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# Economics 310

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1. Economics 310 Chapter 3: Budget Lines, Indifference Curves, Demand and the Theory of Consumer Choice. Department of Economics College of Business and Economics California State University-Northridge Professor Kenneth Ng Thursday, February 22, 2001

2. Administrative Details • Exam on Thursday, Oct. 4th. • Chapters 1-5 • Homework due on Tuesday, Oct. 1st. • Not available yet. • In Class Problems. • Old Exam Problems. • Link on webpage.

3. 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.

4. The Budget Constraint or Budget Line • The Budget Line shows the combinations of goods the consumer can afford given his or her income and the prices of the two goods. • Defined by 3 things: income and the price of two goods.

5. The Budget Constraint

6. The Budget Line • Any point on the budget 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. • These points can be graphed.

7. Quantity of Pepsi Quantity of Pizza The Budget Constraint Line 500 250 0 50 100

8. Quantity of Pepsi Quantity of Pizza The Budget Constraint Line B 500 250 A 0 50 100

9. Quantity of Pepsi Consumer’s budget constraint Quantity of Pizza The Budget Constraint Line B 500 250 A 0 50 100

10. Quantity of Pepsi Consumer’s budget constraint Quantity of Pizza The Budget Constraint Line B 500 C 250 A 0 50 100

11. Two things to know about the Budget Line. • The slope of the budget line equals the relative price of the two goods, that is, the price of one good compared to the price of the other. • The relative price of a good is defined as the number of units of the other good that must be given up in order to get enough income to buy one more unit of the good, • The relative price of pizza (which costs \$10 each) is how many pints of Pepsi must be not consumed to save enough money to but one more pizza. • Relative price measures the rate at which the consumer can 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.

12. Quantity of Pepsi Consumer’s budget constraint Quantity of Pizza Position of the BL represents income Suppose the persons income was reduced to \$500. What would the BL look like? B 500 A parallel shift of the budget line represents a change in income. The farther out budget line on a ray from the origin the more income it represents. C 250 A 0 50 100

13. Quantity of Pepsi Consumer’s budget constraint Quantity of Pizza Slope of the BL represents relative price Suppose the price of good B was raised from \$2 to \$4? What would the new BL look like? Has the relative price of pizza increased or decreased? Explain. The relative price of pizza has decreased because the amount of Pepsi that must be given up to get one more pizza has gone down. B 500 C 250 A 0 50 100

14. Budget Line Exercise (1); Draw 2 budget lines given the income and prices below.

15. Budget Line Exercise (1) What is the slope of the red and purple budget lines?

16. 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.

17. 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

18. Budget Line exercises • The first step in using Budget Lines in economic analysis is to be able to show how a budget line changes when there is a change in the world. • Consider the following 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?

19. Suppose an individual has \$500 of income. The price of good A was \$25 and the price of good B was \$50.

20. Suppose someone gave you a coupon for B that said 2 for the price of 1, limit free 3 units.

21. 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?

22. Quantity of Pepsi Indifference curve, I1 Quantity of Pizza • 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. • 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. Indifference Curves C B A 0

23. Quantity of Pepsi Indifference curve, I1 Quantity of Pizza Indifference Curves • 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. • D is preferred to A, because at D the person has more of both pepsi and pizza. • D is preferred to C, because C is equivalent to A and D is preferred to A. C B D I2 A 0

24. Quantity of Pepsi Indifference curve, I1 Quantity of Pizza The Marginal Rate of Substitution • 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. MRS 1 0

25. 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.

26. Quantity of Pepsi Quantity of Pizza The Consumer’s Optimal Choice I1 0

27. Quantity of Pepsi Quantity of Pizza The Consumer’s Optimal Choice I2 I1 0

28. Quantity of Pepsi Quantity of Pizza The Consumer’s Optimal Choice I3 I2 I1 0

29. Quantity of Pepsi Quantity of Pizza The Consumer’s Optimal Choice I3 I2 I1 Budget constraint 0

30. Quantity of Pepsi Quantity of Pizza The Consumer’s Optimal Choice Optimum I3 I2 I1 Budget constraint 0

31. Quantity of Pepsi Quantity of Pizza MRS must equal relative price at the optimum. This consumer will not choose this point because with this bundle, the MRS is less than the relative price. Explain. Optimum I3 I2 I1 Budget constraint 0

32. Quantity of Pepsi Quantity of Pizza MRS must equal relative price at the optimum. What is the slope of the IC and BL at this point? MRS=rise/run =2/4 =1/2 For each pizza taken away, the person must receive ½ pepsi to keep him just as well off. Relative Price=rise/run =4/4 =1 For each pizza the person gives up, he can get 1 pepsi. Optimum 8 6 I2 4 I1 Budget constraint 0 6 10

33. Quantity of Pepsi Quantity of Pizza MRS must equal relative price at the optimum. If the person is consuming 10 pizzas and 4 Pepsis, the MRS<Relative Price. ½<1 Optimum 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 I2 4 I1 Budget constraint 0 6 10

34. Quantity of Pepsi Quantity of Pizza MRS must equal relative price at the optimum. If the person is consuming 10 pizzas and 4 Pepsis, the MRS<Relative Price. ½<1 Optimum Relative Price of Pizza: If the person gave up 4 pizzas, he could get 4 Pepsis. 8 6 I2 4 I1 Budget constraint 0 6 10

35. Quantity of Pepsi Quantity of Pizza MRS must equal relative price at the optimum. If the person is consuming 10 pizzas and 4 Pepsis, the MRS<Relative Price. ½<1 Optimum Why does moving to the optimum make the person better off? If you take away 4 pizzas and give him 2 Pepsis he would be indifferent, but if he game up 4 pizzas he could actually get 4 Pepsis. 8 6 I2 4 I1 Budget constraint 0 6 10

36. 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.

37. Quantity of Pepsi Quantity of Pizza Changes in Income Affect Consumer Choices 0

38. Quantity of Pepsi Quantity of Pizza Changes in Income Affect Consumer Choices I1 0

39. Quantity of Pepsi Quantity of Pizza Changes in Income Affect Consumer Choices I1 0

40. Quantity of Pepsi Quantity of Pizza Changes in Income Affect Consumer Choices New budget constraint I1 0

41. Quantity of Pepsi Quantity of Pizza Changes in Income Affect Consumer Choices New budget constraint I2 I1 0

42. Quantity of Pepsi Quantity of Pizza Changes in Income Affect Consumer Choices New budget constraint New optimum I2 I1 0

43. Quantity of Pepsi Quantity of Pizza Changes in Income Affect Consumer Choices New budget constraint 1. An increase in income shifts the budget constraint outward… New optimum I2 I1 0

44. Quantity of Pepsi Quantity of Pizza Changes in Income Affect Consumer Choices New budget constraint 1. An increase in income shifts the budget constraint outward… New optimum I2 I1 0 2. …raising pizza consumption…

45. Quantity of Pepsi Quantity of Pizza Changes in Income Affect Consumer Choices 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…

46. 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?

47. An Inferior Good

48. An Inferior Good Quantity of Pepsi 0 Quantity of Pizza

49. An Inferior Good Quantity of Pepsi I1 0 Quantity of Pizza

50. Initial budget constraint An Inferior Good Quantity of Pepsi I1 0 Quantity of Pizza