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Budget lines

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- The document discusses consumer theory and budgets. It explains that a budget line shows the combinations of goods a consumer can afford based on their income and the prices of goods. - It provides an example of a consumer with an income of 8 yuan who can buy bottled water for 2 yuan each or gum for 1 yuan per pack. This illustrates how the budget line is determined by income and prices. - It then explains how changes in income or prices affect the budget line and consumption possibilities. If income rises, the budget line shifts out, allowing more consumption. If a price falls, the budget line rotates outward, also allowing more consumption combinations.

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Consumer Theory (Consumer Theory (BudgetsBudgets)) The Budget LineThe Budget Line
Change in the BudgetChange in the Budget Consumer Theory (Consumer Theory (BudgetsBudgets)) The Budget Line Change in the PriceChange in the Price Income and Substitution EffectsIncome and Substitution Effects Parts to learn in this PPT:Parts to learn in this PPT: Combine Budget line andCombine 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 aNot the same thing as a Marginal Utility CurveMarginal Utility Curve oror Demand CurveDemand Curve,, it is more like ait is more like a PPF curvePPF curve Budget LineBudget Line
Example ofExample of buying gum orbuying gum or waterwater
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 gum A. 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 ideaSimilar idea as thisas this
Consumer Theory (Consumer Theory (BudgetsBudgets)) The slope of the budget constraint equalsThe slope of the budget constraint equals - 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 terms- the opportunity cost of a good in terms of another goodof 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 equalsThe slope of the budget constraint equals  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 inThe 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 water Price 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 anYou can think of the slope of the budget line as an opportunity cost.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 BudgetChange in the Budget Consumer Theory (Consumer Theory (BudgetsBudgets)) The Budget Line Change in the PriceChange in the Price Income and Substitution EffectsIncome and Substitution Effects Parts to learn in this PPT:Parts to learn in this PPT: Combine Budget line andCombine Budget line and Indifference curveIndifference curve
Budget lines
Change in the BudgetChange in the Budget When a budget decreases, consumption possibilities shrink.When a budget decreases, consumption possibilities 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 shrink.When a budget decreases, consumption possibilities shrink. When a budget increases, consumption possibilities expandWhen a budget increases, consumption possibilities expand 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 aIf 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 anIf 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 BudgetChange in the Budget Consumer Theory (Consumer Theory (BudgetsBudgets)) The Budget Line Change in the PriceChange in the Price Income and Substitution EffectsIncome and Substitution Effects Parts to learn in this PPT:Parts to learn in this PPT: Combine Budget line andCombine Budget line and Indifference curveIndifference curve
Budget lines
Continuing thisContinuing this example of buyingexample of buying gum or watergum or water
Change in the price of waterChange in the price of water
Budget LineBudget Line Change in the PriceChange in the Price If the price of one good falls and the budget remain theIf the price of one good falls and the budget remain the same, consumption possibilities expand.same, consumption possibilities 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 of water 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 remain theIf the price of one good falls and the budget remain the same, consumption possibilities expand.same, consumption possibilities expand. If the price of one good rises and budget remain the same,If the price of one good rises and budget remain the same, consumption possibilities shrink.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 of water 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 theYou’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 lineprice of the other good remains the same, the slope of the budget line changes.changes. when the price of water falls, the budget line becomes lesswhen the price of water falls, the budget line becomes less steep.steep. when the price of water rises, the budget line becomes steeper.when the price of water rises, the budget line becomes steeper. You can think of the slope of the budget line as an opportunity cost.You can think of the slope of the budget line as an opportunity 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 BudgetChange in the Budget Consumer Theory (Consumer Theory (BudgetsBudgets)) The Budget Line Change in the PriceChange in the Price Income and Substitution EffectsIncome and Substitution Effects Parts to learn in this PPT:Parts to learn in this PPT: Combine Budget line andCombine Budget line and Indifference curveIndifference curve
((IncomeIncome and SubstitutionSubstitution 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.
