Post on 12-Apr-2017
Consumer Theory (Consumer Theory (BudgetsBudgets))
The Budget LineThe Budget Line
Change in the Change in the BudgetBudget
Consumer Theory (Consumer Theory (BudgetsBudgets))
The Budget Line
Change in the PriceChange in the PriceIncome and Substitution Income and Substitution EffectsEffects
Parts to learn in this PPT:Parts to learn in this PPT:
Combine Budget line and Combine Budget line and Indifference curveIndifference curve
Consumer Theory (Consumer Theory (BudgetsBudgets))
- describes the limits to consumption choices and
depends on a consumer’s budget and the prices of goods and
services.Not the same thing as a Not the same thing as a Marginal Utility Curve Marginal Utility Curve oror Demand Demand CurveCurve,, it is more like a it is more like a PPF curvePPF curve
Budget LineBudget Line
Example of Example of buying gum buying gum
or wateror water
Ian has 8¥ a day to spend on two goods: bottled water and gum.
The price of water is 2¥ a bottle.
The price of gum is 1¥ a pack.
Example:
Consumer Theory (Consumer Theory (BudgetsBudgets))Budget LineBudget Line
Ian’s income: 8¥ Prices: PF = 2¥ per water bottle
PM = 1¥ per pack of gumA. If Ian spends all his income on water,
how many bottle does he buy?
A. 8¥ / 2¥ = 4 bottles of water
Question practice:Question practice:
Ian’s income: 8¥ Prices: PF = 2¥ per water bottle
PM = 1¥ per pack of gum
B. If Ian spends all his income on gum, how many packs does he buy?
B. 8¥ / 1¥ = 8 packs of
gum
Question practice:Question practice:
Ian has 8¥ a day to spend on two goods: bottled water and gum.
The price of water is 2¥ a bottle.The price of gum is 1¥ a pack.
The budget line separates combinations that are affordable from combinations that are unaffordable.
Any point outside of this curve is impossible
The shaded area represents all possible combinations of production possible if it is perfectly efficient or not.
The Production Possibilities Frontier (PPF)What it shows…
Similar Similar idea as thisidea as this
Consumer Theory (Consumer Theory (BudgetsBudgets))
The slope of the budget constraint The slope of the budget constraint equalsequals- the rate at which a person - the rate at which a person can trade one good for another.can trade one good for another.- the opportunity cost of a good in - the opportunity cost of a good in terms of another goodterms of another good
Budget LineBudget Line(continued…)(continued…)
Ian has 8¥ a day to spend on two goods: bottled water and gum.
The price of water is 2¥ a bottle.The price of gum is 1¥ a pack.
Consumer Theory (Consumer Theory (BudgetsBudgets))
The slope of the budget constraint The slope of the budget constraint equalsequals The rate at which IanThe rate at which Ian
can trade gum for water.can trade gum for water. The opportunity cost of a water in The opportunity cost of a water in
terms of gum.terms of gum. The relative price of each:The relative price of each:
Budget LineBudget Line
Price of waterPrice of gum =
2¥1¥ = 2 gum packs per
water bottles
Consumer Theory (Consumer Theory (BudgetsBudgets))Prices and the Slope of the Budget LinePrices and the Slope of the Budget Line
You can think of the slope of the budget line as You can think of the slope of the budget line as an opportunity cost.an opportunity cost.Another name for opportunity cost is: Another name for opportunity cost is:
- Which is the price of one good in terms of
another good.
- It equals the price of one good divided by the price of another good
and equals the slope of the budget line.
Relative PriceRelative Price
Change in the Change in the BudgetBudget
Consumer Theory (Consumer Theory (BudgetsBudgets))
The Budget Line
Change in the PriceChange in the PriceIncome and Substitution Income and Substitution EffectsEffects
Parts to learn in this PPT:Parts to learn in this PPT:
Combine Budget line and Combine Budget line and Indifference curveIndifference curve
Change in the BudgetChange in the Budget
When a budget decreases, consumption possibilities When a budget decreases, consumption possibilities shrink.shrink.
Consumer Theory (Consumer Theory (BudgetsBudgets))Budget LineBudget Line
Budget – 8rmbBudget – 8 ¥
Budget – 4¥
An decrease in the budget
shifts the budget line leftward.
The slope of the budget line doesn’t change because prices have not
changed.
Consumer Theory (BudgetsBudgets)
Change in the BudgetChange in the Budget
When a budget decreases, consumption possibilities When a budget decreases, consumption possibilities shrink.shrink.
When a budget increases, consumption possibilities When a budget increases, consumption possibilities expandexpand
Consumer Theory (Consumer Theory (BudgetsBudgets))Budget LineBudget Line
An increase in the budget
shifts the budget line rightward.
Again, the slope of the budget line doesn’t change because prices have not
changed.
