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Economics 310 Chapter 3: Budget Lines, Indifference Curves, Demand and the Theory of Consumer Choice. Want a deeper understanding of the economic forces underlying the demand curve. The plan for the remainder of the class is to look closer at the economic forces underlying the supply and demand curves. The demand curve shows how much of a good a person or group of people will buy at any given price ceteris paribus (other things equal). What happens when “other things” change. Income. Prices of related goods. Preferences. Taxes. Want to be able to make positive statement like, “if income changes then …..” To answer these questions must take an in depth look at the economic forces underlying the demand curve. This is done using budget lines and indifference curves. The Budget Constraint or Budget Line It shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods. The Budget Constraint Pints of Pepsi 0 50 100 150 200 250 300 350 400 450 500 Number of Spending on Spending on Pizzas Pepsi Pizza 100 90 80 70 60 50 40 30 20 10 0 $ 0 100 200 300 400 500 600 700 800 900 1,000 $1,000 900 800 700 600 500 400 300 200 100 0 Total Spending $1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000 The Budget Constraint Line Any point on the budget constraint line indicates the consumer’s combination or tradeoff between two goods. For example, if the consumer buys no pizzas, he can afford 500 pints of Pepsi. If he buys no Pepsi, he can afford 100 pizzas. Alternately, the consumer can buy 50 pizzas and 250 pints of Pepsi. The Budget Constraint Line Quantity of Pepsi 500 250 0 50 100 Quantity of Pizza The Budget Constraint Line Quantity of Pepsi 500 B 250 0 50 A 100 Quantity of Pizza The Budget Constraint Line Quantity of Pepsi 500 B 250 Consumer’s budget constraint 0 50 A 100 Quantity of Pizza The Budget Constraint Line Quantity of Pepsi 500 250 B C Consumer’s budget constraint 0 50 A 100 Quantity of Pizza Two things to know about the Budget Line. The slope of the budget constraint line equals the relative price of the two goods, that is, the price of one good compared to the price of the other. It measures the rate at which the consumer will trade one good for the other. The steeper the budget line the greater the relative price of the good on the horizontal axis. The position of the budget line represents income. The farther out the budget line on a ray from the origin, the greater the income level it represents. Budget Line Exercise (1); Draw 2 budget lines given the income and prices below. Budget Line Exercise (1) What is the slope of the red and purple budget lines? The slope of the budget line and relative price. What does it mean in terms of relative price of opportunity cost to say that on the red budget line the relative price is 5/2 and on the purple budget line, the relative price is 5/8? Which good, A or B, has a higher relative price? In order for a person to get more good B, how much good A must the give up for each extra unit of B the get? That amount is the relative price of opportunity cost of B. The slope of the budget line is the relative price of the good on the horizontal axis. By definition the relative price of good B is the amount of good A that must be given up to get one more unit of good B. Practice Exam Question Point A represents a bundle that can be purchased with $1000 whether the price of goods A and B are $2 and $5 or $ and $2.50. A=166.67, B=133.33 Budget Line exercises Suppose an individual has $500 of income. The price of good A was $25 and the price of good B was $50. Suppose someone gave you a non-transferable voucher for 10 units of good B, what will budget line look like? Suppose someone gave you a coupon for B that said 2 for the price of 1, limit free 3 units. Advanced problem: the McDonald’s Value Meal Problem. Suppose an individual had $10. Big Macs cost $2 and fries cost $1. What does the budget line look like. Suppose McDonald’s has a value meal which includes a Big Mac and Fries for $2.50? Suppose an individual has $500 of income. The price of good A was $25 and the price of good B was $50. Suppose someone gave you a coupon for B that said 2 for the price of 1, limit free 3 units. Advanced problem:the McDonald’s Value Meal Problem. Suppose an individual had $10. Big Macs cost $2 and fries cost $1. What does the budget line look like. Suppose McDonald’s has a value meal which includes a Big Mac and Fries for $2.50? Preferences: What the Consumer Wants A Budget Line shows the bundles of goods which are attainable by an individual given his income and prices. A consumer’s preference among bundles of goods may be illustrated with indifference curves. An indifference curve shows bundles of goods that leave the consumer equally satisfied. Show bundles of goods, where if the consumer was given a choice between those bundles he wouldn’t care which bundle he receives. Indifference Curves Quantity of Pepsi The consumer is indifferent, or equally happy, with the combination of goods shown at points A, B, and C because they are all on the same indifference curve. C B A 0 Indifference curve, I1 Quantity of Pizza Two things to know about Indifference Curves. The slope at any point on an indifference curve is the marginal rate of substitution. In the broadest terms, it the value of one unit of a good to a person. In more technical terms, it is the rate at which a consumer is willing to trade one good for another. It is the amount of one good that a consumer requires as compensation to give up one unit of the other good. Ask the person, what is the minimum number of units of the other good they must receive to get them to voluntarily give up one unit of a good—that is the goods marginal rate of substitution. The Marginal Rate of Substitution Quantity of Pepsi MRS 1 Indifference curve, I1 0 Quantity of Pizza Higher indifference curves are preferred to lower ones. The position of an indifference curve represents satisfaction, utility or happiness. The farther out an IC from the origin the happier the individual will be if he can attain a bundle on that IC. Indifference Curves D is preferred to A, because at D the person has more of both pepsi and pizza. Quantity of Pepsi C D is preferred to C, because C is equivalent to A and D is preferred to A. B D I2 A 0 Indifference curve, I1 Quantity of Pizza Optimization: Predicting consumer behavior. Can use budget lines and indifference curves to generate positive statements. Using indifference curves and budget lines, the behavior of the consumer can be stated in alternative but equivalent ways: Choose the point on the budget line that is on the highest indifference curve that has at least one point in common with the budget line. Choose the IC that is tangent to the BL. Choose the bundle where the MRS equals the Relative Price. If the MRS < relative price, the person could be made happier by consuming less of the good and more of the other good. If the MRS > relative price, the person could be made happier by consuming more of the good and less of the other good. The Consumer’s Optimal Choice Quantity of Pepsi I1 0 Quantity of Pizza The Consumer’s Optimal Choice Quantity of Pepsi I1 0 I2 Quantity of Pizza The Consumer’s Optimal Choice Quantity of Pepsi I3 I1 0 I2 Quantity of Pizza The Consumer’s Optimal Choice Quantity of Pepsi I3 I1 I2 Budget constraint 0 Quantity of Pizza The Consumer’s Optimal Choice Quantity of Pepsi Optimum I3 I1 I2 Budget constraint 0 Quantity of Pizza MRS must equal relative price at the optimum. Quantity of Pepsi This consumer will not choose this point because with this bundle, the MRS is less than the relative price. Explain. Optimum I3 I1 I2 Budget constraint 0 Quantity of Pizza MRS must equal relative price at the optimum. What is the slope of the IC and BL at this point? Quantity of Pepsi MRS=rise/run Relative Price=rise/run Optimum =2/4 =4/4 =1/2 =1 For each pizza the taken person away,gives the he up, person can get must 1 receive pepsi. ½ pepsi to keep him just as well off. 8 6 4 I1 I2 Budget constraint 0 6 10 Quantity of Pizza MRS must equal relative price at the optimum. If the person is consuming Quantity of Pepsi Optimum 10 pizzas and 4 Pepsis, the MRS<Relative Price. ½<1 MRS: If you took away 4 units of pizza and gave him 2 units of Pepsi in exchange the person’ happiness would be unchanged. 