IncomeIncome and Substitution EffectsSubstitution Effects The SubstitutionThe 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:
IncomeIncome and Substitution EffectsSubstitution Effects The SubstitutionThe 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 lessWater = person feels relatively “poorer” might buy less Income EffectsIncome Effects Gum and Water example:Gum and Water example: *** Real Income was decreased
GoodGood Income EffectIncome 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 ((IncomeIncome and SubstitutionSubstitution 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 B Substitution 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 B C 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 B C 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))
((IncomeIncome and SubstitutionSubstitution 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 moreOne more example:example:
Hurley’s income: $Hurley’s income: $12001200 Prices:Prices: PPFF = $= $44 per fishper fish PPMM = $= $11 per mangoper mango A.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. $$12001200/$/$44 == 300300 fishfish Question practice:Question practice:
Hurley’s income: $Hurley’s income: $12001200 Prices:Prices: PPFF = $= $44 per fishper fish PPMM = $= $11 per mangoper mango B.B. If Hurley spends all his income on mangos,If Hurley spends all his income on mangos, how many mangos does he buy?how many mangos does he buy? B.B. $$12001200/$/$11 == 12001200 mangosmangos Question practice:Question practice:
Hurley’s income: $1200 Prices: 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 Mangos A B C Hurley’s budget constraint shows the bundles he can afford. Hurley’s budget constraint shows the bundles he can afford. A.A. $$12001200/$/$44 == 300300 fishfish B.B. $$12001200/$/$11 == 12001200 mangosmangos C.C. 100100 fishfish cost $cost $400400,, $$800800 leftleft buysbuys 800800 mangosmangos Budget example:Budget example:
Q of Fish Q of Mangos A fall in income shifts the budget constraint down. A fall in income shifts the budget constraint down. Now,Now, HurleyHurley can buycan buy $$800800/$/$44 == 200200 fishfish oror $$800800/$/$11 == 800800 mangosmangos or anyor any combinationcombination in between.in between. Income Change example:Income Change example:
Q of Fish Q of Mangos An increase in the price of one good pivots the budget constraint inward. An increase in the price of one good pivots the budget constraint inward. HurleyHurley can still buycan still buy 300300 fish.fish. But now heBut now he can only buycan only buy $$12001200/$/$22 == 600600 mangos.mangos. Notice:Notice: slope is smaller,slope is smaller, relative price ofrelative price of fish is now onlyfish is now only 2 mangos.2 mangos. Price Change example:Price Change example:
Q of Fish Q of Mangos Both Income and Sub effect may happen at the same time. Both Income and Sub effect may happen at the same time. Both Change example:Both Change example: Have to find theHave to find the newnew MU perMU per dollar pointdollar point (new(new IndifferenceIndifference curvecurve) to know) to know whatwhat combination tocombination to buy now.buy now.
Q of Fish Q of Mangos Change in budget line = new point based on income and sub effect Change in budget line = new point based on income and sub effect Both Change example:Both Change example: AAC Income Effect A to C
Q of Fish Q of Mangos Change in budget line = new point based on income and sub effect Change in budget line = new point based on income and sub effect Both Change example:Both Change example: AAC Income Effect A to C B Substitution Effect C to B
Change in the BudgetChange in the Budget Consumer Theory (Consumer Theory (BudgetsBudgets)) The Budget Line Change in the PriceChange in the Price Income and Substitution EffectsIncome and Substitution Effects Parts to learn in this PPT:Parts to learn in this PPT: Combine Budget line andCombine 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 pointOptimum point Budget + Indifference curveBudget + Indifference curve - the point on the budget line that touches the highest possible indifference curve
Optimum pointOptimum point Budget + Indifference curveBudget + Indifference curve - the point on the budget line that touches the highest possible indifference curve MRS = Pgood 1 Pgood 2 Marginal Rate ofMarginal Rate of SubstitutionSubstitution - the rate at which a consumer is willing to trade one good for another.
Optimization: What the Consumer ChoosesOptimization: What the Consumer Chooses 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 D Ian 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. The optimum is the bundle Ian most prefers out of all the bundles he can afford.
