1,000 of pizza is $10.
300 50 500 500 1,000
350 40 600 400 1,000
400 30 700 300 1,000
450 20 800 200 1,000
500 10 900 100 1,000
0 1,000
0 1,000

Quantity C Figure 21-1
of Pepsi
Consumer’s THE CONSUMER’S BUDGET
B budget constraint CONSTRAINT. The budget
500 constraint shows the various
A bundles of goods that the
250 50 100 consumer can afford for a given
income. Here the consumer buys
0 bundles of Pepsi and pizza. The
more Pepsi he buys, the less
pizza he can afford.

Quantity
of Pizza

measures the number of pizzas. Three points are marked on this figure. At point A, budget constraint
the consumer buys no Pepsi and consumes 100 pizzas. At point B, the consumer the limit on the consumption
buys no pizza and consumes 500 pints of Pepsi. At point C, the consumer buys bundles that a consumer can afford
50 pizzas and 250 pints of Pepsi. Point C, which is exactly at the middle of the line
from A to B, is the point at which the consumer spends an equal amount ($500) on
Pepsi and pizza. Of course, these are only three of the many combinations of Pepsi
and pizza that the consumer can choose. All the points on the line from A to B are
possible. This line, called the budget constraint, shows the consumption bundles
that the consumer can afford. In this case, it shows the tradeoff between Pepsi and
pizza that the consumer faces.

466 PART SEVEN ADVANCED TOPIC

The slope of the budget constraint measures the rate at which the consumer
can trade one good for the other. Recall from the appendix to Chapter 2 that the
slope between two points is calculated as the change in the vertical distance di-
vided by the change in the horizontal distance (“rise over run”). From point A to
point B, the vertical distance is 500 pints, and the horizontal distance is 100 pizzas.
Thus, the slope is 5 pints per pizza. (Actually, because the budget constraint slopes
downward, the slope is a negative number. But for our purposes we can ignore the
minus sign.)

Notice that the slope of the budget constraint equals the relative price of the two
goods—the price of one good compared to the price of the other. A pizza costs 5
times as much as a pint of Pepsi, so the opportunity cost of a pizza is 5 pints of
Pepsi. The budget constraint’s slope of 5 reflects the tradeoff the market is offering
the consumer: 1 pizza for 5 pints of Pepsi.

Q U I C K Q U I Z : Draw the budget constraint for a person with income of
$1,000 if the price of Pepsi is $5 and the price of pizza is $10. What is the slope
of this budget constraint?

PREFERENCES: WHAT THE CONSUMER WANTS

Our goal in this chapter is to see how consumers make choices. The budget con-
straint is one piece of the analysis: It shows what combination of goods the con-
sumer can afford given his income and the prices of the goods. The consumer’s
choices, however, depend not only on his budget constraint but also on his prefer-
ences regarding the two goods. Therefore, the consumer’s preferences are the next
piece of our analysis.

indifference curve REPRESENTING PREFERENCES WITH
a curve that shows consumption INDIFFERENCE CURVES
bundles that give the consumer the
same level of satisfaction The consumer’s preferences allow him to choose among different bundles of Pepsi
and pizza. If you offer the consumer two different bundles, he chooses the bundle
that best suits his tastes. If the two bundles suit his tastes equally well, we say that
the consumer is indifferent between the two bundles.

Just as we have represented the consumer’s budget constraint graphically, we
can also represent his preferences graphically. We do this with indifference curves.
An indifference curve shows the bundles of consumption that make the consumer
equally happy. In this case, the indifference curves show the combinations of Pepsi
and pizza with which the consumer is equally satisfied.

Figure 21-2 shows two of the consumer’s many indifference curves. The con-
sumer is indifferent among combinations A, B, and C, because they are all on the
same curve. Not surprisingly, if the consumer’s consumption of pizza is reduced,
say from point A to point B, consumption of Pepsi must increase to keep him
equally happy. If consumption of pizza is reduced again, from point B to point C,
the amount of Pepsi consumed must increase yet again.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 467

Quantity Figure 21-2
of Pepsi
THE CONSUMER’S PREFERENCES.
C The consumer’s preferences are
represented with indifference
B D I2 curves, which show the
A combinations of Pepsi and pizza
MRS Indifference that make the consumer equally
1 curve, I 1 satisfied. Because the consumer
Quantity prefers more of a good, points
of Pizza on a higher indifference curve
(I2 here) are preferred to points on
a lower indifference curve (I1).
The marginal rate of substitution
(MRS) shows the rate at which
the consumer is willing to trade
Pepsi for pizza.

0

The slope at any point on an indifference curve equals the rate at which the marginal rate of
consumer is willing to substitute one good for the other. This rate is called the substitution
marginal rate of substitution (MRS). In this case, the marginal rate of substitution the rate at which a consumer is
measures how much Pepsi the consumer requires in order to be compensated for willing to trade one good for another
a one-unit reduction in pizza consumption. Notice that because the indifference
curves are not straight lines, the marginal rate of substitution is not the same at all
points on a given indifference curve. The rate at which a consumer is willing to
trade one good for the other depends on the amounts of the goods he is already
consuming. That is, the rate at which a consumer is willing to trade pizza for Pepsi
depends on whether he is more hungry or more thirsty, which in turn depends on
how much pizza and Pepsi he has.

The consumer is equally happy at all points on any given indifference curve,
but he prefers some indifference curves to others. Because he prefers more con-
sumption to less, higher indifference curves are preferred to lower ones. In Fig-
ure 21-2, any point on curve I2 is preferred to any point on curve I1.

A consumer’s set of indifference curves gives a complete ranking of the con-
sumer’s preferences. That is, we can use the indifference curves to rank any two
bundles of goods. For example, the indifference curves tell us that point D is pre-
ferred to point A because point D is on a higher indifference curve than point A.
(That conclusion may be obvious, however, because point D offers the consumer
both more pizza and more Pepsi.) The indifference curves also tell us that point D
is preferred to point C because point D is on a higher indifference curve. Even
though point D has less Pepsi than point C, it has more than enough extra pizza to
make the consumer prefer it. By seeing which point is on the higher indifference
curve, we can use the set of indifference curves to rank any combinations of Pepsi
and pizza.

468 PART SEVEN ADVANCED TOPIC

FOUR PROPERTIES OF INDIFFERENCE CURVES

Because indifference curves represent a consumer’s preferences, they have certain
properties that reflect those preferences. Here we consider four properties that de-
scribe most indifference curves:

N Property 1: Higher indifference curves are preferred to lower ones. Consumers
usually prefer more of something to less of it. (That is why we call this
something a “good” rather than a “bad.”) This preference for greater
quantities is reflected in the indifference curves. As Figure 21-2 shows, higher
indifference curves represent larger quantities of goods than lower
indifference curves. Thus, the consumer prefers being on higher indifference
curves.

N Property 2: Indifference curves are downward sloping. The slope of an
indifference curve reflects the rate at which the consumer is willing to
substitute one good for the other. In most cases, the consumer likes both
goods. Therefore, if the quantity of one good is reduced, the quantity of the
other good must increase in order for the consumer to be equally happy. For
this reason, most indifference curves slope downward.

N Property 3: Indifference curves do not cross. To see why this is true, suppose that
two indifference curves did cross, as in Figure 21-3. Then, because point A is
on the same indifference curve as point B, the two points would make the
consumer equally happy. In addition, because point B is on the same
indifference curve as point C, these two points would make the consumer
equally happy. But these conclusions imply that points A and C would also
make the consumer equally happy, even though point C has more of both
goods. This contradicts our assumption that the consumer always prefers
more of both goods to less. Thus, indifference curves cannot cross.

Figure 21-3 Quantity
of Pepsi
THE IMPOSSIBILITY OF
INTERSECTING INDIFFERENCE C
CURVES. A situation like this A
can never happen. According to
these indifference curves, the
consumer would be equally
satisfied at points A, B, and C,
even though point C has more of
both goods than point A.

B

0 Quantity
of Pizza

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 469

Figure 21-4

Quantity MRS = 1 B BOWED INDIFFERENCE CURVES.
of Pepsi Indifference curves are usually
1 Indifference bowed inward. This shape
14 curve implies that the marginal rate of
67 substitution (MRS) depends on
MRS = 6 Quantity the quantity of the two goods the
8A of Pizza consumer is consuming. At point
A, the consumer has little pizza
1 and much Pepsi, so he requires a
lot of extra Pepsi to induce him to
4 give up one of the pizzas: The
3 marginal rate of substitution is
6 pints of Pepsi per pizza. At
0 23 point B, the consumer has much
pizza and little Pepsi, so he
requires only a little extra Pepsi
to induce him to give up one of
the pizzas: The marginal rate of
substitution is 1 pint of Pepsi per
pizza.

N Property 4: Indifference curves are bowed inward. The slope of an indifference
curve is the marginal rate of substitution—the rate at which the consumer is
willing to trade off one good for the other. The marginal rate of substitution
(MRS) usually depends on the amount of each good the consumer is
currently consuming. In particular, because people are more willing to trade
away goods that they have in abundance and less willing to trade away
goods of which they have little, the indifference curves are bowed inward. As
an example, consider Figure 21-4. At point A, because the consumer has a lot
of Pepsi and only a little pizza, he is very hungry but not very thirsty. To
induce the consumer to give up 1 pizza, the consumer has to be given 6 pints
of Pepsi: The marginal rate of substitution is 6 pints per pizza. By contrast, at
point B, the consumer has little Pepsi and a lot of pizza, so he is very thirsty
but not very hungry. At this point, he would be willing to give up 1 pizza to
get 1 pint of Pepsi: The marginal rate of substitution is 1 pint per pizza. Thus,
the bowed shape of the indifference curve reflects the consumer’s greater
willingness to give up a good that he already has in large quantity.

TWO EXTREME EXAMPLES OF INDIFFERENCE CURVES

The shape of an indifference curve tells us about the consumer’s willingness to
trade one good for the other. When the goods are easy to substitute for each other,
the indifference curves are less bowed; when the goods are hard to substitute, the
indifference curves are very bowed. To see why this is true, let’s consider the ex-
treme cases.

P e r f e c t S u b s t i t u t e s Suppose that someone offered you bundles of nick-
els and dimes. How would you rank the different bundles?

470 PART SEVEN ADVANCED TOPIC

(a) Perfect Substitutes (b) Perfect Complements

Nickels Left
6 Shoes

4 7 I2
5 I1
2
I1 I2 I3 Dimes 0 57 Right Shoes

0 123

Figure 21-5 PERFECT SUBSTITUTES AND PERFECT COMPLEMENTS. When two goods are easily
substitutable, such as nickels and dimes, the indifference curves are straight lines, as
shown in panel (a). When two goods are strongly complementary, such as left shoes and
right shoes, the indifference curves are right angles, as shown in panel (b).

perfect substitutes Most likely, you would care only about the total monetary value of each bun-
two goods with straight-line dle. If so, you would judge a bundle based on the number of nickels plus twice the
indifference curves number of dimes. In other words, you would always be willing to trade 1 dime for
2 nickels, regardless of the number of nickels and dimes in the bundle. Your mar-
perfect complements ginal rate of substitution between nickels and dimes would be a fixed number—2.
two goods with right-angle
indifference curves We can represent your preferences over nickels and dimes with the indiffer-
ence curves in panel (a) of Figure 21-5. Because the marginal rate of substitution is
constant, the indifference curves are straight lines. In this extreme case of straight
indifference curves, we say that the two goods are perfect substitutes.

P e r f e c t C o m p l e m e n t s Suppose now that someone offered you bundles
of shoes. Some of the shoes fit your left foot, others your right foot. How would
you rank these different bundles?

In this case, you might care only about the number of pairs of shoes. In other
words, you would judge a bundle based on the number of pairs you could assem-
ble from it. A bundle of 5 left shoes and 7 right shoes yields only 5 pairs. Getting 1
more right shoe has no value if there is no left shoe to go with it.

We can represent your preferences for right and left shoes with the indiffer-
ence curves in panel (b) of Figure 21-5. In this case, a bundle with 5 left shoes and
5 right shoes is just as good as a bundle with 5 left shoes and 7 right shoes. It is also
just as good as a bundle with 7 left shoes and 5 right shoes. The indifference
curves, therefore, are right angles. In this extreme case of right-angle indifference
curves, we say that the two goods are perfect complements.

In the real world, of course, most goods are neither perfect substitutes (like
nickels and dimes) nor perfect complements (like right shoes and left shoes). More

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 471

FYI We have used indifference curves, bundles of goods on higher indifference curves pro-
Utility: An curves to represent the con- vide higher utility. Because the consumer is equally happy
Alternative sumer’s preferences. Another with all points on the same indifference curve, all these
common way to represent pref- bundles provide the same utility. Indeed, you can think of an
Way to erences is with the concept of indifference curve as an “equal-utility” curve. The slope of
Represent a utility. Utility is an abstract mea- the indifference curve (the marginal rate of substitution) re-
C o n s u m e r ’s flects the marginal utility generated by one good compared
Preferences to the marginal utility generated by the other good.

sure of the satisfaction or happi- When economists discuss the theory of consumer
choice, they might express the theory using different words.
ness that a consumer receives One economist might say that the goal of the consumer is to
maximize utility. Another might say that the goal of the con-
from a bundle of goods. Econo- sumer is to end up on the highest possible indifference
curve. In essence, these are two ways of saying the same
mists say that a consumer thing.

prefers one bundle of goods to

another if the first provides

more utility than the second.

Indifference curves and utility are closely related. Be-

cause the consumer prefers points on higher indifference

typically, the indifference curves are bowed inward, but not so bowed as to be-
come right angles.

Q U I C K Q U I Z : Draw some indifference curves for Pepsi and pizza. Explain
the four properties of these indifference curves.

OPTIMIZATION: WHAT THE CONSUMER CHOOSES

The goal of this chapter is to understand how a consumer makes choices. We have
the two pieces necessary for this analysis: the consumer’s budget constraint and
the consumer’s preferences. Now we put these two pieces together and consider
the consumer’s decision about what to buy.

THE CONSUMER’S OPTIMAL CHOICES

Consider once again our Pepsi and pizza example. The consumer would like to
end up with the best possible combination of Pepsi and pizza—that is, the combi-
nation on the highest possible indifference curve. But the consumer must also end
up on or below his budget constraint, which measures the total resources available
to him.