Budget – 8¥
Budget – 4 ¥
Budget – 12¥
Consumer Theory (BudgetsBudgets)
Change in the BudgetChange in the Budget
If it is a If it is a NORMAL GOODNORMAL GOOD
Consumer Theory (Consumer Theory (BudgetsBudgets))
Rise in income = rise in quantity demanded of that good
Budget LineBudget Line
Change in the BudgetChange in the Budget
If it is an If it is an INFERIOR GOODINFERIOR GOOD
Consumer Theory (Consumer Theory (BudgetsBudgets))
Rise in income = fall in quantity demanded of that good
Budget LineBudget Line
Budget – 8 ¥
Budget – 4 ¥
Budget – 12 ¥
Consumer Theory (BudgetsBudgets)When a budget
decreases, consumption possibilities
shrink.
When a budget increases,
consumption possibilities
expand
Change in the Change in the BudgetBudget
Consumer Theory (Consumer Theory (BudgetsBudgets))
The Budget Line
Change in the PriceChange in the PriceIncome and Substitution Income and Substitution EffectsEffects
Parts to learn in this PPT:Parts to learn in this PPT:
Combine Budget line and Combine Budget line and Indifference curveIndifference curve
Continuing this Continuing this example of example of
buying gum or buying gum or waterwater
Change in the price of Change in the price of waterwater
Budget LineBudget LineChange in the PriceChange in the Price
If the price of one good falls and the budget If the price of one good falls and the budget remain the same, consumption possibilities remain the same, consumption possibilities expand.expand.
Consumer Theory (Consumer Theory (BudgetsBudgets))
Price water = 2 ¥ ¥ Price gum = 1 ¥ ¥ Budget = 8 ¥ ¥
Price – 2 ¥
P= 2 ¥
Consumer Theory (BudgetsBudgets)
Fall in the price of water..
P=2 ¥
P=1 ¥
P= 2 ¥ P= 1 ¥
When the price ofwater falls from 2
to 1, the budget line rotates outward and
becomes less steep.
Consumer Theory (BudgetsBudgets)
Change in the PriceChange in the Price
If the price of one good falls and the budget If the price of one good falls and the budget remain the same, consumption possibilities remain the same, consumption possibilities expand.expand.
If the price of one good rises and budget remain If the price of one good rises and budget remain the same, consumption possibilities shrink.the same, consumption possibilities shrink.
Consumer Theory (Consumer Theory (BudgetsBudgets))
Budget LineBudget Line
P= 2 ¥
P=2 ¥
Price water = Price water = 2 ¥2 ¥ Price gum = Price gum = 1 ¥ 1 ¥ Budget Budget = = 8 ¥8 ¥
Consumer Theory (BudgetsBudgets)
Rise in the price of water.Rise in the price of water.
P= 4 ¥ P= 2 ¥
P=2 ¥
P=4 ¥
When the price ofwater rises from 2 to 4, the budget line rotates inward and becomes steeper.
Consumer Theory (BudgetsBudgets)
Consumer Theory (Consumer Theory (BudgetsBudgets))Prices and the Slope of the Budget LinePrices and the Slope of the Budget Line
You’ve just seen that when the price of one good changes and the You’ve just seen that when the price of one good changes and the price of the other good remains the same, the slope of the budget price of the other good remains the same, the slope of the budget line changes.line changes.
when the price of water falls, the budget line when the price of water falls, the budget line becomes less steep.becomes less steep.
when the price of water rises, the budget line when the price of water rises, the budget line becomes steeper.becomes steeper.
You can think of the slope of the budget line as an opportunity You can think of the slope of the budget line as an opportunity cost.cost.The slope tells us how many packs of gum a bottle of water costs.The slope tells us how many packs of gum a bottle of water costs.
Change in the Change in the BudgetBudget
Consumer Theory (Consumer Theory (BudgetsBudgets))
The Budget Line
Change in the PriceChange in the PriceIncome and Substitution Income and Substitution EffectsEffects
Parts to learn in this PPT:Parts to learn in this PPT:
Combine Budget line and Combine Budget line and Indifference curveIndifference curve
((Income Income and Substitution Substitution Effects)Effects)If the price of a good increases there are two effects:
2.) The increase in price reduces disposable income and this lower income may reduce demand.
1.) The good is relatively more expensive than alternative goods and people can switch to
other goods.
Both effects can happen at the same time. They can both move in the same direction, or
they can move in opposite directions, with the net effect of one being strong then the
other.
Income Income and Substitution EffectsSubstitution Effects
The The Substitution Substitution EffectEffect
- measures how much the higher price encourages consumers to use other goods, assuming the same level of
income.
- It will encourage consumers to buy alternative goods.