Optimization: What the Consumer ChoosesOptimization: What the Consumer Chooses 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/PG A 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.” 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. A B 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. A B Example = Increase in IncomeExample = Increase in Income
50 35 Quantity 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 Effects InitialInitial optimumoptimum atat AA.. PPFF falls.falls. Substitution effect: fromfrom AA toto BB,, buy more water andbuy more water and fewer gum.fewer gum. Quantity of Water Quantity of Gum A B C In this example, the net effect on gum is negative. In this example, the net effect on gum is negative.
The Income and Substitution EffectsThe Income and Substitution Effects InitialInitial optimumoptimum atat AA.. PPFF falls.falls. Substitution effect: fromfrom AA toto BB,, buy more water andbuy more water and fewer gum.fewer gum. Income effect:Income effect: fromfrom BB toto CC,, buy more of bothbuy more of both goods.goods. Quantity of Water Quantity of Gum A B C In this example, the net effect on gum is negative. 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 ByeBye Bye 

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Budget lines

  • 1. Consumer Theory (Consumer Theory (BudgetsBudgets)) The Budget LineThe Budget Line
  • 2. Change in the BudgetChange in the Budget Consumer Theory (Consumer Theory (BudgetsBudgets)) The Budget Line Change in the PriceChange in the Price Income and Substitution EffectsIncome and Substitution Effects Parts to learn in this PPT:Parts to learn in this PPT: Combine Budget line andCombine Budget line and Indifference curveIndifference curve
  • 3. 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 aNot the same thing as a Marginal Utility CurveMarginal Utility Curve oror Demand CurveDemand Curve,, it is more like ait is more like a PPF curvePPF curve Budget LineBudget Line
  • 4. Example ofExample of buying gum orbuying gum or waterwater
  • 5. 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
  • 6. Ian’s income: 8¥ Prices: PF = 2¥ per water bottle PM = 1¥ per pack of gum A. 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:
  • 7. 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:
  • 8. 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.
  • 9. The budget line separates combinations that are affordable from combinations that are unaffordable.
  • 10. 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 ideaSimilar idea as thisas this
  • 11. Consumer Theory (Consumer Theory (BudgetsBudgets)) The slope of the budget constraint equalsThe slope of the budget constraint equals - 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 terms- the opportunity cost of a good in terms of another goodof another good Budget LineBudget Line (continued…)(continued…)
  • 12. 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.
  • 13. Consumer Theory (Consumer Theory (BudgetsBudgets)) The slope of the budget constraint equalsThe slope of the budget constraint equals  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 inThe 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 water Price of gum = 2¥ 1¥ = 2 gum packs per water bottles
  • 14. 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 anYou can think of the slope of the budget line as an opportunity cost.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
  • 15. Change in the BudgetChange in the Budget Consumer Theory (Consumer Theory (BudgetsBudgets)) The Budget Line Change in the PriceChange in the Price Income and Substitution EffectsIncome and Substitution Effects Parts to learn in this PPT:Parts to learn in this PPT: Combine Budget line andCombine Budget line and Indifference curveIndifference curve
  • 17. Change in the BudgetChange in the Budget When a budget decreases, consumption possibilities shrink.When a budget decreases, consumption possibilities shrink. Consumer Theory (Consumer Theory (BudgetsBudgets)) Budget LineBudget Line
  • 18. 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)