Figure 21-6 shows the consumer’s budget constraint and three of his many in-
difference curves. The highest indifference curve that the consumer can reach (I2 in
the figure) is the one that just barely touches the budget constraint. The point at
which this indifference curve and the budget constraint touch is called the opti-
mum. The consumer would prefer point A, but he cannot afford that point because

472 PART SEVEN ADVANCED TOPIC

Figure 21-6 Quantity Quantity
of Pepsi of Pizza
THE CONSUMER’S OPTIMUM.
The consumer chooses the point Optimum
on his budget constraint that lies B
on the highest indifference curve.
At this point, called the optimum, A
the marginal rate of substitution
equals the relative price of the I3
two goods. Here the highest I2
indifference curve the consumer I1
can reach is I2. The consumer Budget constraint
prefers point A, which lies on 0
indifference curve I3, but the
consumer cannot afford this
bundle of Pepsi and pizza. By
contrast, point B is affordable, but
because it lies on a lower
indifference curve, the consumer
does not prefer it.

it lies above his budget constraint. The consumer can afford point B, but that point
is on a lower indifference curve and, therefore, provides the consumer less satis-
faction. The optimum represents the best combination of consumption of Pepsi
and pizza available to the consumer.

Notice that, at the optimum, the slope of the indifference curve equals the
slope of the budget constraint. We say that the indifference curve is tangent to the
budget constraint. The slope of the indifference curve is the marginal rate of sub-
stitution between Pepsi and pizza, and the slope of the budget constraint is the
relative price of Pepsi and pizza. Thus, the consumer chooses consumption of the two
goods so that the marginal rate of substitution equals the relative price.

In Chapter 7 we saw how market prices reflect the marginal value that con-
sumers place on goods. This analysis of consumer choice shows the same result in
another way. In making his consumption choices, the consumer takes as given the
relative price of the two goods and then chooses an optimum at which his mar-
ginal rate of substitution equals this relative price. The relative price is the rate at
which the market is willing to trade one good for the other, whereas the marginal
rate of substitution is the rate at which the consumer is willing to trade one good for
the other. At the consumer’s optimum, the consumer’s valuation of the two goods
(as measured by the marginal rate of substitution) equals the market’s valuation
(as measured by the relative price). As a result of this consumer optimization, mar-
ket prices of different goods reflect the value that consumers place on those goods.

HOW CHANGES IN INCOME AFFECT
THE CONSUMER’S CHOICES

Now that we have seen how the consumer makes the consumption decision, let’s
examine how consumption responds to changes in income. To be specific, suppose

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 473

Quantity New budget constraint Figure 21-7
of Pepsi
AN INCREASE IN INCOME.
1. An increase in income shifts the When the consumer’s income
budget constraint outward . . . rises, the budget constraint shifts
out. If both goods are normal
New optimum goods, the consumer responds to
the increase in income by buying
3. . . . and more of both of them. Here the
Pepsi consumer buys more pizza and
consumption. more Pepsi.

Initial I2
optimum

Initial I1
budget
constraint

0 Quantity
2. . . . raising pizza consumption . . . of Pizza

that income increases. With higher income, the consumer can afford more of both normal good
goods. The increase in income, therefore, shifts the budget constraint outward, a good for which an increase in
as in Figure 21-7. Because the relative price of the two goods has not changed, income raises the quantity demanded
the slope of the new budget constraint is the same as the slope of the initial budget
constraint. That is, an increase in income leads to a parallel shift in the budget inferior good
constraint. a good for which an increase in
income reduces the quantity
The expanded budget constraint allows the consumer to choose a better com- demanded
bination of Pepsi and pizza. In other words, the consumer can now reach a higher
indifference curve. Given the shift in the budget constraint and the consumer’s
preferences as represented by his indifference curves, the consumer’s optimum
moves from the point labeled “initial optimum” to the point labeled “new opti-
mum.”

Notice that, in Figure 21-7, the consumer chooses to consume more Pepsi and
more pizza. Although the logic of the model does not require increased consump-
tion of both goods in response to increased income, this situation is the most com-
mon one. As you may recall from Chapter 4, if a consumer wants more of a good
when his income rises, economists call it a normal good. The indifference curves
in Figure 21-7 are drawn under the assumption that both Pepsi and pizza are nor-
mal goods.

Figure 21-8 shows an example in which an increase in income induces the con-
sumer to buy more pizza but less Pepsi. If a consumer buys less of a good when his
income rises, economists call it an inferior good. Figure 21-8 is drawn under the
assumption that pizza is a normal good and Pepsi is an inferior good.

Although most goods are normal goods, there are some inferior goods in the
world. One example is bus rides. High-income consumers are more likely to own
cars and less likely to ride the bus than low-income consumers. Bus rides, there-
fore, are an inferior good.

474 PART SEVEN ADVANCED TOPIC

Figure 21-8 Quantity New budget constraint
of Pepsi
AN INFERIOR GOOD. A good is
an inferior good if the consumer 3. . . . but Initial 1. When an increase in income shifts the
buys less of it when his income Pepsi optimum budget constraint outward . . .
rises. Here Pepsi is an inferior consumption
good: When the consumer’s falls, making New optimum
income increases and the budget Pepsi an
constraint shifts outward, the inferior good.
consumer buys more pizza but
less Pepsi.

Initial I1 I2
budget
constraint

0 Quantity
2. . . . pizza consumption rises, making pizza a normal good . . . of Pizza

HOW CHANGES IN PRICES AFFECT
THE CONSUMER’S CHOICES

Let’s now use this model of consumer choice to consider how a change in the price
of one of the goods alters the consumer’s choices. Suppose, in particular, that the
price of Pepsi falls from $2 to $1 a pint. It is no surprise that the lower price ex-
pands the consumer’s set of buying opportunities. In other words, a fall in the
price of any good shifts the budget constraint outward.

Figure 21-9 considers more specifically how the fall in price affects the budget
constraint. If the consumer spends his entire $1,000 income on pizza, then the price
of Pepsi is irrelevant. Thus, point A in the figure stays the same. Yet if the con-
sumer spends his entire income of $1,000 on Pepsi, he can now buy 1,000 rather
than only 500 pints. Thus, the end point of the budget constraint moves from point
B to point D.

Notice that in this case the outward shift in the budget constraint changes its
slope. (This differs from what happened previously when prices stayed the same
but the consumer’s income changed.) As we have discussed, the slope of the bud-
get constraint reflects the relative price of Pepsi and pizza. Because the price of
Pepsi has fallen to $1 from $2, while the price of pizza has remained $10, the con-
sumer can now trade a pizza for 10 rather than 5 pints of Pepsi. As a result, the
new budget constraint is more steeply sloped.

How such a change in the budget constraint alters the consumption of both
goods depends on the consumer’s preferences. For the indifference curves drawn
in this figure, the consumer buys more Pepsi and less pizza.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 475

Quantity New budget constraint Figure 21-9
of Pepsi
A CHANGE IN PRICE. When the
1,000 D price of Pepsi falls, the
consumer’s budget constraint
New optimum shifts outward and changes
slope. The consumer moves from
500 B 1. A fall in the price of Pepsi rotates the initial optimum to the new
the budget constraint outward . . . optimum, which changes his
3. . . . and purchases of both Pepsi and
raising Pepsi Initial optimum pizza. In this case, the quantity of
consumption. Pepsi consumed rises, and the
quantity of pizza consumed falls.

Initial I2
budget I1
constraint
A

0 100 Quantity
of Pizza
2. . . . reducing pizza consumption . . .

INCOME AND SUBSTITUTION EFFECTS

The impact of a change in the price of a good on consumption can be decomposed income effect
into two effects: an income effect and a substitution effect. To see what these two the change in consumption that
effects are, consider how our consumer might respond when he learns that the results when a price change moves
price of Pepsi has fallen. He might reason in the following ways: the consumer to a higher or lower
indifference curve
N “Great news! Now that Pepsi is cheaper, my income has greater purchasing
power. I am, in effect, richer than I was. Because I am richer, I can buy both substitution effect
more Pepsi and more pizza.” (This is the income effect.) the change in consumption that
results when a price change moves
N “Now that the price of Pepsi has fallen, I get more pints of Pepsi for every the consumer along a given
pizza that I give up. Because pizza is now relatively more expensive, I should indifference curve to a point with a
buy less pizza and more Pepsi.” (This is the substitution effect.) new marginal rate of substitution

Which statement do you find more compelling?
In fact, both of these statements make sense. The decrease in the price of Pepsi

makes the consumer better off. If Pepsi and pizza are both normal goods, the con-
sumer will want to spread this improvement in his purchasing power over both
goods. This income effect tends to make the consumer buy more pizza and more
Pepsi. Yet, at the same time, consumption of Pepsi has become less expensive rela-
tive to consumption of pizza. This substitution effect tends to make the consumer
choose more Pepsi and less pizza.

Now consider the end result of these two effects. The consumer certainly buys
more Pepsi, because the income and substitution effects both act to raise purchases
of Pepsi. But it is ambiguous whether the consumer buys more pizza, because the

476 PART SEVEN ADVANCED TOPIC

income and substitution effects work in opposite directions. This conclusion is
summarized in Table 21-2.

We can interpret the income and substitution effects using indifference curves.
The income effect is the change in consumption that results from the movement to a higher
indifference curve. The substitution effect is the change in consumption that results from
being at a point on an indifference curve with a different marginal rate of substitution.

Figure 21-10 shows graphically how to decompose the change in the con-
sumer’s decision into the income effect and the substitution effect. When the price

GOOD INCOME EFFECT SUBSTITUTION EFFECT TOTAL EFFECT
Pepsi Consumer is richer, Pepsi is relatively cheaper, so
Income and substitution effects act in
Pizza so he buys more Pepsi. consumer buys more Pepsi. same direction, so consumer buys
more Pepsi.
Consumer is richer, Pizza is relatively more
so he buys more pizza. expensive, so consumer Income and substitution effects act in
buys less pizza. opposite directions, so the total effect
on pizza consumption is ambiguous.

Table 21-2 INCOME AND SUBSTITUTION EFFECTS WHEN THE PRICE OF PEPSI FALLS

Figure 21-10 Quantity
of Pepsi
INCOME AND SUBSTITUTION
EFFECTS. The effect of a change New budget constraint
in price can be broken down into
an income effect and a substitu- C New optimum
tion effect. The substitution
effect—the movement along an Income B A Initial optimum
indifference curve to a point with effect I2
a different marginal rate of Initial
substitution—is shown here as Substitution budget
the change from point A to effect constraint
point B along indifference
curve I1. The income effect—the I1
shift to a higher indifference
curve—is shown here as the 0 Quantity
change from point B on Substitution effect of Pizza
indifference curve I1 to point C on
indifference curve I2.

Income effect

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 477

of Pepsi falls, the consumer moves from the initial optimum, point A, to the new
optimum, point C. We can view this change as occurring in two steps. First, the
consumer moves along the initial indifference curve I1 from point A to point B. The
consumer is equally happy at these two points, but at point B, the marginal rate of
substitution reflects the new relative price. (The dashed line through point B
reflects the new relative price by being parallel to the new budget constraint.)
Next, the consumer shifts to the higher indifference curve I2 by moving from
point B to point C. Even though point B and point C are on different indiffer-
ence curves, they have the same marginal rate of substitution. That is, the slope
of the indifference curve I1 at point B equals the slope of the indifference curve I2
at point C.

Although the consumer never actually chooses point B, this hypothetical point
is useful to clarify the two effects that determine the consumer’s decision. Notice
that the change from point A to point B represents a pure change in the marginal
rate of substitution without any change in the consumer’s welfare. Similarly, the
change from point B to point C represents a pure change in welfare without any
change in the marginal rate of substitution. Thus, the movement from A to B
shows the substitution effect, and the movement from B to C shows the income
effect.

DERIVING THE DEMAND CURVE

We have just seen how changes in the price of a good alter the consumer’s budget
constraint and, therefore, the quantities of the two goods that he chooses to buy.
The demand curve for any good reflects these consumption decisions. Recall that
a demand curve shows the quantity demanded of a good for any given price. We
can view a consumer’s demand curve as a summary of the optimal decisions that
arise from his budget constraint and indifference curves.

For example, Figure 21-11 considers the demand for Pepsi. Panel (a) shows
that when the price of a pint falls from $2 to $1, the consumer’s budget constraint
shifts outward. Because of both income and substitution effects, the consumer in-
creases his purchases of Pepsi from 50 to 150 pints. Panel (b) shows the demand
curve that results from this consumer’s decisions. In this way, the theory of con-
sumer choice provides the theoretical foundation for the consumer’s demand
curve, which we first introduced in Chapter 4.

Although it is comforting to know that the demand curve arises naturally
from the theory of consumer choice, this exercise by itself does not justify devel-
oping the theory. There is no need for a rigorous, analytic framework just to estab-
lish that people respond to changes in prices. The theory of consumer choice is,
however, very useful. As we see in the next section, we can use the theory to delve
more deeply into the determinants of household behavior.

Q U I C K Q U I Z : Draw a budget constraint and indifference curves for Pepsi
and pizza. Show what happens to the budget constraint and the consumer’s
optimum when the price of pizza rises. In your diagram, decompose the
change into an income effect and a substitution effect.

478 PART SEVEN ADVANCED TOPIC

(a) The Consumer’s Optimum (b) The Demand Curve for Pepsi

Quantity Price of
of Pepsi New budget constraint Pepsi

B A B
150 $2 Demand

I2 1 150 Quantity
of Pepsi
A Quantity 0 50
50 of Pizza

I1

0 Initial budget
constraint

Figure 21-11 DERIVING THE DEMAND CURVE. Panel (a) shows that when the price of Pepsi falls from
$2 to $1, the consumer’s optimum moves from point A to point B, and the quantity of
Pepsi consumed rises from 50 to 150 pints. The demand curve in panel (b) reflects this
relationship between the price and the quantity demanded.

FOUR APPLICATIONS

Now that we have developed the basic theory of consumer choice, let’s use it to
shed light on four questions about how the economy works. These four questions
might at first seem unrelated. But because each question involves household
decisionmaking, we can address it with the model of consumer behavior we have
just developed.

DO ALL DEMAND CURVES SLOPE DOWNWARD?

Normally, when the price of a good rises, people buy less of it. Chapter 4 called
this usual behavior the law of demand. This law is reflected in the downward slope
of the demand curve.

As a matter of economic theory, however, demand curves can sometimes slope
upward. In other words, consumers can sometimes violate the law of demand and
buy more of a good when the price rises. To see how this can happen, consider Fig-
ure 21-12. In this example, the consumer buys two goods—meat and potatoes. Ini-
tially, the consumer’s budget constraint is the line from point A to point B. The
optimum is point C. When the price of potatoes rises, the budget constraint shifts
inward and is now the line from point A to point D. The optimum is now point E.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 479

Quantity of Initial budget constraint Figure 21-12
Potatoes
A GIFFEN GOOD. In this
B example, when the price of
potatoes rises, the consumer’s
Optimum with high optimum shifts from point C
to point E. In this case, the
price of potatoes consumer responds to a higher
price of potatoes by buying less
meat and more potatoes.

D Optimum with low
price of potatoes
2. . . . which E C
increases 1. An increase in the price of
potato New budget potatoes rotates the budget
consumption constraint constraint inward . . .
if potatoes
are a Giffen I2 I1
good.