If the price of a good increases:
If the price of a water increases (and normal goods):
Relatively less expensive so buy more
Relatively more expensive so buy less
Gum =
Water =
Substitution EffectsSubstitution Effects Gum and Water example: Gum and Water example:
Income Income and Substitution EffectsSubstitution EffectsThe The Substitution Substitution EffectEffect
- measures how much the higher price will lead to lower demand overall
- Consumers feel poorer therefore buy less
(if it’s a normal good)
If the price of a good increases:
The Income Effect
If the price of a water increases (and normal goods):
Gum =
person feels relatively “poorer” so buy less
Water =
person feels relatively “poorer” might buy less
Income EffectsIncome Effects Gum and Water example: Gum and Water example:
*** Real Income was decreased
Good Good Income Effect Income Effect Substitution effectSubstitution effect total effecttotal effect
Gum
Water
Poorer = buy less
Poorer = buy less
Relatively cheaper so buy more
Relatively more
expensive so buy less
Income and Substitution effect act in
opposite direction = ambiguous
Income and Substitution effect act in
same direction = buy less
((Income Income and Substitution Substitution Effects)Effects)SummarySummary
If the price of a water increases:
Consumer Theory (Consumer Theory (BudgetsBudgets))Rise in the price of water.Rise in the price of water.
P=2¥
P=4¥
Equimarginal Principle- Rise in price changes
consumption from A to B
AA
B
Consumer Theory (Consumer Theory (BudgetsBudgets))Rise in the price of water.Rise in the price of water.
P=2¥
P=4¥
Equimarginal Principle- Rise in price changes
consumption from A to B
AA
B
Income Effect(Keeps prices constant)
-Decrease in purchasing power changes consumption from A
to C
Consumer Theory (Consumer Theory (BudgetsBudgets))Rise in the price of water.Rise in the price of water.
P=2¥
P=4¥
Equimarginal Principle- Rise in price changes
consumption from A to B
AA
BSubstitution Effect
(Keep income constant) -Rise in price changes
consumption from C to B
Income Effect(Keeps prices constant)
-Decrease in purchasing power changes consumption from A
to C
C
Rise in the price of water.Rise in the price of water.
P=2¥
P=4¥
Equimarginal Principle- Rise in price changes
consumption from A to B
AA
BC
Consumer Theory (Consumer Theory (BudgetsBudgets))
You may be asking? Why does it look
like point C is floating in this
nowhere space.
Rise in the price of water.Rise in the price of water.
P=2¥
P=4¥
Equimarginal Principle- Rise in price changes
consumption from A to B
AA
BC
Both substitution and income effects are happening at the
same time. What is not included on this graph is the indifference curves based on the equimarginal principle at
each price point.
Consumer Theory (Consumer Theory (BudgetsBudgets))
((Income Income and Substitution Substitution Effects)Effects)
If the price of a good increases and assuming in is a normal good there are two effects:
2.) Income - The increase in price reduces disposable income and this lower income may
reduce demand.
1.) Substitution - The good is relatively more expensive than alternative goods and people
can switch to other goods.
If price goes down, then it’s just all opposite
Summary so farSummary so far
If the good is an inferior good be careful to realize what is the correct change.
One more One more example:example:
Hurley’s income: $Hurley’s income: $12001200Prices: Prices: PPFF = $ = $44 per fish per fish
PPMM = $ = $11 per mango per mangoA.A. If Hurley spends all his income on fish, If Hurley spends all his income on fish,
how many fish does he buy?how many fish does he buy?
A. A. $$12001200/$/$44= = 300 300 fishfish
Question practice:Question practice:
Hurley’s income: $Hurley’s income: $12001200Prices: Prices: PPFF = $ = $44 per fish per fish
PPMM = $ = $11 per mango per mango
B.B. If Hurley spends all his income on mangos, If Hurley spends all his income on mangos, how many mangos does he buy?how many mangos does he buy?
B. B. $$12001200/$/$11= = 12001200 mangosmangos
Question practice:Question practice:
Hurley’s income: $1200Prices: PF = $4 per fish
PM = $1 per mango
C. If Hurley buys 100 fish, how many mangos can he buy?
C. 100 fish cost $400,$800 left buys 800
mangos
Question practice:Question practice:
Q of Fish
Q of Mango
s
A
B
C
Hurley’s budget constraint shows the bundles he can afford.
A. A. $$12001200/$/$44= = 300300 fish fish
B. B. $$12001200/$/$11= = 12001200 mangosmangos
C. C. 100100 fish fish cost $cost $400400,,$$800 800 left left buys buys 800800 mangosmangos
Budget example:Budget example:
Q of Fish
Q of Mango
sA fall in income shifts the budget constraint
down.
Now, Now, Hurley Hurley can buy can buy $$800800/$/$44= = 200200 fishfishoror$$800800/$/$11= = 800800 mangosmangosor any or any combination combination in between.in between.