  • 19. Change in the BudgetChange in the Budget When a budget decreases, consumption possibilities shrink.When a budget decreases, consumption possibilities shrink. When a budget increases, consumption possibilities expandWhen a budget increases, consumption possibilities expand Consumer Theory (Consumer Theory (BudgetsBudgets)) Budget LineBudget Line
  • 20. 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)
  • 21. Change in the BudgetChange in the Budget If it is aIf it is a NORMAL GOODNORMAL GOOD Consumer Theory (Consumer Theory (BudgetsBudgets)) Rise in income = rise in quantity demanded of that good Budget LineBudget Line
  • 22. Change in the BudgetChange in the Budget If it is anIf it is an INFERIOR GOODINFERIOR GOOD Consumer Theory (Consumer Theory (BudgetsBudgets)) Rise in income = fall in quantity demanded of that good Budget LineBudget Line
  • 23. Budget – 8 ¥ Budget – 4 ¥ Budget – 12 ¥ Consumer Theory (BudgetsBudgets) When a budget decreases, consumption possibilities shrink. When a budget increases, consumption possibilities expand
  • 24. Change in the BudgetChange in the Budget Consumer Theory (Consumer Theory (BudgetsBudgets)) The Budget Line Change in the PriceChange in the Price Income and Substitution EffectsIncome and Substitution Effects Parts to learn in this PPT:Parts to learn in this PPT: Combine Budget line andCombine Budget line and Indifference curveIndifference curve
  • 26. Continuing thisContinuing this example of buyingexample of buying gum or watergum or water
  • 27. Change in the price of waterChange in the price of water
  • 28. Budget LineBudget Line Change in the PriceChange in the Price If the price of one good falls and the budget remain theIf the price of one good falls and the budget remain the same, consumption possibilities expand.same, consumption possibilities expand. Consumer Theory (Consumer Theory (BudgetsBudgets))
  • 29. Price water = 2 ¥¥ Price gum = 1 ¥¥ Budget = 8 ¥¥ Price – 2 ¥ P= 2 ¥ Consumer Theory (BudgetsBudgets)
  • 30. Fall in the price of water.. P=2 ¥ P=1 ¥ P= 2 ¥ P= 1 ¥ When the price of water falls from 2 to 1, the budget line rotates outward and becomes less steep. Consumer Theory (BudgetsBudgets)
  • 31. Change in the PriceChange in the Price If the price of one good falls and the budget remain theIf the price of one good falls and the budget remain the same, consumption possibilities expand.same, consumption possibilities expand. If the price of one good rises and budget remain the same,If the price of one good rises and budget remain the same, consumption possibilities shrink.consumption possibilities shrink. Consumer Theory (Consumer Theory (BudgetsBudgets)) Budget LineBudget Line
  • 32. P= 2 ¥ P=2 ¥ Price water =Price water = 2 ¥2 ¥ Price gum =Price gum = 1 ¥1 ¥ Budget =Budget = 8 ¥8 ¥ Consumer Theory (BudgetsBudgets)
  • 33. Rise in the price of water.Rise in the price of water. P= 4 ¥ P= 2 ¥ P=2 ¥ P=4 ¥ When the price of water rises from 2 to 4, the budget line rotates inward and becomes steeper. Consumer Theory (BudgetsBudgets)
  • 34. 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 theYou’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 lineprice of the other good remains the same, the slope of the budget line changes.changes. when the price of water falls, the budget line becomes lesswhen the price of water falls, the budget line becomes less steep.steep. when the price of water rises, the budget line becomes steeper.when the price of water rises, the budget line becomes steeper. You can think of the slope of the budget line as an opportunity cost.You can think of the slope of the budget line as an opportunity 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.
  • 35. Change in the BudgetChange in the Budget Consumer Theory (Consumer Theory (BudgetsBudgets)) The Budget Line Change in the PriceChange in the Price Income and Substitution EffectsIncome and Substitution Effects Parts to learn in this PPT:Parts to learn in this PPT: Combine Budget line andCombine Budget line and Indifference curveIndifference curve
  • 36. ((IncomeIncome and SubstitutionSubstitution 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.