0A Quantity
of Meat

Notice that a rise in the price of potatoes has led the consumer to buy a larger Giffen good
quantity of potatoes. a good for which an increase in the
price raises the quantity demanded
Why is the consumer responding in a seemingly perverse way? The reason is
that potatoes here are a strongly inferior good. When the price of potatoes rises,
the consumer is poorer. The income effect makes the consumer want to buy less
meat and more potatoes. At the same time, because the potatoes have become
more expensive relative to meat, the substitution effect makes the consumer want
to buy more meat and less potatoes. In this particular case, however, the income ef-
fect is so strong that it exceeds the substitution effect. In the end, the consumer re-
sponds to the higher price of potatoes by buying less meat and more potatoes.

Economists use the term Giffen good to describe a good that violates the law
of demand. (The term is named for economist Robert Giffen, who first noted this
possibility.) In this example, potatoes are a Giffen good. Giffen goods are inferior
goods for which the income effect dominates the substitution effect. Therefore,
they have demand curves that slope upward.

Economists disagree about whether any Giffen good has ever been discovered.
Some historians suggest that potatoes were in fact a Giffen good during the Irish
potato famine of the nineteenth century. Potatoes were such a large part of peo-
ple’s diet that when the price of potatoes rose, it had a large income effect. People
responded to their reduced living standard by cutting back on the luxury of meat
and buying more of the staple food of potatoes. Thus, it is argued that a higher
price of potatoes actually raised the quantity of potatoes demanded.

Whether or not this historical account is true, it is safe to say that Giffen goods
are very rare. The theory of consumer choice does allow demand curves to slope
upward. Yet such occurrences are so unusual that the law of demand is as reliable
a law as any in economics.

480 PART SEVEN ADVANCED TOPIC

Figure 21-13 Consumption
$5,000
THE WORK-LEISURE DECISION.
This figure shows Sally’s budget
constraint for deciding how
much to work, her indifference
curves for consumption and
leisure, and her optimum.

2,000 Optimum I3
60
0 I2
I1
100 Hours of Leisure

HOW DO WAGES AFFECT LABOR SUPPLY?

So far we have used the theory of consumer choice to analyze how a person de-
cides how to allocate his income between two goods. We can use the same theory
to analyze how a person decides to allocate his time between work and leisure.

Consider the decision facing Sally, a freelance software designer. Sally is
awake for 100 hours per week. She spends some of this time enjoying leisure—rid-
ing her bike, watching television, studying economics, and so on. She spends the
rest of this time at her computer developing software. For every hour she spends
developing software, she earns $50, which she spends on consumption goods.
Thus, her wage ($50) reflects the tradeoff Sally faces between leisure and con-
sumption. For every hour of leisure she gives up, she works one more hour and
gets $50 of consumption.

Figure 21-13 shows Sally’s budget constraint. If she spends all 100 hours en-
joying leisure, she has no consumption. If she spends all 100 hours working, she
earns a weekly consumption of $5,000 but has no time for leisure. If she works a
normal 40-hour week, she enjoys 60 hours of leisure and has weekly consumption
of $2,000.

Figure 21-13 uses indifference curves to represent Sally’s preferences for con-
sumption and leisure. Here consumption and leisure are the two “goods” between
which Sally is choosing. Because Sally always prefers more leisure and more con-
sumption, she prefers points on higher indifference curves to points on lower ones.
At a wage of $50 per hour, Sally chooses a combination of consumption and leisure
represented by the point labeled “optimum.” This is the point on the budget con-
straint that is on the highest possible indifference curve, which is curve I2.

Now consider what happens when Sally’s wage increases from $50 to $60 per
hour. Figure 21-14 shows two possible outcomes. In each case, the budget con-
straint, shown in the left-hand graph, shifts outward from BC1 to BC2. In the
process, the budget constraint becomes steeper, reflecting the change in relative

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 481

(a) For a person with these preferences . . . . . . the labor supply curve slopes upward.

Consumption Wage

Labor
supply

1. When the wage rises . . .

BC1
BC2 I 2

I1 Hours of 0 Hours of Labor
0 Leisure
3. . . . and hours of labor increase. Supplied
2. . . . hours of leisure decrease . . .

(b) For a person with these preferences . . . . . . the labor supply curve slopes backward.
Wage
Consumption

BC2
1. When the wage rises . . .

BC1 Labor
supply
I2 Hours of
I1 Leisure 0 Hours of Labor
3. . . . and hours of labor decrease. Supplied
0
2. . . . hours of leisure increase . . .

AN INCREASE IN THE WAGE. The two panels of this figure show how a person might Figure 21-14
respond to an increase in the wage. The graphs on the left show the consumer’s initial
budget constraint BC1 and new budget constraint BC2, as well as the consumer’s optimal
choices over consumption and leisure. The graphs on the right show the resulting labor
supply curve. Because hours worked equal total hours available minus hours of leisure,
any change in leisure implies an opposite change in the quantity of labor supplied. In
panel (a), when the wage rises, consumption rises and leisure falls, resulting in a labor
supply curve that slopes upward. In panel (b), when the wage rises, both consumption
and leisure rise, resulting in a labor supply curve that slopes backward.

price: At the higher wage, Sally gets more consumption for every hour of leisure
that she gives up.

Sally’s preferences, as represented by her indifference curves, determine the
resulting responses of consumption and leisure to the higher wage. In both panels,

482 PART SEVEN ADVANCED TOPIC

consumption rises. Yet the response of leisure to the change in the wage is differ-
ent in the two cases. In panel (a), Sally responds to the higher wage by enjoying
less leisure. In panel (b), Sally responds by enjoying more leisure.

Sally’s decision between leisure and consumption determines her supply of
labor, for the more leisure she enjoys the less time she has left to work. In each
panel, the right-hand graph in Figure 21-14 shows the labor supply curve implied
by Sally’s decision. In panel (a), a higher wage induces Sally to enjoy less leisure
and work more, so the labor supply curve slopes upward. In panel (b), a higher
wage induces Sally to enjoy more leisure and work less, so the labor supply curve
slopes “backward.”

At first, the backward-sloping labor supply curve is puzzling. Why would a
person respond to a higher wage by working less? The answer comes from con-
sidering the income and substitution effects of a higher wage.

Consider first the substitution effect. When Sally’s wage rises, leisure becomes
more costly relative to consumption, and this encourages Sally to substitute con-
sumption for leisure. In other words, the substitution effect induces Sally to work
harder in response to higher wages, which tends to make the labor supply curve
slope upward.

Now consider the income effect. When Sally’s wage rises, she moves to a
higher indifference curve. She is now better off than she was. As long as con-
sumption and leisure are both normal goods, she tends to want to use this increase
in well-being to enjoy both higher consumption and greater leisure. In other
words, the income effect induces her to work less, which tends to make the labor
supply curve slope backward.

In the end, economic theory does not give a clear prediction about whether an
increase in the wage induces Sally to work more or less. If the substitution effect is
greater than the income effect for Sally, she works more. If the income effect is
greater than the substitution effect, she works less. The labor supply curve, there-
fore, could be either upward or backward sloping.

“NO MORE 9-TO-5 FOR ME.” C A S E S T U D Y INCOME EFFECTS ON LABOR SUPPLY:
HISTORICAL TRENDS, LOTTERY WINNERS,
AND THE CARNEGIE CONJECTURE

The idea of a backward-sloping labor supply curve might at first seem like a mere
theoretical curiosity, but in fact it is not. Evidence indicates that the labor supply
curve, considered over long periods of time, does in fact slope backward. A hun-
dred years ago many people worked six days a week. Today five-day workweeks
are the norm. At the same time that the length of the workweek has been falling,
the wage of the typical worker (adjusted for inflation) has been rising.

Here is how economists explain this historical pattern: Over time, advances
in technology raise workers’ productivity and, thereby, the demand for labor.
The increase in labor demand raises equilibrium wages. As wages rise, so does
the reward for working. Yet rather than responding to this increased incentive
by working more, most workers choose to take part of their greater prosperity
in the form of more leisure. In other words, the income effect of higher wages
dominates the substitution effect.

Further evidence that the income effect on labor supply is strong comes
from a very different kind of data: winners of lotteries. Winners of large prizes

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 483

in the lottery see large increases in their incomes and, as a result, large outward
shifts in their budget constraints. Because the winners’ wages have not
changed, however, the slopes of their budget constraints remain the same. There
is, therefore, no substitution effect. By examining the behavior of lottery win-
ners, we can isolate the income effect on labor supply.

The results from studies of lottery winners are striking. Of those winners
who win more than $50,000, almost 25 percent quit working within a year, and
another 9 percent reduce the number of hours they work. Of those winners who
win more than $1 million, almost 40 percent stop working. The income effect on
labor supply of winning such a large prize is substantial.

Similar results were found in a study, published in the May 1993 issue of the
Quarterly Journal of Economics, of how receiving a bequest affects a person’s la-
bor supply. The study found that a single person who inherits more than
$150,000 is four times as likely to stop working as a single person who inherits
less than $25,000. This finding would not have surprised the nineteenth-century
industrialist Andrew Carnegie. Carnegie warned that “the parent who leaves
his son enormous wealth generally deadens the talents and energies of the son,
and tempts him to lead a less useful and less worthy life than he otherwise
would.” That is, Carnegie viewed the income effect on labor supply to be sub-
stantial and, from his paternalistic perspective, regrettable. During his life and
at his death, Carnegie gave much of his vast fortune to charity.

HOW DO INTEREST RATES AFFECT HOUSEHOLD SAVING?

An important decision that every person faces is how much income to consume to-
day and how much to save for the future. We can use the theory of consumer
choice to analyze how people make this decision and how the amount they save
depends on the interest rate their savings will earn.

Consider the decision facing Sam, a worker planning ahead for retirement. To
keep things simple, let’s divide Sam’s life into two periods. In the first period, Sam
is young and working. In the second period, he is old and retired. When young,
Sam earns a total of $100,000. He divides this income between current consump-
tion and saving. When he is old, Sam will consume what he has saved, including
the interest that his savings have earned.

Suppose that the interest rate is 10 percent. Then for every dollar that Sam
saves when young, he can consume $1.10 when old. We can view “consumption
when young” and “consumption when old” as the two goods that Sam must
choose between. The interest rate determines the relative price of these two goods.

Figure 21-15 shows Sam’s budget constraint. If he saves nothing, he consumes
$100,000 when young and nothing when old. If he saves everything, he consumes
nothing when young and $110,000 when old. The budget constraint shows these
and all the intermediate possibilities.

Figure 21-15 uses indifference curves to represent Sam’s preferences for con-
sumption in the two periods. Because Sam prefers more consumption in both pe-
riods, he prefers points on higher indifference curves to points on lower ones.
Given his preferences, Sam chooses the optimal combination of consumption in
both periods of life, which is the point on the budget constraint that is on the high-
est possible indifference curve. At this optimum, Sam consumes $50,000 when
young and $55,000 when old.

484 PART SEVEN ADVANCED TOPIC

Figure 21-15 Consumption Budget
when Old constraint
THE CONSUMPTION-SAVING
DECISION. This figure shows $110,000
the budget constraint for a person
deciding how much to consume
in the two periods of his life, the
indifference curves representing
his preferences, and the
optimum.

55,000 Optimum
0
I3

$50,000 I2 Consumption
I1 when Young
100,000

Now consider what happens when the interest rate increases from 10 percent
to 20 percent. Figure 21-16 shows two possible outcomes. In both cases, the budget
constraint shifts outward and becomes steeper. At the new higher interest rate,
Sam gets more consumption when old for every dollar of consumption that he
gives up when young.

The two panels show different preferences for Sam and the resulting response
to the higher interest rate. In both cases, consumption when old rises. Yet the re-
sponse of consumption when young to the change in the interest rate is different
in the two cases. In panel (a), Sam responds to the higher interest rate by con-
suming less when young. In panel (b), Sam responds by consuming more when
young.

Sam’s saving, of course, is his income when young minus the amount he con-
sumes when young. In panel (a), consumption when young falls when the interest
rate rises, so saving must rise. In panel (b), Sam consumes more when young, so
saving must fall.

The case shown in panel (b) might at first seem odd: Sam responds to an in-
crease in the return to saving by saving less. Yet this behavior is not as peculiar as
it might seem. We can understand it by considering the income and substitution
effects of a higher interest rate.

Consider first the substitution effect. When the interest rate rises, consumption
when old becomes less costly relative to consumption when young. Therefore, the
substitution effect induces Sam to consume more when old and less when young.
In other words, the substitution effect induces Sam to save more.

Now consider the income effect. When the interest rate rises, Sam moves to a
higher indifference curve. He is now better off than he was. As long as consump-
tion in both periods consists of normal goods, he tends to want to use this increase
in well-being to enjoy higher consumption in both periods. In other words, the in-
come effect induces him to save less.

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 485

(a) Higher Interest Rate Raises Saving (b) Higher Interest Rate Lowers Saving

Consumption Consumption
when Old BC2 when Old BC2

1. A higher interest rate rotates 1. A higher interest rate rotates
the budget constraint outward . . . the budget constraint outward . . .

BC1 BC1

I2

I1 I1 I2

0 Consumption 0 Consumption
2. . . . resulting in higher when Young
2. . . . resulting in lower when Young consumption when young
and, thus, lower saving.
consumption when young

and, thus, higher saving.

AN INCREASE IN THE INTEREST RATE. In both panels, an increase in the interest rate Figure 21-16
shifts the budget constraint outward. In panel (a), consumption when young falls, and
consumption when old rises. The result is an increase in saving when young. In panel (b),
consumption in both periods rises. The result is a decrease in saving when young.

The end result, of course, depends on both the income and substitution effects.
If the substitution effect of a higher interest rate is greater than the income effect,
Sam saves more. If the income effect is greater than the substitution effect, Sam
saves less. Thus, the theory of consumer choice says that an increase in the interest
rate could either encourage or discourage saving.

Although this ambiguous result is interesting from the standpoint of economic
theory, it is disappointing from the standpoint of economic policy. It turns out that
an important issue in tax policy hinges in part on how saving responds to interest
rates. Some economists have advocated reducing the taxation of interest and other
capital income, arguing that such a policy change would raise the after-tax interest
rate that savers can earn and would thereby encourage people to save more. Other
economists have argued that because of offsetting income and substitution effects,
such a tax change might not increase saving and could even reduce it. Unfortu-
nately, research has not led to a consensus about how interest rates affect saving.
As a result, there remains disagreement among economists about whether changes
in tax policy aimed to encourage saving would, in fact, have the intended effect.

DO THE POOR PREFER TO RECEIVE CASH
OR IN-KIND TRANSFERS?