8 6 4 I1 I2 Budget constraint 0 6 10 Quantity of Pizza MRS must equal relative price at the optimum. If the person is consuming Quantity of Pepsi Optimum 10 pizzas and 4 Pepsis, the MRS<Relative Price. ½<1 Relative Price of Pizza: If the person gave up 4 pizzas, he could get 4 Pepsis. 8 6 4 I1 I2 Budget constraint 0 6 10 Quantity of Pizza MRS must equal relative price at the optimum. If the person is consuming Quantity of Pepsi Optimum If you take away 4 pizzas and give him 2 Pepsis he would be indifferent, but if he game up 4 pizzas I2 he could actually get 4 I1 Pepsis. Budget constraint 8 6 4 0 10 pizzas and 4 Pepsis, the MRS<Relative Price. ½<1 Why does moving to the optimum make the person better off? 6 10 Quantity of Pizza How a change in income will affect the bundle of goods chosen by a person. An increase in income shifts the budget constraint outward. The consumer is able to choose a better combination of goods on a higher indifference curve. Changes in Income Affect Consumer Choices Changes in Income Affect Consumer Choices Quantity of Pepsi 0 Quantity of Pizza Changes in Income Affect Consumer Choices Quantity of Pepsi I1 0 Quantity of Pizza Changes in Income Affect Consumer Choices Quantity of Pepsi I1 0 Quantity of Pizza Changes in Income Affect Consumer Choices Quantity of Pepsi New budget constraint I1 0 Quantity of Pizza Changes in Income Affect Consumer Choices Quantity of Pepsi New budget constraint I2 I1 0 Quantity of Pizza Changes in Income Affect Consumer Choices Quantity of Pepsi New budget constraint New optimum I2 I1 0 Quantity of Pizza Changes in Income Affect Consumer Choices Quantity of Pepsi New budget constraint 1. An increase in income shifts the budget constraint outward… New optimum I2 I1 0 Quantity of Pizza Changes in Income Affect Consumer Choices Quantity of Pepsi New budget constraint 1. An increase in income shifts the budget constraint outward… New optimum I2 I1 0 2. …raising pizza consumption… Quantity of Pizza Changes in Income Affect Consumer Choices Quantity of Pepsi New budget constraint 1. An increase in income shifts the budget constraint outward… New optimum 3. …and Pepsi consumption. I2 I1 0 2. …raising pizza consumption… Quantity of Pizza An increase in income can cause the consumption of a good to increase or decrease. If a consumer buys more of a good when his or her income rises, the good is called a normal good. If a consumer buys less of a good when his or her income rises, the good is called an inferior good. Consider the previous example. Are Pepsis and Pizzas normal or inferior? An Inferior Good An Inferior Good Quantity of Pepsi 0 Quantity of Pizza An Inferior Good Quantity of Pepsi I1 0 Quantity of Pizza An Inferior Good Quantity of Pepsi Initial budget constraint I1 0 Quantity of Pizza An Inferior Good Quantity of Pepsi Initial optimum Initial budget constraint I1 0 Quantity of Pizza An Inferior Good Quantity of Pepsi New budget constraint Initial optimum Initial budget constraint I1 0 Quantity of Pizza An Inferior Good Quantity of Pepsi New budget constraint Initial optimum Initial budget constraint I1 0 I2 Quantity of Pizza An Inferior Good Quantity of Pepsi New budget constraint Initial optimum New optimum Initial budget constraint I1 0 I2 Quantity of Pizza An Inferior Good Quantity of Pepsi New budget constraint Initial optimum 1. When an increase in income shifts the budget constraint outward... New optimum Initial budget constraint I1 0 I2 Quantity of Pizza An Inferior Good Quantity of Pepsi New budget constraint Initial optimum 1. When an increase in income shifts the budget constraint outward... New optimum Initial budget constraint I1 I2 0 2. ... pizza consumption rises, making pizza a normal good... Quantity of Pizza An Inferior Good Quantity of Pepsi 3. ... but Pepsi consumption falls, making Pepsi an inferior good. New budget constraint Initial optimum 1. When an increase in income shifts the budget