  • 37. IncomeIncome and Substitution EffectsSubstitution Effects The SubstitutionThe 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:
  • 38. 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:
  • 39. IncomeIncome and Substitution EffectsSubstitution Effects The SubstitutionThe 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
  • 40. If the price of a water increases (and normal goods): Gum = person feels relatively “poorer” so buy lessWater = person feels relatively “poorer” might buy less Income EffectsIncome Effects Gum and Water example:Gum and Water example: *** Real Income was decreased
  • 41. GoodGood Income EffectIncome 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 ((IncomeIncome and SubstitutionSubstitution Effects)Effects) SummarySummary If the price of a water increases:
  • 42. 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
  • 43. 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
  • 44. 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 Substitution 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
  • 45. 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 C Consumer Theory (Consumer Theory (BudgetsBudgets)) You may be asking? Why does it look like point C is floating in this nowhere space.
  • 46. 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 C 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))
  • 47. ((IncomeIncome and SubstitutionSubstitution 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.
  • 49. Hurley’s income: $Hurley’s income: $12001200 Prices:Prices: PPFF = $= $44 per fishper fish PPMM = $= $11 per mangoper mango A.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. $$12001200/$/$44 == 300300 fishfish Question practice:Question practice:
  • 50. Hurley’s income: $Hurley’s income: $12001200 Prices:Prices: PPFF = $= $44 per fishper fish PPMM = $= $11 per mangoper mango B.B. If Hurley spends all his income on mangos,If Hurley spends all his income on mangos, how many mangos does he buy?how many mangos does he buy? B.B. $$12001200/$/$11 == 12001200 mangosmangos Question practice:Question practice:
  • 51. Hurley’s income: $1200 Prices: 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:
  • 52. Q of Fish Q of Mangos A B C Hurley’s budget constraint shows the bundles he can afford. Hurley’s budget constraint shows the bundles he can afford. A.A. $$12001200/$/$44 == 300300 fishfish B.B. $$12001200/$/$11 == 12001200 mangosmangos C.C. 100100 fishfish cost $cost $400400,, $$800800 leftleft buysbuys 800800 mangosmangos Budget example:Budget example:
  • 53. Q of Fish Q of Mangos A fall in income shifts the budget constraint down. A fall in income shifts the budget constraint down. Now,Now, HurleyHurley can buycan buy $$800800/$/$44 == 200200 fishfish oror $$800800/$/$11 == 800800 mangosmangos or anyor any combinationcombination in between.in between. Income Change example:Income Change example:
  • 54. Q of Fish Q of Mangos An increase in the price of one good pivots the budget constraint inward. An increase in the price of one good pivots the budget constraint inward. HurleyHurley can still buycan still buy 300300 fish.fish. But now heBut now he can only buycan only buy $$12001200/$/$22 == 600600 mangos.mangos. Notice:Notice: slope is smaller,slope is smaller, relative price ofrelative price of fish is now onlyfish is now only 2 mangos.2 mangos. Price Change example:Price Change example:
  • 55. Q of Fish Q of Mangos Both Income and Sub effect may happen at the same time. Both Income and Sub effect may happen at the same time. Both Change example:Both Change example: Have to find theHave to find the newnew MU perMU per dollar pointdollar point (new(new IndifferenceIndifference curvecurve) to know) to know whatwhat combination tocombination to buy now.buy now.
  • 56. Q of Fish Q of Mangos Change in budget line = new point based on income and sub effect Change in budget line = new point based on income and sub effect Both Change example:Both Change example: AAC Income Effect A to C
  • 57. Q of Fish Q of Mangos Change in budget line = new point based on income and sub effect Change in budget line = new point based on income and sub effect Both Change example:Both Change example: AAC Income Effect A to C B Substitution Effect C to B
  • 58. Change in the BudgetChange in the Budget Consumer Theory (Consumer Theory (BudgetsBudgets)) The Budget Line Change in the PriceChange in the Price Income and Substitution EffectsIncome and Substitution Effects Parts to learn in this PPT:Parts to learn in this PPT: Combine Budget line andCombine Budget line and Indifference curveIndifference curve
  • 59. {{ Use this example again, and use indifference curves to see this floating issue better.