Paul is a pauper. Because of his low income, he has a meager standard of liv-
ing. The government wants to help. It can either give Paul $1,000 worth of food

486 PART SEVEN ADVANCED TOPIC

Cash Transfer (a) The Constraint Is Not Binding In-Kind Transfer
BC2 (with $1,000 cash) Food
Food

BC2 (with $1,000 food stamps)

BC 1 BC 1

$1,000 B $1,000 B
I2 I2
A A
I1 I1

0 Nonfood 0 Nonfood
Consumption Consumption

Cash Transfer (b) The Constraint Is Binding In-Kind Transfer
BC2 (with $1,000 cash) Food
Food

BC2 (with $1,000 food stamps)

BC1 BC1

$1,000 $1,000 C
0 AB
AB I3 I2
I1
I1 I2 Nonfood
Nonfood 0 Consumption

Consumption

Figure 21-17 CASH VERSUS IN-KIND TRANSFERS. Both panels compare a cash transfer and a similar
in-kind transfer of food. In panel (a), the in-kind transfer does not impose a binding
constraint, and the consumer ends up on the same indifference curve under the two
policies. In panel (b), the in-kind transfer imposes a binding constraint, and the consumer
ends up on a lower indifference curve with the in-kind transfer than with the cash
transfer.

(perhaps by issuing him food stamps) or simply give him $1,000 in cash. What
does the theory of consumer choice have to say about the comparison between
these two policy options?

Figure 21-17 shows how the two options might work. If the government gives
Paul cash, then the budget constraint shifts outward. He can divide the extra cash

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 487

between food and nonfood consumption however he pleases. By contrast, if the
government gives Paul an in-kind transfer of food, then his new budget constraint
is more complicated. The budget constraint has again shifted out. But now the
budget constraint has a kink at $1,000 of food, for Paul must consume at least that
amount in food. That is, even if Paul spends all his money on nonfood consump-
tion, he still consumes $1,000 in food.

The ultimate comparison between the cash transfer and in-kind transfer de-
pends on Paul’s preferences. In panel (a), Paul would choose to spend at least
$1,000 on food even if he receives a cash transfer. Therefore, the constraint im-
posed by the in-kind transfer is not binding. In this case, his consumption moves
from point A to point B regardless of the type of transfer. That is, Paul’s choice be-
tween food and nonfood consumption is the same under the two policies.

In panel (b), however, the story is very different. In this case, Paul would pre-
fer to spend less than $1,000 on food and spend more on nonfood consumption.
The cash transfer allows him discretion to spend the money as he pleases, and he
consumes at point B. By contrast, the in-kind transfer imposes the binding con-
straint that he consume at least $1,000 of food. His optimal allocation is at the kink,
point C. Compared to the cash transfer, the in-kind transfer induces Paul to con-
sume more food and less of other goods. The in-kind transfer also forces Paul to
end up on a lower (and thus less preferred) indifference curve. Paul is worse off
than if he had the cash transfer.

Thus, the theory of consumer choice teaches a simple lesson about cash versus
in-kind transfers. If an in-kind transfer of a good forces the recipient to consume
more of the good than he would on his own, then the recipient prefers the cash
transfer. If the in-kind transfer does not force the recipient to consume more of the
good than he would on his own, then the cash and in-kind transfer have exactly
the same effect on the consumption and welfare of the recipient.

Q U I C K Q U I Z : Explain how an increase in the wage can potentially
decrease the amount that a person wants to work.

CONCLUSION: DO PEOPLE
R E A L LY T H I N K T H I S WAY ?

The theory of consumer choice describes how people make decisions. As we have
seen, it has broad applicability. It can explain how a person chooses between Pepsi
and pizza, work and leisure, consumption and saving, and on and on.

At this point, however, you might be tempted to treat the theory of consumer
choice with some skepticism. After all, you are a consumer. You decide what to
buy every time you walk into a store. And you know that you do not decide by
writing down budget constraints and indifference curves. Doesn’t this knowledge
about your own decisionmaking provide evidence against the theory?

The answer is no. The theory of consumer choice does not try to present a lit-
eral account of how people make decisions. It is a model. And, as we first dis-
cussed in Chapter 2, models are not intended to be completely realistic.

The best way to view the theory of consumer choice is as a metaphor for how
consumers make decisions. No consumer (except an occasional economist) goes

488 PART SEVEN ADVANCED TOPIC

through the explicit optimization envisioned in the theory. Yet consumers are
aware that their choices are constrained by their financial resources. And, given
those constraints, they do the best they can to achieve the highest level of satisfac-
tion. The theory of consumer choice tries to describe this implicit, psychological
process in a way that permits explicit, economic analysis.

The proof of the pudding is in the eating. And the test of a theory is in its ap-
plications. In the last section of this chapter we applied the theory of consumer
choice to four practical issues about the economy. If you take more advanced
courses in economics, you will see that this theory provides the framework for
much additional analysis.

Summary

N A consumer’s budget constraint shows the possible N When the price of a good falls, the impact on the
combinations of different goods he can buy given his consumer’s choices can be broken down into an income
income and the prices of the goods. The slope of the effect and a substitution effect. The income effect is the
budget constraint equals the relative price of the goods. change in consumption that arises because a lower price
makes the consumer better off. The substitution effect is
N The consumer’s indifference curves represent his the change in consumption that arises because a price
preferences. An indifference curve shows the various change encourages greater consumption of the good
bundles of goods that make the consumer equally that has become relatively cheaper. The income effect is
happy. Points on higher indifference curves are reflected in the movement from a lower to a higher
preferred to points on lower indifference curves. The indifference curve, whereas the substitution effect is
slope of an indifference curve at any point is the reflected by a movement along an indifference curve to
consumer’s marginal rate of substitution—the rate at a point with a different slope.
which the consumer is willing to trade one good for the
other. N The theory of consumer choice can be applied in many
situations. It can explain why demand curves can
N The consumer optimizes by choosing the point on his potentially slope upward, why higher wages could
budget constraint that lies on the highest indifference either increase or decrease the quantity of labor
curve. At this point, the slope of the indifference curve supplied, why higher interest rates could either increase
(the marginal rate of substitution between the goods) or decrease saving, and why the poor prefer cash to
equals the slope of the budget constraint (the relative in-kind transfers.
price of the goods).

budget constraint, p. 465 Key Concepts substitution effect, p. 475
indifference curve, p. 466 Giffen good, p. 479
marginal rate of substitution, p. 467 perfect complements, p. 470
perfect substitutes, p. 470 normal good, p. 473
inferior good, p. 473
income effect, p. 475

Questions for Review

1. A consumer has income of $3,000. Wine costs $3 a glass, budget constraint. What is the slope of this budget
and cheese costs $6 a pound. Draw the consumer’s constraint?

CHAPTER 21 THE THEORY OF CONSUMER CHOICE 489

2. Draw a consumer’s indifference curves for wine and 6. The price of cheese rises from $6 to $10 a pound, while
cheese. Describe and explain four properties of these the price of wine remains $3 a glass. For a consumer
indifference curves. with a constant income of $3,000, show what happens to
consumption of wine and cheese. Decompose the
3. Pick a point on an indifference curve for wine and change into income and substitution effects.
cheese and show the marginal rate of substitution. What
does the marginal rate of substitution tell us? 7. Can an increase in the price of cheese possibly induce a
consumer to buy more cheese? Explain.
4. Show a consumer’s budget constraint and indifference
curves for wine and cheese. Show the optimal 8. Suppose a person who buys only wine and cheese is
consumption choice. If the price of wine is $3 a glass given $1,000 in food stamps to supplement his $1,000
and the price of cheese is $6 a pound, what is the income. The food stamps cannot be used to buy wine.
marginal rate of substitution at this optimum? Might the consumer be better off with $2,000 in income?
Explain in words and with a diagram.
5. A person who consumes wine and cheese gets a raise, so
his income increases from $3,000 to $4,000. Show what
happens if both wine and cheese are normal goods.
Now show what happens if cheese is an inferior good.

Problems and Applications

1. Jennifer divides her income between coffee and 4. Jim buys only milk and cookies.
croissants (both of which are normal goods). An early a. In 2001, Jim earns $100, milk costs $2 per quart, and
frost in Brazil causes a large increase in the price of cookies cost $4 per dozen. Draw Jim’s budget
coffee in the United States. constraint.
a. Show the effect of the frost on Jennifer’s budget b. Now suppose that all prices increase by 10 percent
constraint. in 2002 and that Jim’s salary increases by 10 percent
b. Show the effect of the frost on Jennifer’s optimal as well. Draw Jim’s new budget constraint. How
consumption bundle assuming that the substitution would Jim’s optimal combination of milk and
effect outweighs the income effect for croissants. cookies in 2002 compare to his optimal combination
c. Show the effect of the frost on Jennifer’s optimal in 2001?
consumption bundle assuming that the income
effect outweighs the substitution effect for 5. Consider your decision about how many hours to
croissants. work.
a. Draw your budget constraint assuming that you
2. Compare the following two pairs of goods: pay no taxes on your income. On the same
N Coke and Pepsi diagram, draw another budget constraint assuming
N Skis and ski bindings that you pay a 15 percent tax.
b. Show how the tax might lead to more hours of
In which case do you expect the indifference curves to work, fewer hours, or the same number of hours.
be fairly straight, and in which case do you expect the Explain.
indifference curves to be very bowed? In which case will
the consumer respond more to a change in the relative 6. Sarah is awake for 100 hours per week. Using one
price of the two goods? diagram, show Sarah’s budget constraints if she earns
$6 per hour, $8 per hour, and $10 per hour. Now draw
3. Mario consumes only cheese and crackers. indifference curves such that Sarah’s labor supply curve
a. Could cheese and crackers both be inferior goods is upward sloping when the wage is between $6 and $8
for Mario? Explain. per hour, and backward sloping when the wage is
b. Suppose that cheese is a normal good for Mario between $8 and $10 per hour.
whereas crackers are an inferior good. If the price of
cheese falls, what happens to Mario’s consumption 7. Draw the indifference curve for someone deciding how
of crackers? What happens to his consumption of much to work. Suppose the wage increases. Is it possible
cheese? Explain. that the person’s consumption would fall? Is this

490 PART SEVEN ADVANCED TOPIC

plausible? Discuss. (Hint: Think about income and disappears. Let’s consider the possible effects of this
substitution effects.) program on a family’s labor supply.
a. Draw a budget constraint for a family assuming
8. Suppose you take a job that pays $30,000 and set some
of this income aside in a savings account that pays an that the welfare system did not exist. On the same
annual interest rate of 5 percent. Use a diagram with a diagram, draw a budget constraint that reflects the
budget constraint and indifference curves to show how existence of the welfare system.
your consumption changes in each of the following b. Adding indifference curves to your diagram, show
situations. To keep things simple, assume that you pay how the welfare system could reduce the number of
no taxes on your income. hours worked by the family. Explain, with reference
a. Your salary increases to $40,000. to both the income and substitution effects.
b. The interest rate on your bank account rises to c. Using your diagram from part (b), show the effect
8 percent. of the welfare system on the well-being of the
family.
9. As discussed in the text, we can divide an individual’s
life into two hypothetical periods: “young” and “old.” 12. (This problem is challenging.) Suppose that an
Suppose that the individual earns income only when individual owed no taxes on the first $10,000 she earned
young and saves some of that income to consume when and 15 percent of any income she earned over $10,000.
old. If the interest rate on savings falls, can you tell what (This is a simplified version of the actual U.S. income
happens to consumption when young? Can you tell tax.) Now suppose that Congress is considering two
what happens to consumption when old? Explain. ways to reduce the tax burden: a reduction in the tax
rate and an increase in the amount on which no tax is
10. Suppose that your state gives each town $5 million in owed.
aid per year. The way in which the money is spent is a. What effect would a reduction in the tax rate have
currently unrestricted, but the governor has proposed on the individual’s labor supply if she earned
that towns be required to spend the entire $5 million on $30,000 to start? Explain in words using the income
education. You can illustrate the effect of this proposal and substitution effects. You do not need to use a
on your town’s spending on education using a budget diagram.
constraint and indifference-curve diagram. The two b. What effect would an increase in the amount on
goods are education and noneducation spending. which no tax is owed have on the individual’s labor
a. Draw your town’s budget constraint under the supply? Again, explain in words using the income
existing policy, assuming that your town’s only and substitution effects.
source of revenue besides the state aid is a property
tax that yields $10 million. On the same diagram, 13. (This problem is challenging.) Consider a person
draw the budget constraint under the governor’s deciding how much to consume and how much to save
proposal. for retirement. This person has particular preferences:
b. Would your town spend more on education under Her lifetime utility depends on the lowest level of
the governor’s proposal than under the existing consumption during the two periods of her life. That is,
policy? Explain.
c. Now compare two towns—Youngsville and Utility ϭ Minimum {consumption when young,
Oldsville—with the same revenue and the same consumption when old}.
state aid. Youngsville has a large school-age
population, and Oldsville has a large elderly a. Draw this person’s indifference curves. (Hint:
population. In which town is the governor’s Recall that indifference curves show the
proposal most likely to increase education combinations of consumption in the two periods
spending? Explain. that yield the same level of utility.)

11. (This problem is challenging.) The welfare system b. Draw the budget constraint and the optimum.
provides income to some needy families. Typically, the c. When the interest rate increases, does this person
maximum payment goes to families that earn no
income; then, as families begin to earn income, the save more or less? Explain your answer using
welfare payment declines gradually and eventually income and substitution effects.

IN THIS CHAPTER
YOU WILL . . .

Consider why an
economy’s total
income equals its
total expenditure

Learn how gross
domestic product
(GDP) is defined and

calculated

MEASURING A NATION’S See the breakdown
of GDP into its four
INCOME major components

When you finish school and start looking for a full-time job, your experience will, Learn the
to a large extent, be shaped by prevailing economic conditions. In some years, distinction between
firms throughout the economy are expanding their production of goods and ser-
vices, employment is rising, and jobs are easy to find. In other years, firms are cut- real GDP and
ting back on production, employment is declining, and finding a good job takes a nominal GDP
long time. Not surprisingly, any college graduate would rather enter the labor
force in a year of economic expansion than in a year of economic contraction. Consider whether
GDP is a good
Because the condition of the overall economy profoundly affects all of us, measure of
changes in economic conditions are widely reported by the media. Indeed, it is hard
to pick up a newspaper without seeing some newly reported statistic about the economic well-being
economy. The statistic might measure the total income of everyone in the economy
(GDP), the rate at which average prices are rising (inflation), the percentage of the
labor force that is out of work (unemployment), total spending at stores (retail

493

494 PART EIGHT THE DATA OF MACROECONOMICS

microeconomics sales), or the imbalance of trade between the United States and the rest of the world
the study of how households and (the trade deficit). All these statistics are macroeconomic. Rather than telling us about
firms make decisions and how they a particular household or firm, they tell us something about the entire economy.
interact in markets
As you may recall from Chapter 2, economics is divided into two branches:
macroeconomics microeconomics and macroeconomics. Microeconomics is the study of how indi-
the study of economy-wide vidual households and firms make decisions and how they interact with one
phenomena, including inflation, another in markets. Macroeconomics is the study of the economy as a whole. The
unemployment, and economic goal of macroeconomics is to explain the economic changes that affect many
growth households, firms, and markets at once. Macroeconomists address diverse ques-
tions: Why is average income high in some countries while it is low in others? Why
do prices rise rapidly in some periods of time while they are more stable in other
periods? Why do production and employment expand in some years and contract
in others? What, if anything, can the government do to promote rapid growth in
incomes, low inflation, and stable employment? These questions are all macroeco-
nomic in nature because they concern the workings of the entire economy.