constraint outward... New optimum Initial budget constraint I1 I2 0 2. ... pizza consumption rises, making pizza a normal good... Quantity of Pizza How a change in price will affect the bundle of goods chosen by a person. A fall in the price of any good rotates the budget constraint outward and changes the slope of the budget constraint. Changes in Prices Affect Consumer Choices Quantity of Pepsi 0 Quantity of Pizza Changes in Prices Affect Consumer Choices Quantity of Pepsi 500 I1 0 100 Quantity of Pizza Changes in Prices Affect Consumer Choices Quantity of Pepsi 500 Initial budget constraint 0 I1 100 Quantity of Pizza Changes in Prices Affect Consumer Choices Quantity of Pepsi 500 Initial optimum Initial budget constraint 0 I1 100 Quantity of Pizza Changes in Prices Affect Consumer Choices Quantity of Pepsi 1. A fall in the price of Pepsi rotates the budget constraint outward… 500 Initial budget constraint 0 I1 100 Quantity of Pizza Changes in Prices Affect Consumer Choices Quantity of Pepsi 1,000 New budget constraint 1. A fall in the price of Pepsi rotates the budget constraint outward… 500 Initial budget constraint 0 I1 100 Quantity of Pizza Changes in Prices Affect Consumer Choices Quantity of Pepsi 1,000 New budget constraint 1. A fall in the price of Pepsi rotates the budget constraint outward… 500 Initial budget constraint 0 I1 100 I2 Quantity of Pizza Changes in Prices Affect Consumer Choices Quantity of Pepsi 1,000 New budget constraint New optimum 1. A fall in the price of Pepsi rotates the budget constraint outward… 500 Initial budget constraint 0 I1 100 I2 Quantity of Pizza Changes in Prices Affect Consumer Choices Quantity of Pepsi 1,000 New budget constraint New optimum 1. A fall in the price of Pepsi rotates the budget constraint outward… 500 Initial budget constraint 0 I1 I2 Quantity of Pizza 100 2. …reducing pizza consumption… Changes in Prices Affect Consumer Choices Quantity of Pepsi 1,000 New budget constraint New optimum 1. A fall in the price of Pepsi rotates the budget constraint outward… 500 3. …and raising Pepsi consumption. Initial budget constraint 0 I1 I2 Quantity of Pizza 100 2. …reducing pizza consumption… Income and Substitution Effects A price change causes a compound effect— both the slope and position of the BL are changed. An income effect-change in the position of the BL. The income effect is the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve. A substitution effect-change in the slope of the BL. The substitution effect is the change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution. When the price of a good increases, the amount of other goods that must be given up increases. Income and Substitution Effects Quantity of Pepsi 0 Quantity of Pizza Income and Substitution Effects Quantity of Pepsi Initial budget constraint I1 0 Quantity of Pizza Income and Substitution Effects Quantity of Pepsi Initial optimum A Initial budget constraint I1 0 Quantity of Pizza Income and Substitution Effects Quantity of Pepsi Initial optimum A Initial budget constraint I1 0 Quantity of Pizza Income and Substitution Effects Quantity of Pepsi B Initial optimum A Initial budget constraint I1 0 Quantity of Pizza Income and Substitution Effects Quantity of Pepsi A price change first causes the consumer to move from one point on a indifference curve to another on the same curve. B Substitution effect Initial optimum A Initial budget constraint I1 0 Quantity of Pizza Substitution effect Income and Substitution Effects Quantity of Pepsi New budget constraint B Substitution effect Initial optimum A Initial budget constraint I1 0 Quantity of Pizza Substitution effect Income and Substitution Effects Quantity of Pepsi New budget constraint B Substitution effect Initial optimum A Initial budget constraint I1 0 Quantity of Pizza Substitution effect Income and Substitution Effects Quantity of Pepsi New budget constraint B Substitution effect Initial optimum A I2 Initial budget constraint I1 0 Quantity of Pizza Substitution effect Income and Substitution Effects Quantity of Pepsi New budget constraint C New optimum B Substitution