Income Change example:Income Change example:
Q of Fish
Q of Mango
sAn increase in the price of one good pivots the budget constraint inward.
Hurley Hurley can still buy can still buy 300300 fish. fish. But now he But now he can only buy can only buy $$12001200/$/$22 = = 600600 mangos.mangos.Notice: Notice: slope is slope is smaller, smaller, relative price relative price of fish is now of fish is now only 2 mangos.only 2 mangos.
Price Change example:Price Change example:
Q of Fish
Q of Mango
sBoth Income and Sub effect may happen at
the same time.
Both Change example:Both Change example:
Have to find Have to find the new the new MU MU per dollar per dollar point point (new (new Indifference Indifference curvecurve) to ) to know what know what combination combination to buy now.to buy now.
Q of Fish
Q of Mango
sChange in budget line = new point based on income and sub effect
Both Change example:Both Change example:
AAC
Income EffectA to C
Q of Fish
Q of Mango
sChange in budget line = new point based on income and sub effect
Both Change example:Both Change example:
AAC
Income EffectA to C
BSubstitution Effect
C to B
Change in the Change in the BudgetBudget
Consumer Theory (Consumer Theory (BudgetsBudgets))
The Budget Line
Change in the PriceChange in the PriceIncome and Substitution Income and Substitution EffectsEffects
Parts to learn in this PPT:Parts to learn in this PPT:
Combine Budget line and Combine Budget line and Indifference curveIndifference curve
{{ Use this example again, and use
indifference curves to see this floating
issue better.
Ian is Morpheus from the Matrix, 黑客帝国 He will open you mind
Optimum Optimum pointpoint
Budget + Indifference curve Budget + Indifference curve - the point on the budget line
that touches the highest possible indifference curve
Optimum Optimum pointpoint
Budget + Indifference curve Budget + Indifference curve - the point on the budget line
that touches the highest possible indifference curve
MRS = Pgood 1
Pgood 2
Marginal Rate Marginal Rate of of SubstitutionSubstitution
- the rate at which a consumer
is willing to trade one good for another.
Optimization: What the Consumer Optimization: What the Consumer ChoosesChooses
Quantity of Water
Quantity of Gum
120
60
3015
A is the optimum: the point on the budget line that
touches the highest possible
indifference curve.
Ian prefers B to A, but he cannot afford B. A
C
DIan can afford C
and D, but A is on a higher indifference curve.
B
The optimum is the bundle
Ian most prefers out of all the bundles he can afford.
Optimization: What the Consumer Optimization: What the Consumer ChoosesChooses
Quantity of Water
Quantity of Gum
120
60
3015
At the optimum, slope of the
indifference curve equals
slope of the budget line:
MRS = PW/PGA
marginal value of water
(in terms of gum)
price of gum (in terms
of water)
Consumer optimization is
another example of “thinking at the
margin.”
Quantity of Water
Quantity of GumAn increase in
income shifts the budget line outward.
If both goods are normal goods, Ian buys more of each.
AB
Example = Increase in IncomeExample = Increase in Income
Quantity of Water
Quantity of GumIf gum is an inferior
good, the new optimum point will contain fewer gum.
AB
Example = Increase in IncomeExample = Increase in Income
50
35Quantity of Water
Quantity of Gum
120
60
3015 60
initial optimum
new optimum
If Initially,PW = $4
PG = $1
PW falls to $2
budget line rotates outward,Ian buys
more water and fewer gum.
Example = Increase in PriceExample = Increase in Price
The Income and Substitution EffectsThe Income and Substitution EffectsInitial Initial optimumoptimum at at AA..
PPFF falls. falls.
Substitution effect:from from AA to to BB, , buy more water buy more water and fewer gum.and fewer gum.
Quantity
of Water
Quantity of Gum
A
B
C
In this example, the net effect on
gum is negative.
The Income and Substitution EffectsThe Income and Substitution EffectsInitial Initial optimumoptimum at at AA..
PPFF falls. falls.
Substitution effect:from from AA to to BB, , buy more water buy more water and fewer gum.and fewer gum.
Income effect:Income effect:from from BB to to CC, , buy more of both buy more of both goods.goods.
Quantity
of Water
Quantity of Gum
A
B
C
In this example, the net effect on
gum is negative.
Example Question:Example Question:
The consumer is originally consuming his or her optimal consumption bundle at point A in the figure when the price of Good K falls. The movement from K1 to K2 reflects:
a.the total change in quantity demanded due to the decrease in the price of Good K.b.the income effect of the price decrease of Good K.c.the substitution effect of the price decrease of Good K.d.the income effect of the price decrease of Good K and the substitution effect of the price decrease of Good K.
That’s it.That’s it.Bye Bye Bye Bye