Because the economy as a whole is just a collection of many households and
many firms interacting in many markets, microeconomics and macroeconomics
are closely linked. The basic tools of supply and demand, for instance, are as cen-
tral to macroeconomic analysis as they are to microeconomic analysis. Yet study-
ing the economy in its entirety raises some new and intriguing challenges.

In this chapter and the next one, we discuss some of the data that economists
and policymakers use to monitor the performance of the overall economy. These
data reflect the economic changes that macroeconomists try to explain. This chap-
ter considers gross domestic product, or simply GDP, which measures the total
income of a nation. GDP is the most closely watched economic statistic because it
is thought to be the best single measure of a society’s economic well-being.

THE ECONOMY’S INCOME AND EXPENDITURE

If you were to judge how a person is doing economically, you might first look at
his or her income. A person with a high income can more easily afford life’s neces-
sities and luxuries. It is no surprise that people with higher incomes enjoy higher
standards of living—better housing, better health care, fancier cars, more opulent
vacations, and so on.

The same logic applies to a nation’s overall economy. When judging whether the
economy is doing well or poorly, it is natural to look at the total income that every-
one in the economy is earning. That is the task of gross domestic product (GDP).

GDP measures two things at once: the total income of everyone in the econo-
my and the total expenditure on the economy’s output of goods and services. The
reason that GDP can perform the trick of measuring both total income and total
expenditure is that these two things are really the same. For an economy as a whole,
income must equal expenditure.

Why is this true? The reason that an economy’s income is the same as its expen-
diture is simply that every transaction has two parties: a buyer and a seller. Every
dollar of spending by some buyer is a dollar of income for some seller. Suppose, for
instance, that Karen pays Doug $100 to mow her lawn. In this case, Doug is a seller
of a service, and Karen is a buyer. Doug earns $100, and Karen spends $100. Thus,

CHAPTER 22 MEASURING A NATION’S INCOME 495

Revenue MARKETS FOR Spending Figure 22-1
(= GDP) GOODS AND (= GDP)
Goods and THE CIRCULAR-FLOW DIAGRAM.
Goods SERVICES services Households buy goods and
and services bought services from firms, and firms use
sold their revenue from sales to pay
HOUSEHOLDS wages to workers, rent to
FIRMS landowners, and profit to firm
owners. GDP equals the total
amount spent by households in
the market for goods and
services. It also equals the total
wages, rent, and profit paid by
firms in the markets for the
factors of production.

Inputs for MARKETS FOR Labor, land,
production FACTORS OF and capital
PRODUCTION
Wages, rent, Income (= GDP)
and profit ϭ Flow of goods
(= GDP) and services
ϭ Flow of dollars

the transaction contributes equally to the economy’s income and to its expenditure.
GDP, whether measured as total income or total expenditure, rises by $100.

Another way to see the equality of income and expenditure is with the circular-
flow diagram in Figure 22-1. (You may recall this circular-flow diagram from
Chapter 2.) This diagram describes all the transactions between households and
firms in a simple economy. In this economy, households buy goods and services
from firms; these expenditures flow through the markets for goods and services.
The firms in turn use the money they receive from sales to pay workers’ wages,
landowners’ rent, and firm owners’ profit; this income flows through the markets
for the factors of production. In this economy, money continuously flows from
households to firms and then back to households.

We can compute GDP for this economy in one of two ways: by adding up the
total expenditure by households or by adding up the total income (wages, rent,
and profit) paid by firms. Because all expenditure in the economy ends up as
someone’s income, GDP is the same regardless of how we compute it.

The actual economy is, of course, more complicated than the one illustrated in
Figure 22-1. In particular, households do not spend all of their income. Households
pay some of their income to the government in taxes, and they save and invest
some of their income for use in the future. In addition, households do not buy all

496 PART EIGHT THE DATA OF MACROECONOMICS

goods and services produced in the economy. Some goods and services are bought
by governments, and some are bought by firms that plan to use them in the future
to produce their own output. Yet, regardless of whether a household, government,
or firm buys a good or service, the transaction has a buyer and seller. Thus, for the
economy as a whole, expenditure and income are always the same.

Q U I C K Q U I Z : What two things does gross domestic product measure?
How can it measure two things at once?

THE MEASUREMENT OF GROSS
DOMESTIC PRODUCT

gross domestic product Now that we have discussed the meaning of gross domestic product in general
terms, let’s be more precise about how this statistic is measured. Here is a defini-
(GDP) tion of GDP:
the market value of all final goods
and services produced within a N Gross domestic product (GDP) is the market value of all final goods and
country in a given period of time services produced within a country in a given period of time.

This definition might seem simple enough. But, in fact, many subtle issues arise
when computing an economy’s GDP. Let’s therefore consider each phrase in this
definition with some care.

“GDP IS THE MARKET VALUE . . .”

You have probably heard the adage, “You can’t compare apples and oranges.” Yet
GDP does exactly that. GDP adds together many different kinds of products into a
single measure of the value of economic activity. To do this, it uses market prices.
Because market prices measure the amount people are willing to pay for different
goods, they reflect the value of those goods. If the price of an apple is twice the price
of an orange, then an apple contributes twice as much to GDP as does an orange.

“OF ALL . . .”

GDP tries to be comprehensive. It includes all items produced in the economy and
sold legally in markets. GDP measures the market value of not just apples and
oranges, but also pears and grapefruit, books and movies, haircuts and health care,
and on and on.

GDP also includes the market value of the housing services provided by the
economy’s stock of housing. For rental housing, this value is easy to calculate—the
rent equals both the tenant’s expenditure and the landlord’s income. Yet many
people own the place where they live and, therefore, do not pay rent. The govern-
ment includes this owner-occupied housing in GDP by estimating its rental value.
That is, GDP is based on the assumption that the owner, in effect, pays rent to him-
self, so the rent is included both in his expenditure and in his income.

There are some products, however, that GDP excludes because measuring
them is so difficult. GDP excludes items produced and sold illicitly, such as illegal

CHAPTER 22 MEASURING A NATION’S INCOME 497

drugs. It also excludes most items that are produced and consumed at home and,
therefore, never enter the marketplace. Vegetables you buy at the grocery store are
part of GDP; vegetables you grow in your garden are not.

These exclusions from GDP can at times lead to paradoxical results. For exam-
ple, when Karen pays Doug to mow her lawn, that transaction is part of GDP. If
Karen were to marry Doug, the situation would change. Even though Doug may
continue to mow Karen’s lawn, the value of the mowing is now left out of GDP
because Doug’s service is no longer sold in a market. Thus, when Karen and Doug
marry, GDP falls.

“FINAL . . .”

When International Paper makes paper, which Hallmark then uses to make a
greeting card, the paper is called an intermediate good, and the card is called a final
good. GDP includes only the value of final goods. The reason is that the value of
intermediate goods is already included in the prices of the final goods. Adding the
market value of the paper to the market value of the card would be double count-
ing. That is, it would (incorrectly) count the paper twice.

An important exception to this principle arises when an intermediate good is
produced and, rather than being used, is added to a firm’s inventory of goods to be
used or sold at a later date. In this case, the intermediate good is taken to be “final”
for the moment, and its value as inventory investment is added to GDP. When the
inventory of the intermediate good is later used or sold, the firm’s inventory invest-
ment is negative, and GDP for the later period is reduced accordingly.

“GOODS AND SERVICES . . .”

GDP includes both tangible goods (food, clothing, cars) and intangible services
(haircuts, housecleaning, doctor visits). When you buy a CD by your favorite
singing group, you are buying a good, and the purchase price is part of GDP.
When you pay to hear a concert by the same group, you are buying a service, and
the ticket price is also part of GDP.

“PRODUCED . . .”

GDP includes goods and services currently produced. It does not include transac-
tions involving items produced in the past. When General Motors produces and
sells a new car, the value of the car is included in GDP. When one person sells a
used car to another person, the value of the used car is not included in GDP.

“WITHIN A COUNTRY . . .”

GDP measures the value of production within the geographic confines of a coun-
try. When a Canadian citizen works temporarily in the United States, his produc-
tion is part of U.S. GDP. When an American citizen owns a factory in Haiti, the
production at his factory is not part of U.S. GDP. (It is part of Haiti’s GDP.) Thus,
items are included in a nation’s GDP if they are produced domestically, regardless
of the nationality of the producer.

498 PART EIGHT THE DATA OF MACROECONOMICS

FYI When the U.S. Department N National income is the total income earned by a
Other Measures of Commerce computes the nation’s residents in the production of goods and ser-
nation’s GDP every three vices. It differs from net national product by excluding
of Income months, it also computes vari- indirect business taxes (such as sales taxes) and
ous other measures of income including business subsidies. NNP and national income
to get a more complete picture also differ because of a “statistical discrepancy” that
of what’s happening in the econ- arises from problems in data collection.
omy. These other measures dif-
fer from GDP by excluding or N Personal income is the income that households and
including certain categories of noncorporate businesses receive. Unlike national
income. What follows is a brief income, it excludes retained earnings, which is income
description of five of these that corporations have earned but have not paid out to
income measures, ordered from their owners. It also subtracts corporate income taxes
largest to smallest. and contributions for social insurance (mostly Social
Security taxes). In addition, personal income includes
N Gross national product (GNP) is the total income the interest income that households receive from their
earned by a nation’s permanent residents (called holdings of government debt and the income that
nationals). It differs from GDP by including income that households receive from government transfer pro-
our citizens earn abroad and excluding income that for- grams, such as welfare and Social Security.
eigners earn here. For example, when a Canadian citi-
zen works temporarily in the United States, his N Disposable personal income is the income that house-
production is part of U.S. GDP, but it is not part of U.S. holds and noncorporate businesses have left after sat-
GNP. (It is part of Canada’s GNP.) For most countries, isfying all their obligations to the government. It equals
including the United States, domestic residents are personal income minus personal taxes and certain non-
responsible for most domestic production, so GDP and tax payments (such as traffic tickets).
GNP are quite close.
Although the various measures of income differ in detail,
N Net national product (NNP) is the total income of a they almost always tell the same story about economic con-
nation’s residents (GNP) minus losses from depreciation. ditions. When GDP is growing rapidly, these other measures
Depreciation is the wear and tear on the economy’s of income are usually growing rapidly. And when GDP is
stock of equipment and structures, such as trucks rust- falling, these other measures are usually falling as well. For
ing and lightbulbs burning out. In the national income monitoring fluctuations in the overall economy, it does not
accounts prepared by the Department of Commerce, matter much which measure of income we use.
depreciation is called the “consumption of fixed capital.”

“. . . IN A GIVEN PERIOD OF TIME.”

GDP measures the value of production that takes place within a specific interval of
time. Usually that interval is a year or a quarter (three months). GDP measures the
economy’s flow of income and expenditure during that interval.

When the government reports the GDP for a quarter, it usually presents
GDP “at an annual rate.” This means that the figure reported for quarterly GDP is
the amount of income and expenditure during the quarter multiplied by 4. The
government uses this convention so that quarterly and annual figures on GDP can
be compared more easily.

In addition, when the government reports quarterly GDP, it presents the data
after they have been modified by a statistical procedure called seasonal adjustment.
The unadjusted data show clearly that the economy produces more goods and
services during some times of year than during others. (As you might guess,
December’s Christmas shopping season is a high point.) When monitoring the

CHAPTER 22 MEASURING A NATION’S INCOME 499

condition of the economy, economists and policymakers often want to look
beyond these regular seasonal changes. Therefore, government statisticians adjust
the quarterly data to take out the seasonal cycle. The GDP data reported in the
news are always seasonally adjusted.

Now let’s repeat the definition of GDP:

N Gross domestic product (GDP) is the market value of all final goods and
services produced within a country in a given period of time.

It should be apparent that GDP is a sophisticated measure of the value of economic
activity. In advanced courses in macroeconomics, you will learn more of the sub-
tleties that arise in its calculation. But even now you can see that each phrase in
this definition is packed with meaning.

Q U I C K Q U I Z : Which contributes more to GDP—the production of a pound
of hamburger or the production of a pound of caviar? Why?

THE COMPONENTS OF GDP

Spending in the economy takes many forms. At any moment, the Smith family
may be having lunch at Burger King; General Motors may be building a car facto-
ry; the Navy may be procuring a submarine; and British Airways may be buying
an airplane from Boeing. GDP includes all of these various forms of spending on
domestically produced goods and services.

To understand how the economy is using its scarce resources, economists are
often interested in studying the composition of GDP among various types of spend-
ing. To do this, GDP (which we denote as Y) is divided into four components: con-
sumption (C), investment (I), government purchases (G), and net exports (NX):

Y ϭ C ϩ I ϩ G ϩ NX. consumption
spending by households on goods
This equation is an identity—an equation that must be true by the way the vari- and services, with the exception of
ables in the equation are defined. In this case, because each dollar of expenditure purchases of new housing
included in GDP is placed into one of the four components of GDP, the total of the
four components must be equal to GDP. investment
spending on capital equipment,
We have just seen an example of each component. Consumption is spending inventories, and structures,
by households on goods and services, such as the Smiths’ lunch at Burger King. including household purchases of
Investment is the purchase of capital equipment, inventories, and structures, such new housing
as the General Motors factory. Investment also includes expenditure on new hous-
ing. (By convention, expenditure on new housing is the one form of household government purchases
spending categorized as investment rather than consumption.) Government pur- spending on goods and services by
chases include spending on goods and services by local, state, and federal govern- local, state, and federal governments
ments, such as the Navy’s purchase of a submarine. Net exports equal the
purchases of domestically produced goods by foreigners (exports) minus the net exports
domestic purchases of foreign goods (imports). A domestic firm’s sale to a buyer in spending on domestically produced
another country, such as the Boeing sale to British Airways, increases net exports. goods by foreigners (exports) minus
spending on foreign goods by
The “net” in “net exports” refers to the fact that imports are subtracted from domestic residents (imports)
exports. This subtraction is made because imports of goods and services are

500 PART EIGHT THE DATA OF MACROECONOMICS

Table 22-1 TOTAL PER PERSON PERCENT
(IN BILLIONS) OF TOTAL
GDP AND ITS COMPONENTS. $31,522
This table shows total GDP for Gross domestic product, Y $8,511 21,511 100%
the U.S. economy in 1998 and the Consumption, C 5,808 5,063 68
breakdown of GDP among its Investment, I 1,367 5,507 16
four components. When reading Government purchases, G 1,487 Ϫ559 18
this table, recall the identity Net exports, NX Ϫ151 Ϫ2
Y ϭ C ϩ I ϩ G ϩ NX.