effect Initial optimum A I2 Initial budget constraint I1 0 Quantity of Pizza Substitution effect Income and Substitution Effects After moving from one point to another on the same curve, the consumer will move to another indifference curve. Quantity of Pepsi New budget constraint C New optimum Income effect B Substitution effect Initial optimum A I2 Initial budget constraint I1 0 Quantity of Pizza Substitution effect Income effect Practice Exam Question. Draw budget lines and indifference curves that show the effect of a price change when one good is normal and the other good is inferior. Income and Substitution Effects: Inferior Good Quantity of Pepsi 0 Quantity of Pizza Income and Substitution Effects: Inferior Good Quantity of Pepsi Initial budget constraint I1 0 Quantity of Pizza Income and Substitution Effects: Inferior Good Quantity of Pepsi Initial optimum A Initial budget constraint I1 0 Quantity of Pizza Income and Substitution Effects: Inferior Good--Substitution Effect Quantity of Pepsi Initial optimum A Initial budget constraint I1 0 Quantity of Pizza Income and Substitution Effects: Inferior Good--Substitution Effect Quantity of Pepsi The Substitution Effect shows the effect of the change in the relative price on the combination of the two goods chosen. It is derived by drawing a budget line with a slope incorporating the new relative price but tangent to the original indifference curve. B Initial optimum A Initial budget constraint I1 0 Quantity of Pizza Income and Substitution Effects: Inferior Good--Substitution Effect Quantity of Pepsi A price change first causes the consumer to move from one point on a indifference curve to another on the same curve. B Substitution effect Initial optimum A Initial budget constraint I1 0 Quantity of Pizza Substitution effect Income and Substitution Effects: Inferior Good--Income Effect Quantity of Pepsi New budget constraint B Substitution effect Initial optimum A Initial budget constraint I1 0 Quantity of Pizza Substitution effect Income and Substitution Effects: Inferior Good--Income Effect Quantity of Pepsi New budget constraint B Substitution effect Initial optimum A Initial budget constraint I1 0 Quantity of Pizza Substitution effect Income and Substitution Effects Quantity of Pepsi New budget constraint B Substitution effect Initial optimum A I2 Initial budget constraint I1 0 Quantity of Pizza Substitution effect Income and Substitution Effects: Inferior Good--Income Effect Quantity of Pepsi New budget constraint B C Substitution effect New optimum A Initial optimum I2 Initial budget constraint I1 0 Quantity of Pizza Substitution effect Income and Substitution Effects: Inferior Good--Income Effect Quantity of Pepsi New budget constraint Pepsi is an inferior good because the parallel shift outward of budget line (income change) caused the consumption of Pepsi to decline. B Income effect Substitution effect Initial budget constraint A C New optimum Initial optimum I2 I1 0 Quantity of Pizza Substitution effect Income effect Deriving the Demand Curve The demand curve shows the amount of a good purchased by a person at different prices. Budget lines and indifference curves can be used to show how a change in the price of a good affects the amount purchased. Budget lines and indifference curves can be used to derive a person’s demand curve. Deriving the Demand Curve: The Consumer’s Optimum Quantity of Pepsi The Demand Curve for Pepsi Price of Pepsi New budget constraint 150 B I2 50 A At a price of $2, the person buys 50 Pepsis. $2 What would happen if the price of Pepsi fell to $1? 1 A B Demand I1 0 Initial budget constraint Quantity of Pizza 0 50 150 Quantity of Pepsi Budget Line and Indifference Curve Analysis: Example 1. Budget lines and indifference curves are flexible analytical tools that can be used to analyze many questions. For instance, how do wages affect the supply of labor? Question: can an increase in a person’s wage make him work less? If the substitution effect is greater than the income effect for the worker, he or she works more. If income effect is greater than the substitution effect, he or she works less. Setting up the problem: What goes on the axes? Consumption $5,000 Optimum I 3 2,000 I 2 I 1 0 60 100 Hours of Leisure Show indifference curves and budget lines for a person whose supply curve is upward sloping, I.e. and increase in the wage makes him work more hours. (a) For a person with these preferences… Wage Consumption . . . the labor supply curve slopes upward. 