Budget lines

Consumer Theory (Consumer Theory (BudgetsBudgets))

The Budget LineThe Budget Line

Change in the Change in the BudgetBudget


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


- 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



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


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…)


The price of water is 2¥ a bottle.The price of gum is 1¥ a pack.


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:


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



The Budget Line




Change in the BudgetChange in the Budget

When a budget decreases, consumption possibilities When a budget decreases, consumption possibilities shrink.shrink.


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)


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


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¥



If it is a If it is a NORMAL GOODNORMAL GOOD


Rise in income = rise in quantity demanded of that good



If it is an If it is an INFERIOR GOODINFERIOR GOOD


Rise in income = fall in quantity demanded of that good


Budget – 8 ¥

Budget – 4 ¥

Budget – 12 ¥

Consumer Theory (BudgetsBudgets)When a budget

decreases, consumption possibilities

shrink.

When a budget increases,

consumption possibilities

expand



The Budget Line




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.


Price water = 2 ¥ ¥ Price gum = 1 ¥ ¥ Budget = 8 ¥ ¥

Price – 2 ¥

P= 2 ¥


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.


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.



P= 2 ¥

P=2 ¥

Price water = Price water = 2 ¥2 ¥ Price gum = Price gum = 1 ¥ 1 ¥ Budget Budget = = 8 ¥8 ¥


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 (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.



The Budget Line




((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


P=2¥

P=4¥



AA

B

Income Effect(Keeps prices constant)

-Decrease in purchasing power changes consumption from A

to C


P=2¥

P=4¥



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


P=2¥

P=4¥



AA

BC


You may be asking? Why does it look

like point C is floating in this

nowhere space.


P=2¥

P=4¥



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.


((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


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


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


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


AAC

Income EffectA to C

Q of Fish

Q of Mango

sChange in budget line = new point based on income and sub effect


AAC

Income EffectA to C

BSubstitution Effect

C to B



The Budget Line




{{ 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

Education

Budget lines