SOURCE: U.S. Department of Commerce.

included in other components of GDP. For example, suppose that a household
buys a $30,000 car from Volvo, the Swedish carmaker. That transaction increases
consumption by $30,000 because car purchases are part of consumer spending. It
also reduces net exports by $30,000 because the car is an import. In other words,
net exports include goods and services produced abroad (with a minus sign)
because these goods and services are included in consumption, investment, and
government purchases (with a plus sign). Thus, when a domestic household, firm,
or government buys a good or service from abroad, the purchase reduces net
exports—but because it also raises consumption, investment, or government pur-
chases, it does not affect GDP.

The meaning of “government purchases” also requires a bit of clarification.
When the government pays the salary of an Army general, that salary is part of
government purchases. But what happens when the government pays a Social
Security benefit to one of the elderly? Such government spending is called a trans-
fer payment because it is not made in exchange for a currently produced good or
service. From a macroeconomic standpoint, transfer payments are like a tax rebate.
Like taxes, transfer payments alter household income, but they do not reflect the
economy’s production. Because GDP is intended to measure income from (and
expenditure on) the production of goods and services, transfer payments are not
counted as part of government purchases.

Table 22-1 shows the composition of U.S. GDP in 1998. In this year, the GDP of
the United States was about $8.5 trillion. If we divide this number by the 1998 U.S.
population of 270 million, we find that GDP per person—the amount of expendi-
ture for the average American—was $31,522. Consumption made up about two-
thirds of GDP, or $21,511 per person. Investment was $5,063 per person.
Government purchases were $5,507 per person. Net exports were –$559 per per-
son. This number is negative because Americans earned less from selling to for-
eigners than they spent on foreign goods.

Q U I C K Q U I Z : List the four components of expenditure. Which is the largest?

REAL VERSUS NOMINAL GDP

As we have seen, GDP measures the total spending on goods and services in all
markets in the economy. If total spending rises from one year to the next, one of
two things must be true: (1) the economy is producing a larger output of goods

CHAPTER 22 MEASURING A NATION’S INCOME 501

PRICES AND QUANTITIES

YEAR PRICE OF HOT DOGS QUANTITY OF HOT DOGS PRICE OF HAMBURGERS QUANTITY OF HAMBURGERS

2001 $1 100 $2 50
2002 2 150 3 100
2003 3 200 4 150

YEAR CALCULATING NOMINAL GDP

2001 ($1 per hot dog ϫ 100 hot dogs) ϩ ($2 per hamburger ϫ 50 hamburgers) ϭ $200
2002 ($2 per hot dog ϫ 150 hot dogs) ϩ ($3 per hamburger ϫ 100 hamburgers) ϭ $600
2003 ($3 per hot dog ϫ 200 hot dogs) ϩ ($4 per hamburger ϫ 150 hamburgers) ϭ $1,200

YEAR CALCULATING REAL GDP (BASE YEAR 2001)

2001 ($1 per hot dog ϫ 100 hot dogs) ϩ ($2 per hamburger ϫ 50 hamburgers) ϭ $200
2002 ($1 per hot dog ϫ 150 hot dogs) ϩ ($2 per hamburger ϫ 100 hamburgers) ϭ $350
2003 ($1 per hot dog ϫ 200 hot dogs) ϩ ($2 per hamburger ϫ 150 hamburgers) ϭ $500

YEAR CALCULATING THE GDP DEFLATOR

2001 ($200/$200) ϫ 100 ϭ 100
2002 ($600/$350) ϫ 100 ϭ 171
2003 ($1,200/$500) ϫ 100 ϭ 240

REAL AND NOMINAL GDP. This table shows how to calculate real GDP, nominal GDP, Table 22-2
and the GDP deflator for a hypothetical economy that produces only hot dogs and
hamburgers.

and services, or (2) goods and services are being sold at higher prices. When
studying changes in the economy over time, economists want to separate these
two effects. In particular, they want a measure of the total quantity of goods and
services the economy is producing that is not affected by changes in the prices of
those goods and services.

To do this, economists use a measure called real GDP. Real GDP answers a
hypothetical question: What would be the value of the goods and services pro-
duced this year if we valued these goods and services at the prices that prevailed
in some specific year in the past? By evaluating current production using prices
that are fixed at past levels, real GDP shows how the economy’s overall produc-
tion of goods and services changes over time.

To see more precisely how real GDP is constructed, let’s consider an example.

A NUMERICAL EXAMPLE

Table 22-2 shows some data for an economy that produces only two goods—hot
dogs and hamburgers. The table shows the quantities of the two goods produced
and their prices in the years 2001, 2002, and 2003.

502 PART EIGHT THE DATA OF MACROECONOMICS

nominal GDP To compute total spending in this economy, we would multiply the quantities
the production of goods and services of hot dogs and hamburgers by their prices. In the year 2001, 100 hot dogs are sold
valued at current prices at a price of $1 per hot dog, so expenditure on hot dogs equals $100. In the same
year, 50 hamburgers are sold for $2 per hamburger, so expenditure on hamburgers
real GDP also equals $100. Total expenditure in the economy—the sum of expenditure on
the production of goods and services hot dogs and expenditure on hamburgers—is $200. This amount, the production
valued at constant prices of goods and services valued at current prices, is called nominal GDP.

The table shows the calculation of nominal GDP for these three years. Total
spending rises from $200 in 2001 to $600 in 2002 and then to $1,200 in 2003. Part of
this rise is attributable to the increase in the quantities of hot dogs and hamburgers,
and part is attributable to the increase in the prices of hot dogs and hamburgers.

To obtain a measure of the amount produced that is not affected by changes in
prices, we use real GDP, which is the production of goods and services valued at
constant prices. We calculate real GDP by first choosing one year as a base year. We
then use the prices of hot dogs and hamburgers in the base year to compute the
value of goods and services in all of the years. In other words, the prices in the
base year provide the basis for comparing quantities in different years.

Suppose that we choose 2001 to be the base year in our example. We can then
use the prices of hot dogs and hamburgers in 2001 to compute the value of goods
and services produced in 2001, 2002, and 2003. Table 22-2 shows these calculations.
To compute real GDP for 2001, we use the prices of hot dogs and hamburgers in
2001 (the base year) and the quantities of hot dogs and hamburgers produced in
2001. (Thus, for the base year, real GDP always equals nominal GDP.) To compute
real GDP for 2002, we use the prices of hot dogs and hamburgers in 2001 (the base
year) and the quantities of hot dogs and hamburgers produced in 2002. Similarly,
to compute real GDP for 2003, we use the prices in 2001 and the quantities in 2003.
When we find that real GDP has risen from $200 in 2001 to $350 in 2002 and then
to $500 in 2003, we know that the increase is attributable to an increase in the quan-
tities produced, because the prices are being held fixed at base-year levels.

To sum up: Nominal GDP uses current prices to place a value on the economy’s pro-
duction of goods and services. Real GDP uses constant base-year prices to place a value on
the economy’s production of goods and services. Because real GDP is not affected by
changes in prices, changes in real GDP reflect only changes in the amounts being
produced. Thus, real GDP is a measure of the economy’s production of goods and
services.

Our goal in computing GDP is to gauge how well the overall economy is per-
forming. Because real GDP measures the economy’s production of goods and ser-
vices, it reflects the economy’s ability to satisfy people’s needs and desires. Thus,
real GDP is a better gauge of economic well-being than is nominal GDP. When
economists talk about the economy’s GDP, they usually mean real GDP rather than
nominal GDP. And when they talk about growth in the economy, they measure
that growth as the percentage change in real GDP from one period to another.

THE GDP DEFLATOR

As we have just seen, nominal GDP reflects both the prices of goods and services
and the quantities of goods and services the economy is producing. By contrast, by
holding prices constant at base-year levels, real GDP reflects only the quantities
produced. From these two statistics, we can compute a third, called the GDP defla-
tor, which reflects the prices of goods and services but not the quantities produced.

CHAPTER 22 MEASURING A NATION’S INCOME 503

The GDP deflator is calculated as follows: GDP deflator
GDP deflator ϭ Nominal GDP ϫ 100. a measure of the price level
Real GDP calculated as the ratio of nominal
GDP to real GDP times 100

Because nominal GDP and real GDP must be the same in the base year, the GDP
deflator for the base year always equals 100. The GDP deflator for subsequent
years measures the rise in nominal GDP from the base year that cannot be attrib-
utable to a rise in real GDP.

The GDP deflator measures the current level of prices relative to the level of
prices in the base year. To see why this is true, consider a couple of simple exam-
ples. First, imagine that the quantities produced in the economy rise over time but
prices remain the same. In this case, both nominal and real GDP rise together, so
the GDP deflator is constant. Now suppose, instead, that prices rise over time but
the quantities produced stay the same. In this second case, nominal GDP rises but
real GDP remains the same, so the GDP deflator rises as well. Notice that, in both
cases, the GDP deflator reflects what’s happening to prices, not quantities.

Let’s now return to our numerical example in Table 22-2. The GDP deflator is
computed at the bottom of the table. For year 2001, nominal GDP is $200, and real
GDP is $200, so the GDP deflator is 100. For the year 2002, nominal GDP is $600,
and real GDP is $350, so the GDP deflator is 171. Because the GDP deflator rose in
year 2002 from 100 to 171, we can say that the price level increased by 71 percent.

The GDP deflator is one measure that economists use to monitor the average
level of prices in the economy. We examine another—the consumer price index—in
the next chapter, where we also describe the differences between the two measures.

C A S E S T U D Y REAL GDP OVER RECENT HISTORY

Now that we know how real GDP is defined and measured, let’s look at what this
macroeconomic variable tells us about the recent history of the United States. Fig-
ure 22-2 shows quarterly data on real GDP for the U.S. economy since 1970.

Billions of Figure 22-2
1992 Dollars
REAL GDP IN THE UNITED
$8,000 STATES. This figure shows
quarterly data on real GDP for
$7,000 the U.S. economy since 1970.
Recessions—periods of falling
6,000 real GDP—are marked with the
shaded vertical bars.
5,000
SOURCE: U.S. Department of Commerce.
4,000
1975 1980 1985 1990 1995 2000
3,000
1970

504 PART EIGHT THE DATA OF MACROECONOMICS

The most obvious feature of these data is that real GDP grows over time.
The real GDP of the U.S. economy in 1999 was more than twice its 1970 level.
Put differently, the output of goods and services produced in the United States
has grown on average about 3 percent per year since 1970. This continued
growth in real GDP enables the typical American to enjoy greater economic
prosperity than his or her parents and grandparents did.

A second feature of the GDP data is that growth is not steady. The upward
climb of real GDP is occasionally interrupted by periods during which GDP
declines, called recessions. Figure 22-2 marks recessions with shaded vertical
bars. (There is no ironclad rule for when the official business cycle dating com-
mittee will declare that a recession has occurred, but a good rule of thumb is
two consecutive quarters of falling real GDP.) Recessions are associated not only
with lower incomes but also with other forms of economic distress: rising
unemployment, falling profits, increased bankruptcies, and so on.

Much of macroeconomics is aimed at explaining the long-run growth
and short-run fluctuations in real GDP. As we will see in the coming chap-
ters, we need different models for these two purposes. Because the short-run
fluctuations represent deviations from the long-run trend, we first examine the
behavior of the economy in the long run. In particular, Chapters 24 through 30
examine how key macroeconomic variables, including real GDP, are deter-
mined in the long run. We then build on this analysis to explain short-run fluc-
tuations in Chapters 31 through 33.

Q U I C K Q U I Z : Define real and nominal GDP. Which is a better measure of
economic well-being? Why?

GDP AND ECONOMIC WELL-BEING

Earlier in this chapter, GDP was called the best single measure of the economic well-
being of a society. Now that we know what GDP is, we can evaluate this claim.

As we have seen, GDP measures both the economy’s total income and the econ-
omy’s total expenditure on goods and services. Thus, GDP per person tells us the
income and expenditure of the average person in the economy. Because most people
would prefer to receive higher income and enjoy higher expenditure, GDP per per-
son seems a natural measure of the economic well-being of the average individual.

Yet some people dispute the validity of GDP as a measure of well-being. When
Senator Robert Kennedy was running for president in 1968, he gave a moving cri-
tique of such economic measures:

[Gross domestic product] does not allow for the health of our children, the
quality of their education, or the joy of their play. It does not include the beauty
of our poetry or the strength of our marriages, the intelligence of our public
debate or the integrity of our public officials. It measures neither our courage,
nor our wisdom, nor our devotion to our country. It measures everything, in
short, except that which makes life worthwhile, and it can tell us everything
about America except why we are proud that we are Americans.

CHAPTER 22 MEASURING A NATION’S INCOME 505

IN THE NEWS With synthetic fibers, clothes weigh less. ever before. . . . [It] also helps explain
GDP Lightens Up And the electronics revolution has pro- why there is so much international trade
duced televisions so light they can be these days. “The . . . downsizing of out-
GDP measures the value of the econ- worn on the wrist. put,” Mr. Greenspan said recently,
omy’s output of goods and services. “meant that products were easier and
What do you think we would learn if, By conventional measures, the [real] hence less costly to move, and most
instead, we measured the weight of the gross domestic product—the value of all especially across national borders.” . . .
economy’s output? goods and services produced in the
nation—is five times as great as it was “The world of 1948 was vastly dif-
From Greenspan, a (Truly) 50 years ago. Yet “the physical weight ferent,” Mr. Greenspan observed a few
Weighty Idea of our gross domestic product is evi- years back. “The quintessential model of
dently only modestly higher than it was industry might in those days was the
BY DAVID WESSEL 50 or 100 years ago,” Mr. Greenspan array of vast, smoke-encased integrated
Having weighed the evidence carefully, told an audience in Dallas recently. steel mills . . . on the shores of Lake
Federal Reserve Chairman Alan Michigan. Output was things, big physi-
Greenspan wants you to know that the When you think about it, it’s not so cal things.”
U.S. economy is getting lighter. surprising that the economy is getting
lighter. An ever-growing proportion of Today, one exemplar of U.S. eco-
Literally. the U.S. GDP consists of things that nomic might is Microsoft Corp., with its
When he refers to “downsizing” in don’t weigh anything at all—lawyers’ almost weightless output. “Virtually
this instance, Mr. Greenspan means that services, psychotherapy, e-mail, online unimaginable a half-century ago was the
a dollar’s worth of the goods and ser- information. extent to which concepts and ideas
vices produced in the mighty U.S. econ- would substitute for physical resources
omy weighs a lot less than it used to, But Mr. Greenspan has a way of and human brawn in the production of
even after adjusting for inflation. making the obvious sound profound. goods and services,” he has said.
A modern 10-story office building, Only “a small fraction” of the nation’s
he says, weighs less than a 10-story economic growth in the past several Of course, one thing Made in the
building erected in the late 19th century. decades “represents growth in the ton- U.S. is heavier than it used to be: peo-
nage of physical materials—oil, coal, ple. The National Institutes of Health
ores, wood, raw chemicals,” he has says 22.3% of Americans are obese, up
observed. “The remainder represents from 12.8% in the early 1960. But Mr.
new insights into how to rearrange those Greenspan doesn’t talk about that.
physical materials to better serve human
needs.” . . . SOURCE: The Wall Street Journal, May 20, 1999,
p. B1.
The incredible shrinking GDP helps
explain why American workers can pro-
duce more for each hour of work than

Much of what Robert Kennedy said is correct. Why then do we care about GDP?
The answer is that a large GDP does in fact help us to lead a good life. GDP

does not measure the health of our children, but nations with larger GDP can
afford better health care for their children. GDP does not measure the quality of
their education, but nations with larger GDP can afford better educational sys-
tems. GDP does not measure the beauty of our poetry, but nations with larger GDP
can afford to teach more of their citizens to read and to enjoy poetry. GDP does not
take account of our intelligence, integrity, courage, wisdom, or devotion to coun-
try, but all of these laudable attributes are easier to foster when people are less con-
cerned about being able to afford the material necessities of life. In short, GDP does
not directly measure those things that make life worthwhile, but it does measure
our ability to obtain the inputs into a worthwhile life.