1. When the wage rises… BC1 BC2 I2 I1 0 2. …hours of leisure decrease… Hour of Leisure 0 Hours of Labor Supplied 3. and hours of labor increase. Show indifference curves and budget lines for a person whose supply curve is upward sloping, I.e. and increase in the wage makes him work more hours. (a) For a person with these preferences… Consumption BC1 . . . the labor supply curve slopes backward. Wage 1. When the wage rises… BC2 I 2 I1 0 2. …hours of leisure increase… Hours of Leisure 0 Hours of Labor Supplied 3. and hours of labor decrease. How do interest rates affect household saving—another example of substitution and income effects. If the substitution effect of a higher interest rate is greater than the income effect, households save more. If the income effect of a higher interest rate is greater than the substitution effect, households save less. Thus, an increase in the interest rate could either encourage or discourage saving. Consumption when Old Budget constraint What goes on the axes? $110,000 55,000 Optimum I1 0 $50,000 100,000 Consumption when Young (a) Higher Interest Rate Raises Saving Consumption when Old (b) Higher Interest Rate Lowers Saving Consumption when Old How will an increase in interest rates affect the BL? 0 0 Consumption when Young Practice Exam Question (Part 1): Show BL’s and IC’s that depict a person who saves more when interest rates rise and a person who saves less when interest rates rise. (a) Higher Interest Rate Raises Saving Consumption when Old (b) Higher Interest Rate Lowers Saving Consumption when Old BC 2 BC 2 1. A higher interest rate rotates the budget constraint outward . . . BC 1 1. A higher interest rate rotates the budget constraint outward . . . BC1 I2 I1 0 2. . . . resulting in lower consumption when young and, thus, higher saving. I I 1 0 2. . . . resulting in higher consumption when young and, thus, lower saving. 2 Consumption when Young Practice Exam Question (Part 2): How can a the person in (b) be saving less but have more Consumption When Old? (a) Higher Interest Rate Raises Saving Consumption when Old (b) Higher Interest Rate Lowers Saving Consumption when Old BC 2 BC 2 Income Effect Income BC 1 Effect I2 I I1 0 I 1 0 Practice Exam Question (Part 3): On which graph (a) or (b) is Consumption when old an inferior good? Explain and show graphically. 2 Consumption when Young Do the poor prefer to receive cash or in-kind transfers? Examples of in-kind transfers: Food Stamps. “Free” public schools. Subsidized student loans. Free college tuition. 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 recipient does not consume more of the good than he would on his own, then the cash and in-kind transfer have exactly the same effect on his consumption and welfare. It would always be better to give a poor person a cash transfer than an in-kind transfer. (a) The Constraint Is Not Binding Cash Transfer In-Kind Transfer Food Food BC2 (with $1,000 cash) BC $1,000 0 1 B A BC2 (with $1,000 food stamps) BC 1 I2 $1,000 I1 Nonfood 0 Consumption B I2 A I1 Nonfood Consumption (a) The Constraint Is Not Binding Cash Transfer In-Kind Transfer Food BC2 (with $1,000 cash) BC2 (with $1,000 food stamps) Food BC 1 $1,000 B A BC 1 I2 I2 $1,000 A I1 0 B I1 Nonfood 0 Consumption Nonfood Consumption (b) The Constraint Is Binding Cash Transfer In-Kind Transfer Food BC 2 (with $1,000 cash) BC 2 (with $1,000 food stamps) Food BC BC 1 $1,000 C $1,000 A 0 1 B I1 A I2 Nonfood 0 Consumption B I 1 I 3I 2 Nonfood Consumption First Exam. Start reading Chapter 4. Monday, October 2nd. Covers Chapter 1-4 in Landsburg. Homework due Friday. Do only problems 4 and 5 to turn in on Friday. Do problems 8 and 9 for Wednesday's lecture.