  • 60. Ian is Morpheus from the Matrix, 黑客帝国 He will open you mind
  • 61. Optimum pointOptimum point Budget + Indifference curveBudget + Indifference curve - the point on the budget line that touches the highest possible indifference curve
  • 62. Optimum pointOptimum point Budget + Indifference curveBudget + Indifference curve - the point on the budget line that touches the highest possible indifference curve MRS = Pgood 1 Pgood 2 Marginal Rate ofMarginal Rate of SubstitutionSubstitution - the rate at which a consumer is willing to trade one good for another.
  • 63. Optimization: What the Consumer ChoosesOptimization: What the Consumer Chooses 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 D Ian 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. The optimum is the bundle Ian most prefers out of all the bundles he can afford.
  • 64. Optimization: What the Consumer ChoosesOptimization: What the Consumer Chooses 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/PG A 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.” Consumer optimization is another example of “thinking at the margin.”
  • 65. 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. A B Example = Increase in IncomeExample = Increase in Income
  • 66. Quantity of Water Quantity of GumIf gum is an inferior good, the new optimum point will contain fewer gum. A B Example = Increase in IncomeExample = Increase in Income
  • 67. 50 35 Quantity 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
  • 68. The Income and Substitution EffectsThe Income and Substitution Effects InitialInitial optimumoptimum atat AA.. PPFF falls.falls. Substitution effect: fromfrom AA toto BB,, buy more water andbuy more water and fewer gum.fewer gum. Quantity of Water Quantity of Gum A B C In this example, the net effect on gum is negative. In this example, the net effect on gum is negative.
  • 69. The Income and Substitution EffectsThe Income and Substitution Effects InitialInitial optimumoptimum atat AA.. PPFF falls.falls. Substitution effect: fromfrom AA toto BB,, buy more water andbuy more water and fewer gum.fewer gum. Income effect:Income effect: fromfrom BB toto CC,, buy more of bothbuy more of both goods.goods. Quantity of Water Quantity of Gum A B C In this example, the net effect on gum is negative. In this example, the net effect on gum is negative.
  • 70. 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 ByeBye Bye 

Editor's Notes

  • #7: A very straightforward exercise.
  • #8: A very straightforward exercise.
  • #50: A very straightforward exercise.
  • #51: A very straightforward exercise.
  • #52: A very straightforward exercise.
  • #64: Simply put, optimization means buying the bundle that makes the consumer happiest, given his or her income.
  • #65: Consumer optimization is another example of “thinking at the margin.” Remember that MRS = marginal value of the good on the X-axis (fish) in terms of the good on Y-axis (mangos). If MRS > Pf/Pm, the value of another fish is greater than its cost, so Hurley can make himself happier by decreasing his mango purchases and using the proceeds to buy another fish. If MRS < Pf/Pm, the value of another fish is less than its cost, so Hurley should move along his budget line to a bundle with less fish and more mangos to make himself happier.
  • #66: In Active Learning 2, students determined that a fall in income shifts the budget constraint downward. They should readily accept, then, that an increase in income shifts the budget line upward/outward.
  • #68: In Active Learning 2, students determined that an increase in the price of a good pivots the budget constraint inward. Here, the price of a good is falling, so the budget line pivots outward.
  • #69: This diagram decomposes the movement from the old optimum (A) to the new one (C) into two parts. The first part, from A to B, represents the substitution effect. It shows the change in the optimal bundle due to the relative price change, holding constant the consumer’s level of well-being. The second part, from B to C, represents the income effect. It shows the change in the optimal bundle due to the increase in the purchasing power of the consumer’s income. The dashed line through point B is parallel to the new budget line through point C, indicating that we are holding relative prices constant to see how the increase in income affects the optimal bundle.
  • #70: This diagram decomposes the movement from the old optimum (A) to the new one (C) into two parts. The first part, from A to B, represents the substitution effect. It shows the change in the optimal bundle due to the relative price change, holding constant the consumer’s level of well-being. The second part, from B to C, represents the income effect. It shows the change in the optimal bundle due to the increase in the purchasing power of the consumer’s income. The dashed line through point B is parallel to the new budget line through point C, indicating that we are holding relative prices constant to see how the increase in income affects the optimal bundle.