506 PART EIGHT THE DATA OF MACROECONOMICS

GDP REFLECTS THE FACTORY’S GDP is not, however, a perfect measure of well-being. Some things that con-
PRODUCTION, BUT NOT THE HARM THAT IT tribute to a good life are left out of GDP. One is leisure. Suppose, for instance, that
INFLICTS ON THE ENVIRONMENT. everyone in the economy suddenly started working every day of the week, rather
than enjoying leisure on weekends. More goods and services would be produced,
and GDP would rise. Yet, despite the increase in GDP, we should not conclude that
everyone would be better off. The loss from reduced leisure would offset the gain
from producing and consuming a greater quantity of goods and services.

Because GDP uses market prices to value goods and services, it excludes the
value of almost all activity that takes place outside of markets. In particular, GDP
omits the value of goods and services produced at home. When a chef prepares a
delicious meal and sells it at his restaurant, the value of that meal is part of GDP.
But if the chef prepares the same meal for his spouse, the value he has added to the
raw ingredients is left out of GDP. Similarly, child care provided in day care cen-
ters is part of GDP, whereas child care by parents at home is not. Volunteer work
also contributes to the well-being of those in society, but GDP does not reflect these
contributions.

Another thing that GDP excludes is the quality of the environment. Imagine
that the government eliminated all environmental regulations. Firms could then
produce goods and services without considering the pollution they create, and
GDP might rise. Yet well-being would most likely fall. The deterioration in the
quality of air and water would more than offset the gains from greater production.

GDP also says nothing about the distribution of income. A society in which
100 people have annual incomes of $50,000 has GDP of $5 million and, not sur-
prisingly, GDP per person of $50,000. So does a society in which 10 people earn
$500,000 and 90 suffer with nothing at all. Few people would look at those two sit-
uations and call them equivalent. GDP per person tells us what happens to the
average person, but behind the average lies a large variety of personal experiences.

In the end, we can conclude that GDP is a good measure of economic well-
being for most—but not all—purposes. It is important to keep in mind what GDP
includes and what it leaves out.

C A S E S T U D Y INTERNATIONAL DIFFERENCES IN GDP AND THE
QUALITY OF LIFE

One way to gauge the usefulness of GDP as a measure of economic well-being
is to examine international data. Rich and poor countries have vastly different
levels of GDP per person. If a large GDP leads to a higher standard of living,
then we should observe GDP to be strongly correlated with measures of the
quality of life. And, in fact, we do.

Table 22-3 shows 12 of the world’s most populous countries ranked in order
of GDP per person. The table also shows life expectancy (the expected life span
at birth) and literacy (the percentage of the adult population that can read).
These data show a clear pattern. In rich countries, such as the United States,
Japan, and Germany, people can expect to live into their late seventies, and
almost all of the population can read. In poor countries, such as Nigeria,
Bangladesh, and Pakistan, people typically live only until their fifties or early
sixties, and only about half of the population is literate.

Although data on other aspects of the quality of life are less complete, they
tell a similar story. Countries with low GDP per person tend to have more
infants with low birth weight, higher rates of infant mortality, higher rates of

CHAPTER 22 MEASURING A NATION’S INCOME 507

COUNTRY REAL GDP PER LIFE ADULT Table 22-3
PERSON, 1997 EXPECTANCY LITERACY
GDP, LIFE EXPECTANCY, AND
United States $29,010 77 years 99% LITERACY. The table shows
Japan 24,070 80 99 GDP per person and two
Germany 21,260 77 99 measures of the quality of life for
Mexico 72 90 12 major countries.
Brazil 8,370 67 84
Russia 6,480 67 99
Indonesia 4,370 65 85
China 3,490 70 83
India 3,130 63 53
Pakistan 1,670 64 41
Bangladesh 1,560 58 39
Nigeria 1,050 50 59

920

Source: Human Development Report 1999, United Nations.

IN THE NEWS that people are eating more bread and Government experts insist that if the
Hidden GDP bakeries are selling less. Or consider vod- shadow economy is taken into account,
ka. Distillers are able to produce far more the overall economy is finally starting to
Measuring a nation’s gross domestic vodka than is officially being sold. But giv- grow. In turn, Mr. Yeltsin’s critics com-
product is never easy, but it becomes en the well-deserved Russian fondness for plain that the new calculations are more
especially difficult when people have vodka there is every reason to think the propaganda than economics. . . .
every incentive to hide their economic distilleries are operating at full capacity.
activities from the eyes of government. There is no question that measuring
The Russian Government’s top economic activity in a former Communist
The Russian Economy: number crunchers say the contradictions country on the road to capitalism is a
Notes from Underground are easy to explain: high taxes, govern- frustratingly elusive task.
ment red tape, and the simple desire to
BY MICHAEL R. GORDON sock away some extra cash have driven “There is a serious problem with
If you want to know what is happening in much of Russia’s economic activity post-socialist statistics,” said Yegor T.
the Russian economy, it helps to think underground. Gaidar, the former Prime Minister and
about bread. Government statistics show pro-reform director of the Institute of
For the last six years, the Russian Economic Problems of the Transitional
economy has been going down, down, Period.
down. But as President Boris N. Yeltsin
tries to deliver the growth he has “Seven years ago to report an
promised, economists are taking a clos- increase in the amount of production
er look at the murky but vibrant shadow was to become a Hero of Socialist
economy. It includes everything from Labor,” he said. “Now it is to get addi-
small businesses that never report their tional visits from the tax collector.”
sales to huge companies that understate
their production to avoid taxes. SOURCE: The New York Times, May 18, 1997, Week
in Review, p. 4.

508 PART EIGHT THE DATA OF MACROECONOMICS

maternal mortality, higher rates of child malnutrition, and less common access
to safe drinking water. In countries with low GDP per person, fewer school-age
children are actually in school, and those who are in school must learn with
fewer teachers per student. These countries also tend to have fewer televisions,
fewer telephones, fewer paved roads, and fewer households with electricity.
International data leave no doubt that a nation’s GDP is closely associated with
its citizens’ standard of living.

Q U I C K Q U I Z : Why should policymakers care about GDP?

CONCLUSION

This chapter has discussed how economists measure the total income of a nation.
Measurement is, of course, only a starting point. Much of macroeconomics is
aimed at revealing the long-run and short-run determinants of a nation’s gross
domestic product. Why, for example, is GDP higher in the United States and Japan
than in India and Nigeria? What can the governments of the poorest countries do
to promote more rapid growth in GDP? Why does GDP in the United States rise
rapidly in some years and fall in others? What can U.S. policymakers do to reduce
the severity of these fluctuations in GDP? These are the questions we will take up
shortly.

At this point, it is important to acknowledge the importance of just measuring
GDP. We all get some sense of how the economy is doing as we go about our lives.
But the economists who study changes in the economy and the policymakers who
formulate economic policies need more than this vague sense—they need concrete
data on which to base their judgments. Quantifying the behavior of the economy
with statistics such as GDP is, therefore, the first step to developing a science of
macroeconomics.

Summary

N Because every transaction has a buyer and a seller, the purchases of new housing. Investment includes
total expenditure in the economy must equal the total spending on new equipment and structures, including
income in the economy. households’ purchases of new housing. Government
purchases include spending on goods and services by
N Gross domestic product (GDP) measures an economy’s local, state, and federal governments. Net exports equal
total expenditure on newly produced goods and the value of goods and services produced domestically
services and the total income earned from the and sold abroad (exports) minus the value of goods and
production of these goods and services. More precisely, services produced abroad and sold domestically
GDP is the market value of all final goods and services (imports).
produced within a country in a given period of time.
N Nominal GDP uses current prices to value the
N GDP is divided among four components of expenditure: economy’s production of goods and services. Real GDP
consumption, investment, government purchases, and uses constant base-year prices to value the economy’s
net exports. Consumption includes spending on goods production of goods and services. The GDP deflator—
and services by households, with the exception of

CHAPTER 22 MEASURING A NATION’S INCOME 509

calculated from the ratio of nominal to real GDP— perfect measure of well-being. For example, GDP
measures the level of prices in the economy. excludes the value of leisure and the value of a clean
environment.
N GDP is a good measure of economic well-being because
people prefer higher to lower incomes. But it is not a

microeconomics, p. 494 Key Concepts real GDP, p. 502
macroeconomics, p. 494 GDP deflator, p. 503
gross domestic product (GDP), p. 496 investment, p. 499
consumption, p. 499 government purchases, p. 499
net exports, p. 499
nominal GDP, p. 502

Questions for Review

1. Explain why an economy’s income must equal its 6. Why do economists use real GDP rather than nominal
expenditure. GDP to gauge economic well-being?

2. Which contributes more to GDP—the production of an 7. In the year 2001, the economy produces 100 loaves of
economy car or the production of a luxury car? Why? bread that sell for $2 each. In the year 2002, the economy
produces 200 loaves of bread that sell for $3 each.
3. A farmer sells wheat to a baker for $2. The baker uses Calculate nominal GDP, real GDP, and the GDP deflator
the wheat to make bread, which is sold for $3. What is for each year. (Use 2001 as the base year.) By what
the total contribution of these transactions to GDP? percentage does each of these three statistics rise from
one year to the next?
4. Many years ago Peggy paid $500 to put together a
record collection. Today she sold her albums at a garage 8. Why is it desirable for a country to have a large GDP?
sale for $100. How does this sale affect current GDP? Give an example of something that would raise GDP
and yet be undesirable.
5. List the four components of GDP. Give an example of
each.

Problems and Applications

1. What components of GDP (if any) would each of the think of a reason why households’ purchases of new
following transactions affect? Explain. cars should also be included in investment rather than
a. A family buys a new refrigerator. in consumption? To what other consumption goods
b. Aunt Jane buys a new house. might this logic apply?
c. Ford sells a Thunderbird from its inventory.
d. You buy a pizza. 4. As the chapter states, GDP does not include the value of
e. California repaves Highway 101. used goods that are resold. Why would including such
f. Your parents buy a bottle of French wine. transactions make GDP a less informative measure of
g. Honda expands its factory in Marysville, Ohio. economic well-being?

2. The “government purchases” component of GDP does 5. Below are some data from the land of milk and honey.
not include spending on transfer payments such as
Social Security. Thinking about the definition of GDP, YEAR PRICE QUANTITY PRICE OF QUANTITY
explain why transfer payments are excluded. OF MILK OF MILK HONEY OF HONEY
2001
3. Why do you think households’ purchases of new 2002 $1 100 qts. $2 50 qts.
housing are included in the investment component of 2003 $1 200 $2 100
GDP rather than the consumption component? Can you $2 200 $4 100

510 PART EIGHT THE DATA OF MACROECONOMICS

a. Compute nominal GDP, real GDP, and the GDP 9. One day Barry the Barber, Inc., collects $400 for haircuts.
deflator for each year, using 2001 as the base year. Over this day, his equipment depreciates in value by
$50. Of the remaining $350, Barry sends $30 to the
b. Compute the percentage change in nominal GDP, government in sales taxes, takes home $220 in wages,
real GDP, and the GDP deflator in 2002 and 2003 and retains $100 in his business to add new equipment
from the preceding year. For each year, identify the in the future. From the $220 that Barry takes home, he
variable that does not change. Explain in words pays $70 in income taxes. Based on this information,
why your answer makes sense. compute Barry’s contribution to the following measures
of income:
c. Did economic well-being rise more in 2002 or 2003? a. gross domestic product
Explain. b. net national product
c. national income
6. Consider the following data on U.S. GDP: d. personal income
e. disposable personal income
YEAR NOMINAL GDP GDP DEFLATOR
(IN BILLIONS) (BASE YEAR 1992) 10. Goods and services that are not sold in markets, such as
1996 food produced and consumed at home, are generally
1997 7,662 110 not included in GDP. Can you think of how this might
8,111 112 cause the numbers in the second column of Table 22-3 to
be misleading in a comparison of the economic well-
a. What was the growth rate of nominal GDP between being of the United States and India? Explain.
1996 and 1997? (Note: The growth rate is the
percentage change from one period to the next.) 11. Until the early 1990s, the U.S. government emphasized
GNP rather than GDP as a measure of economic well-
b. What was the growth rate of the GDP deflator being. Which measure should the government prefer if
between 1996 and 1997? it cares about the total income of Americans? Which
measure should it prefer if it cares about the total
c. What was real GDP in 1996 measured in 1992 amount of economic activity occurring in the United
prices? States?

d. What was real GDP in 1997 measured in 1992 12. The participation of women in the U.S. labor force has
prices? risen dramatically since 1970.
a. How do you think this rise affected GDP?
e. What was the growth rate of real GDP between b. Now imagine a measure of well-being that includes
1996 and 1997? time spent working in the home and taking leisure.
How would the change in this measure of well-
f. Was the growth rate of nominal GDP higher or being compare to the change in GDP?
lower than the growth rate of real GDP? Explain. c. Can you think of other aspects of well-being that
are associated with the rise in women’s labor force
7. If prices rise, people’s income from selling goods participation? Would it be practical to construct a
increases. The growth of real GDP ignores this gain, measure of well-being that includes these aspects?
however. Why, then, do economists prefer real GDP as a
measure of economic well-being?

8. Revised estimates of U.S. GDP are usually released by
the government near the end of each month. Go to a
library and find a newspaper article that reports on the
most recent release. Discuss the recent changes in real
and nominal GDP and in the components of GDP.
(Alternatively, you can get the data at www.bea.doc.gov,
the Web site of the U.S. Bureau of Economic Analysis.)

IN THIS CHAPTER
YOU WILL . . .

Learn how the
consumer price
index (CPI) is

constructed

Consider why the
CPI is an imperfect
measure of the cost

of living

MEASURING THE Compare the CPI
and the GDP
COST OF LIVING deflator as

In 1931, as the U.S. economy was suffering through the Great Depression, famed measures of the
baseball player Babe Ruth earned $80,000. At the time, this salary was extraordi- overall price level
nary, even among the stars of baseball. According to one story, a reporter asked
Ruth whether he thought it was right that he made more than President Herbert See how to use a
Hoover, who had a salary of only $75,000. Ruth replied, “I had a better year.” price index to
compare dollar
Today the average baseball player earns more than 10 times Ruth’s 1931 salary, figures from
and the best players can earn 100 times as much. At first, this fact might lead you different times
to think that baseball has become much more lucrative over the past six decades.
But, as everyone knows, the prices of goods and services have also risen. In 1931, Learn the
a nickel would buy an ice-cream cone, and a quarter would buy a ticket at the local distinction between
movie theater. Because prices were so much lower in Babe Ruth’s day than they
are in ours, it is not clear whether Ruth enjoyed a higher or lower standard of liv- real and nominal
ing than today’s players. interest rates

511

512 PART EIGHT THE DATA OF MACROECONOMICS

In the preceding chapter we looked at how economists use gross domestic
product (GDP) to measure the quantity of goods and services that the economy is
producing. This chapter examines how economists measure the overall cost of liv-
ing. To compare Babe Ruth’s salary of $80,000 to salaries from today, we need to
find some way of turning dollar figures into meaningful measures of purchasing
power. That is exactly the job of a statistic called the consumer price index. After see-
ing how the consumer price index is constructed, we discuss how we can use such
a price index to compare dollar figures from different points in time.

The consumer price index is used to monitor changes in the cost of living over
time. When the consumer price index rises, the typical family has to spend more
dollars to maintain the same standard of living. Economists use the term inflation
to describe a situation in which the economy’s overall price level is rising. The
inflation rate is the percentage change in the price level from the previous period.
As we will see in the coming chapters, inflation is a closely watched aspect of
macroeconomic performance and is a key variable guiding macroeconomic policy.
This chapter provides the background for that analysis by showing how econo-
mists measure the inflation rate using the consumer price index.

consumer price THE CONSUMER PRICE INDEX

index (CPI) The consumer price index (CPI) is a measure of the overall cost of the goods and
a measure of the overall cost of services bought by a typical consumer. Each month the Bureau of Labor Statistics,
the goods and services bought which is part of the Department of Labor, computes and reports the consumer
by a typical consumer price index. In this section we discuss how the consumer price index is calculated
and what problems arise in its measurement. We also consider how this index
compares to the GDP deflator, another measure of the overall level of prices, which
we examined in the preceding chapter.

HOW THE CONSUMER PRICE INDEX IS CALCULATED

When the Bureau of Labor Statistics calculates the consumer price index and the
inflation rate, it uses data on the prices of thousands of goods and services. To see
exactly how these statistics are constructed, let’s consider a simple economy in
which consumers buy only two goods—hot dogs and hamburgers. Table 23-1
shows the five steps that the Bureau of Labor Statistics follows.

1. Fix the Basket. The first step in computing the consumer price index is to
determine which prices are most important to the typical consumer. If the
typical consumer buys more hot dogs than hamburgers, then the price of hot
dogs is more important than the price of hamburgers and, therefore, should
be given greater weight in measuring the cost of living. The Bureau of Labor
Statistics sets these weights by surveying consumers and finding the basket
of goods and services that the typical consumer buys. In the example in the
table, the typical consumer buys a basket of 4 hot dogs and 2 hamburgers.

CHAPTER 23 MEASURING THE COST OF LIVING 513

STEP 1: SURVEY CONSUMERS TO DETERMINE A FIXED BASKET OF GOODS Table 23-1
4 hot dogs, 2 hamburgers
CALCULATING THE CONSUMER
STEP 2: FIND THE PRICE OF EACH GOOD IN EACH YEAR PRICE INDEX AND THE INFLATION
RATE: AN EXAMPLE. This table
YEAR PRICE OF HOT DOGS PRICE OF HAMBURGERS shows how to calculate the
consumer price index and the
2001 $1 $2 inflation rate for a hypothetical
2002 2 3 economy in which consumers
2003 3 4 buy only hot dogs and
hamburgers.

STEP 3: COMPUTE THE COST OF THE BASKET OF GOODS IN EACH YEAR

2001 ($1 per hot dog ϫ 4 hot dogs) ϩ ($2 per hamburger ϫ 2 hamburgers) ϭ $8
2002 ($2 per hot dog ϫ 4 hot dogs) ϩ ($3 per hamburger ϫ 2 hamburgers) ϭ $14
2003 ($3 per hot dog ϫ 4 hot dogs) ϩ ($4 per hamburger ϫ 2 hamburgers) ϭ $20

STEP 4: CHOOSE ONE YEAR AS A BASE YEAR (2001) AND COMPUTE THE CONSUMER
PRICE INDEX IN EACH YEAR

2001 ($8/$8) ϫ 100 ϭ 100
2002 ($14/$8) ϫ 100 ϭ 175
2003 ($20/$8) ϫ 100 ϭ 250

STEP 5: USE THE CONSUMER PRICE INDEX TO COMPUTE THE INFLATION RATE FROM
PREVIOUS YEAR

2002 (175 Ϫ 100)/100 ϫ 100 ϭ 75%
2003 (250 Ϫ 175)/175 ϫ 100 ϭ 43%

2. Find the Prices. The second step in computing the consumer price index is to
find the prices of each of the goods and services in the basket for each point
in time. The table shows the prices of hot dogs and hamburgers for three
different years.

3. Compute the Basket’s Cost. The third step is to use the data on prices
to calculate the cost of the basket of goods and services at different times.
The table shows this calculation for each of the three years. Notice that only
the prices in this calculation change. By keeping the basket of goods the
same (4 hot dogs and 2 hamburgers), we are isolating the effects of price
changes from the effect of any quantity changes that might be occurring
at the same time.

4. Choose a Base Year and Compute the Index. The fourth step is to designate
one year as the base year, which is the benchmark against which other years
are compared. To calculate the index, the price of the basket of goods and

514 PART EIGHT THE DATA OF MACROECONOMICS

FYI When constructing the con-

What Is in the sumer price index, the Bureau
of Labor Statistics tries to

CPI’s Basket? include all the goods and ser- 16%
vices that the typical consumer Food and
beverages
buys. Moreover, it tries to

weight these goods and ser-

vices according to how much

consumers buy of each item. 17% 40%
Transportation Housing
Figure 23-1 shows the

breakdown of consumer spend-

ing into the major categories of 6%
6%
goods and services. By far the Recreation 5% 5% 5%
Medical care
largest category is housing, which makes up 40 percent of

the typical consumer’s budget. This category includes the

cost of shelter (30 percent), fuel and other utilities (5 per- Other goods
and services
cent), and household furnishings and operation (5 percent). Education and
communication
The next largest category, at 17 percent, is transportation, Apparel

which includes spending on cars, gasoline, buses, subways,

and so on. The next category, at 16 percent, is food and

beverages; this includes food at home (9 percent), food

away from home (6 percent), and alcoholic beverages (1 per- Figure 23-1

cent). Next are medical care at 6 percent, recreation at 6 THE TYPICAL BASKET OF GOODS AND SERVICES. This
figure shows how the typical consumer divides his
percent, apparel at 5 percent, and education and communi- spending among various categories of goods and services.
The Bureau of Labor Statistics calls each percentage the
cation at 5 percent. This last category includes, for exam- “relative importance” of the category.

ple, college tuition and personal computers. SOURCE: Bureau of Labor Statistics.

Also included in the figure, at 5 percent of spending, is

a category for other goods and services. This is a catchall

for things consumers buy that do not naturally fit into the

other categories, such as cigarettes, haircuts, and funeral

expenses.

inflation rate services in each year is divided by the price of the basket in the base year,
the percentage change in the price and this ratio is then multiplied by 100. The resulting number is the
index from the preceding period consumer price index.

In the example in the table, the year 2001 is the base year. In this year,
the basket of hot dogs and hamburgers costs $8. Therefore, the price of the
basket in all years is divided by $8 and multiplied by 100. The consumer
price index is 100 in 2001. (The index is always 100 in the base year.) The
consumer price index is 175 in 2002. This means that the price of the basket
in 2002 is 175 percent of its price in the base year. Put differently, a basket
of goods that costs $100 in the base year costs $175 in 2002. Similarly, the
consumer price index is 250 in 2003, indicating that the price level in 2003
is 250 percent of the price level in the base year.

5. Compute the Inflation Rate. The fifth and final step is to use the consumer price
index to calculate the inflation rate, which is the percentage change in the
price index from the preceding period. That is, the inflation rate between two
consecutive years is computed as follows:

CHAPTER 23 MEASURING THE COST OF LIVING 515

Inflation rate in year 2 ϭ CPI in year 2 Ϫ CPI in year 1 ϫ 100.

CPI in year 1

In our example, the inflation rate is 75 percent in 2002 and 43 percent in 2003.

Although this example simplifies the real world by including only two goods, producer price index
it shows how the Bureau of Labor Statistics (BLS) computes the consumer price a measure of the cost of a basket of
index and the inflation rate. The BLS collects and processes data on the prices of goods and services bought by firms
thousands of goods and services every month and, by following the five foregoing
steps, determines how quickly the cost of living for the typical consumer is rising.
When the bureau makes its monthly announcement of the consumer price index,
you can usually hear the number on the evening television news or see it in the
next day’s newspaper.

In addition to the consumer price index for the overall economy, the BLS cal-
culates several other price indexes. It reports the index for specific regions within
the country (such as Boston, New York, and Los Angeles) and for some narrow
categories of goods and services (such as food, clothing, and energy). It also calcu-
lates the producer price index, which measures the cost of a basket of goods and
services bought by firms rather than consumers. Because firms eventually pass on
their costs to consumers in the form of higher consumer prices, changes in the pro-
ducer price index are often thought to be useful in predicting changes in the con-
sumer price index.

PROBLEMS IN MEASURING THE COST OF LIVING

The goal of the consumer price index is to measure changes in the cost of living. In
other words, the consumer price index tries to gauge how much incomes must rise
in order to maintain a constant standard of living. The consumer price index, how-
ever, is not a perfect measure of the cost of living. Three problems with the index
are widely acknowledged but difficult to solve.

The first problem is called substitution bias. When prices change from one year
to the next, they do not all change proportionately: Some prices rise by more than
others. Consumers respond to these differing price changes by buying less of the
goods whose prices have risen by large amounts and by buying more of the goods
whose prices have risen less or perhaps even have fallen. That is, consumers sub-
stitute toward goods that have become relatively less expensive. Yet the consumer
price index is computed assuming a fixed basket of goods. By not taking into
account the possibility of consumer substitution, the index overstates the increase
in the cost of living from one year to the next.

Let’s consider a simple example. Imagine that in the base year, apples are
cheaper than pears, and so consumers buy more apples than pears. When the
Bureau of Labor Statistics constructs the basket of goods, it will include more
apples than pears. Suppose that next year pears are cheaper than apples. Con-
sumers will naturally respond to the price changes by buying more pears and few-
er apples. Yet, when computing the consumer price index, the Bureau of Labor
Statistics uses a fixed basket, which in essence assumes that consumers continue
buying the now expensive apples in the same quantities as before. For this reason,
the index will measure a much larger increase in the cost of living than consumers
actually experience.

516 PART EIGHT THE DATA OF MACROECONOMICS

IN THE NEWS Bloom asks. “We haven’t changed any selects popular stores and item cate-
Shopping for the CPI prices,” the woman insists. Mrs. gories—say, women’s tops. The price-
Bloom’s fast talk finally pries the woman taker then asks a store employee to help
BEHIND EVERY MACROECONOMIC STATISTIC from behind her desk, and she gets the zero in on an item of the price-taker’s
are thousands of individual pieces of numbers. It turns out that a semiprivate choosing. They narrow to the size of the
data on the economy. This article fol- surgery recovery room now costs top, its style (short-sleeve, long-sleeve,
lows some of the people who collect $753.80 a day—or $0.04 less than a tank, or turtleneck), and so on; items
these data. month ago. that generate the most revenue in a cat-
egory have the best chance of getting
Is the CPI Accurate? Chalk up another small success for picked.
Ask the Federal Sleuths Mrs. Bloom, one of about 300 Bureau of
Labor Statistics employees who gather Shoppers know that relying on
Who Get the Numbers the information that is fed into the employees for anything can be chancy.
monthly Consumer Price Index. . . . At a downtown Chicago department
BY CHRISTINA DUFF store (the government doesn’t disclose
TRENTON, N.J.—The hospital’s finance Mrs. Bloom’s travails sometimes
director is relentlessly unhelpful, but she read like a detective novel. Each month,
is still no match for Sabina Bloom, gov- she covers 900 miles in her beat-up Geo
ernment gumshoe. Prizm (three accidents in the past 18
months) to visit about 150 sites. Her
Mrs. Bloom wants to know the mission: to record the prices of certain
exact prices of some hospital services. items, time and again. If prices change,
“Nothing’s changed,” the woman says. she needs to find out why. Each month,
“Well, do you have the ledger?” Mrs. some 90,000 prices are shipped to
Washington, plugged into a computer,
scrutinized, aggregated, adjusted for
seasonal ups or downs, and then spit
out as the monthly CPI report.

Choosing what to price—for ex-
ample, the “regular” or “fancy” baby
parakeet—can seem arbitrary. After con-
sulting surveys that track consumer buy-
ing habits, the labor statistics bureau

THE INTRODUCTION OF NEW PRODUCTS The second problem with the consumer price index is the introduction of new
BIASES THE CPI. goods. When a new good is introduced, consumers have more variety from which
to choose. Greater variety, in turn, makes each dollar more valuable, so consumers
need fewer dollars to maintain any given standard of living. Yet because the con-
sumer price index is based on a fixed basket of goods and services, it does not
reflect this change in the purchasing power of the dollar.

Again, let’s consider an example. When VCRs were introduced, consumers
were able to watch their favorite movies at home. Compared to going to a movie
theater, the convenience is greater and the cost is less. A perfect cost-of-living index
would reflect the introduction of the VCR with a decrease in the cost of living. The
consumer price index, however, did not decrease in response to the introduction of
the VCR. Eventually, the Bureau of Labor Statistics did revise the basket of goods