Lectures 1 and 2 Quiz PDF
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This document is a set of lecture notes on microeconomics. It covers fundamental concepts of supply and demand, including opportunity costs, scarcity, market mechanisms and elasticity.
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Framework Consumers maximize...
Framework Consumers maximize their levels of Opportunity satisfaction Time, Money, and Costs Markets allow other resources are scarce While we do so, we interaction of We make choices in account for the two and presence of this opportunity costs we obtain an scarcity (cost of the best foregone alternative) equilibrium Scarcity Producers maximize their profits Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. CHAPTER 2 The Basics of Supply and Demand Prepared by: Fernando & Yvonn Quijano Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. CHAPTER 2 OUTLINE Chapter 2 The Basics of Supply and Demand 2.1 Supply and Demand 2.2 The Market Mechanism 2.3 Changes in Market Equilibrium 2.4 Elasticities of Supply and Demand Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 3 of 52 The Basics of Supply and Demand Supply-demand analysis is a fundamental and powerful tool that can be applied to a wide variety of interesting Chapter 2 The Basics of Supply and Demand and important problems. To name a few: Understanding and predicting how changing world economic conditions affect market price and production Evaluating the impact of government policies Determining how these policies affect consumers and producers Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 4 of 52 2.1 SUPPLY AND DEMAND The Supply Curve supply curve Relationship between the quantity of a good that producers are willing to sell and the price of the good. QS QS (P) Figure 2.1 The Supply Curve Chapter 2 The Basics of Supply and Demand The supply curve, labeled S in the figure, shows how the quantity of a good offered for sale changes as the price of the good changes. The supply curve is upward sloping: The higher the price, the more firms are able and willing to produce and sell. If production costs fall, firms can produce the same quantity at a lower price or a larger quantity at the same price. The supply curve then shifts to the right (from S to S’). Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 5 of 52 2.1 SUPPLY AND DEMAND The Supply Curve Other Variables That Affect Supply The quantity supplied can depend on other variables besides price. For example: Chapter 2 The Basics of Supply and Demand production costs, including wages, interest charges, and the costs of raw materials. When production costs decrease, output increases no matter what the market price happens to be. The entire supply curve thus shifts to the right. Economists often use the phrase change in supply to refer to shifts in the supply curve, while reserving the phrase change in the quantity supplied to apply to movements along the supply curve. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 6 of 52 2.1 SUPPLY AND DEMAND The Demand Curve demand curve Relationship between the quantity of a good that consumers are willing to buy and the price of the good. QD QD ( P) Figure 2.2 The Demand Curve Chapter 2 The Basics of Supply and Demand The demand curve, labeled D, shows how the quantity of a good demanded by consumers depends on its price. The demand curve is downward sloping; holding other things equal, consumers will want to purchase more of a good as its price goes down. The quantity demanded may also depend on other variables, such as income, the weather, and the prices of other goods. For most products, the quantity demanded increases when income rises. A higher income level shifts the demand curve to the right (from D to D’). Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 7 of 52 2.1 SUPPLY AND DEMAND The Demand Curve Shifting the Demand Curve If the market price were held constant, we would expect to see an increase in the quantity demanded as a result of consumers’ higher Chapter 2 The Basics of Supply and Demand incomes. Because this increase would occur no matter what the market price, the result would be a shift to the right of the entire demand curve. Substitute and Complementary Goods substitutes Two goods for which an increase in the price of one leads to an increase in the quantity demanded of the other. complements Two goods for which an increase in the price of one leads to a decrease in the quantity demanded of the other. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 8 of 52 2.2 THE MARKET MECHANISM Equilibrium equilibrium (or market clearing) price Price that equates the quantity supplied to the quantity demanded. Chapter 2 The Basics of Supply and Demand market mechanism Tendency in a free market for price to change until the market clears. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 9 of 52 2.2 THE MARKET MECHANISM Figure 2.3 Supply and Demand The market clears at price P0 and quantity Q0. Chapter 2 The Basics of Supply and Demand At the higher price P1, a surplus develops, so price falls. At the lower price P2, there is a shortage, so price is bid up. surplus Situation in which the quantity supplied exceeds the quantity demanded. shortage Situation in which the quantity demanded exceeds the quantity supplied. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 10 of 52 2.2 THE MARKET MECHANISM When Can We Use the Supply-Demand Model? We are assuming that at any given price, a given quantity will be produced and sold. Chapter 2 The Basics of Supply and Demand This assumption makes sense only if a market is at least roughly competitive. By this we mean that both sellers and buyers should have little market power—i.e., little ability individually to affect the market price. Suppose that supply were controlled by a single producer. If the demand curve shifts in a particular way, it may be in the monopolist’s interest to keep the quantity fixed but change the price, or to keep the price fixed and change the quantity. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 11 of 52 2.3 CHANGES IN MARKET EQUILIBRIUM Figure 2.4 New Equilibrium Following Shift in Supply Chapter 2 The Basics of Supply and Demand When the supply curve shifts to the right, the market clears at a lower price P3 and a larger quantity Q3. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 12 of 52 2.3 CHANGES IN MARKET EQUILIBRIUM Figure 2.5 New Equilibrium Following Shift in Demand Chapter 2 The Basics of Supply and Demand When the demand curve shifts to the right, the market clears at a higher price P3 and a larger quantity Q3. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 13 of 52 2.3 CHANGES IN MARKET EQUILIBRIUM Figure 2.6 New Equilibrium Following Shifts in Supply and Demand Supply and demand curves Chapter 2 The Basics of Supply and Demand shift over time as market conditions change. In this example, rightward shifts of the supply and demand curves lead to a slightly higher price and a much larger quantity. In general, changes in price and quantity depend on the amount by which each curve shifts and the shape of each curve. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 14 of 52 2.3 CHANGES IN MARKET EQUILIBRIUM From 1970 to 2007, the real (constant-dollar) price of eggs fell by 49 percent, while the real price of a college education rose by 105 percent. Chapter 2 The Basics of Supply and Demand The mechanization of poultry farms sharply reduced the cost of producing eggs, shifting the supply curve downward. The demand curve for eggs shifted to the left as a more health-conscious population tended to avoid egg. As for college, increases in the costs of equipping and maintaining modern classrooms, laboratories, and libraries, along with increases in faculty salaries, pushed the supply curve up. The demand curve shifted to the right as a larger percentage of a growing number of high school graduates decided that a college education was essential. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 15 of 52 2.3 CHANGES IN MARKET EQUILIBRIUM Figure 2.6 Market for Eggs (a) The supply curve for Chapter 2 The Basics of Supply and Demand eggs shifted downward as production costs fell; the demand curve shifted to the left as consumer preferences changed. As a result, the real price of eggs fell sharply and egg consumption rose. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 16 of 52 2.3 CHANGES IN MARKET EQUILIBRIUM Figure 2.7 Market for College Education Chapter 2 The Basics of Supply and Demand (b) The supply curve for a college education shifted up as the costs of equipment, maintenance, and staffing rose. The demand curve shifted to the right as a growing number of high school graduates desired a college education. As a result, both price and enrollments rose sharply. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 17 of 52 2.3 CHANGES IN MARKET EQUILIBRIUM Figure 2.10 Supply and Demand for New York City Office Space Chapter 2 The Basics of Supply and Demand Following 9/11 the supply curve shifted to the left, but the demand curve also shifted to the left, so that the average rental price fell. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 18 of 52 2.4 ELASTICITIES OF SUPPLY AND DEMAND elasticity Percentage change in one variable resulting from a 1-percent increase in another. Price Elasticity of Demand Chapter 2 The Basics of Supply and Demand price elasticity of demand Percentage change in quantity demanded of a good resulting from a 1-percent increase in its price. (2.1) Positive or negative? Magnitude? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 19 of 52 2.4 ELASTICITIES OF SUPPLY AND DEMAND Linear Demand Curve linear demand curve Demand curve that is a straight line. Figure 2.11 Revise the Linear Demand Curve concept of slope- Chapter 2 The Basics of Supply and Demand here The price elasticity of demand depends not only on the slope of the demand curve but also on the price and quantity. The elasticity, therefore, varies along the curve as price and quantity change. Slope is constant for this linear demand curve. Near the top, because price is high and quantity is small, the elasticity is large in magnitude. The elasticity becomes smaller as we move down the curve. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 20 of 52 2.4 ELASTICITIES OF SUPPLY AND DEMAND Linear Demand Curve Figure 2.12 (a) Infinitely Elastic Demand For a horizontal demand curve, ΔQ/ΔP is infinite. Chapter 2 The Basics of Supply and Demand Because a tiny change in price leads to an enormous change in demand, the elasticity of demand is infinite. infinitely elastic demand Principle that consumers will buy as much of a good as they can get at a single price, but for any higher price the quantity demanded drops to zero, while for any lower price the quantity demanded increases without limit. Examples- sports vehicles, cruise fares Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 21 of 52 2.4 ELASTICITIES OF SUPPLY AND DEMAND Linear Demand Curve Figure 2.12 (b) Completely Inelastic Demand For a vertical demand curve, ΔQ/ΔP is zero. Because the Chapter 2 The Basics of Supply and Demand quantity demanded is the same no matter what the price, the elasticity of demand is zero. completely inelastic demand Principle that consumers will buy a fixed quantity of a good regardless of its price. Examples- life saving drugs, salt, gasoline Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 22 of 52 2.4 ELASTICITIES OF SUPPLY AND DEMAND Other Demand Elasticities income elasticity of demand Percentage change in the quantity demanded resulting from a 1-percent increase in income. (2.2) Chapter 2 The Basics of Supply and Demand cross-price elasticity of demand Percentage change in the quantity demanded of one good resulting from a 1-percent increase in the price of another. (2.3) Elasticities of Supply price elasticity of supply Percentage change in quantity supplied resulting from a 1-percent increase in price. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 23 of 52 2.4 ELASTICITIES OF SUPPLY AND DEMAND For a few decades, changes in the wheat market had major implications for both American farmers and U.S. agricultural policy. Chapter 2 The Basics of Supply and Demand To understand what happened, let’s examine the behavior of supply and demand beginning in 1981. By setting the quantity supplied equal to the quantity demanded, we can determine the market-clearing price of wheat for 1981: Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 24 of 52 2.4 ELASTICITIES OF SUPPLY AND DEMAND Substituting into the supply curve equation, we get Chapter 2 The Basics of Supply and Demand We use the demand curve to find the price elasticity of demand: Thus demand is inelastic. We can likewise calculate the price elasticity of supply: Because these supply and demand curves are linear, the price elasticities will vary as we move along the curves. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 25 of 52 * Some practice problems 1. Use supply and demand curves to illustrate how each of the following events would affect the price of butter and the quantity of butter bought and sold: (A) An increase in the price of margarine. (B) An increase in the price of milk Chapter 2 The Basics of Supply and Demand (C) A decrease in average income levels. 2. Suppose the demand curve for a product is given by Q = 10 2P + PS, where P is the price of the product and PS is the price of a substitute good. The price of the substitute good is $2.00. (A) Suppose P = $1.00. What is the price elasticity of demand? What is the cross-price elasticity of demand? (B) Suppose the price of the good, P, goes to $2.00. Now what is the price elasticity of demand? What is the cross-price elasticity of demand? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 26 of 52 CHAPTER 2 The Basics of Supply and Demand Prepared by: Fernando & Yvonn Quijano Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. Framework Consumers Chapter 2 The Basics of Supply and Demand maximize their levels of satisfaction Markets allow interaction of the two and we obtain an equilibrium Producers maximize their profits Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 28 of 52 Consumer Theory Allocating time between watching your favourite show and studying Chapter 2 The Basics of Supply and Demand - Would you want to spend more time on your favourite pastime more than less? - Is it in your best interest to spend more time studying? - You have only 3 hours to spare - Decision of how many hours to allocate between the two activities given that total time is 3 hours Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 29 of 52 CHAPTER 3 OUTLINE Chapter 2 The Basics of Supply and Demand 3.1 Consumer Preferences 3.2 Budget Constraints 3.3 Consumer Choice Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 30 of 52 Consumer Behavior theory of consumer behavior Description of how consumers allocate incomes among different goods and services to maximize their well-being. Chapter 2 The Basics of Supply and Demand Consumer behavior is best understood in three distinct steps: 1. Consumer preferences 2. Budget constraints 3. Consumer choices Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 31 of 52 3.1 CONSUMER PREFERENCES Market Baskets market basket (or bundle) List with specific quantities of one or more goods. TABLE 3.1 Alternative Market Baskets Chapter 2 The Basics of Supply and Demand Market Basket Units of Food Units of Clothing A 20 30 B 10 50 D 40 20 E 30 40 G 10 20 H 10 40 To explain the theory of consumer behavior, we will ask whether consumers prefer one market basket to another. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 32 of 52 3.1 CONSUMER PREFERENCES Some Basic Assumptions about Preferences 1. Completeness: Preferences are assumed to be complete. In other words, consumers can compare and rank all possible baskets. Thus, for any two market baskets A and B, a consumer Chapter 2 The Basics of Supply and Demand will prefer A to B, will prefer B to A, or will be indifferent between the two. By indifferent we mean that a person will be equally satisfied with either basket. Note that these preferences ignore costs. A consumer might prefer steak to hamburger but buy hamburger because it is cheaper. Ex- I might prefer 4 hrs of studying for ME and 4 hrs of watching my fav show over 1 hr of studying and 1.5 hr of watching Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 33 of 52 3.1 CONSUMER PREFERENCES Some Basic Assumptions about Preferences 2. More is better than less: Goods are assumed to be desirable—i.e., to be good. Consequently, consumers always prefer more of any good to less. In addition, consumers are never satisfied or satiated; more is always better, even if just a little better. This assumption is Chapter 2 The Basics of Supply and Demand made for pedagogic reasons; namely, it simplifies the graphical analysis. Ex- (4,3) is preferred to (3,2) Of course, some goods, such as air pollution, may be undesirable, and consumers will always prefer less. We ignore these “bads” in the context of our immediate discussion. 3. Transitivity: Preferences are transitive. Transitivity means that if a consumer prefers basket A to basket B and basket B to basket C, then the consumer also prefers A to C. Transitivity is normally regarded as necessary for consumer consistency. Ex- (4,3) is preferred to (3,2) is preferred to (1,1)=> (4,3) is preferred to (1,1) hrs of studying and watching Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 34 of 52 3.1 CONSUMER PREFERENCES Indifference curves Figure 3.1 Describing Individual Preferences Chapter 2 The Basics of Supply and Demand Because more of each good is preferred to less, we can compare market baskets in the shaded areas. Basket A is clearly preferred to basket G, while E is clearly preferred to A. However, A cannot be compared with B, D, or H without additional information. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 35 of 52 3.1 CONSUMER PREFERENCES Indifference curves indifference curve Curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction. Figure 3.2 Chapter 2 The Basics of Supply and Demand An Indifference Curve The indifference curve U1 that passes through market basket A shows all baskets that give the consumer the same level of satisfaction as does market basket A; these include baskets B and D. Our consumer prefers basket E, which lies above U1, to A, but prefers A to H or G, which lie below U1. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 36 of 52 3.1 CONSUMER PREFERENCES Indifference Maps indifference map Graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent. Figure 3.3 Chapter 2 The Basics of Supply and Demand An Indifference Map An indifference map is a set of indifference curves that describes a person's preferences. Any market basket on indifference curve U3, such as basket A, is preferred to any basket on curve U2 (e.g., basket B), which in turn is preferred to any basket on U1, such as D. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 37 of 52 3.1 CONSUMER PREFERENCES Indifference Maps Figure 3.4 Indifference Curves Cannot Intersect Chapter 2 The Basics of Supply and Demand If indifference curves U1 and U2 intersect, one of the assumptions of consumer theory is violated. According to this diagram, the consumer should be indifferent among market baskets A, B, and D. Yet B should be preferred to D because B has more of both goods Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 38 of 52 3.1 CONSUMER PREFERENCES The Marginal Rate of Substitution marginal rate of substitution Maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good. Figure 3.5 The Marginal Rate of Substitution Chapter 2 The Basics of Supply and Demand The magnitude of the slope of an indifference curve measures the consumer’s marginal rate of substitution (MRS) between two goods. In this figure, the MRS between clothing (C) and food (F) falls from 6 (between A and B) to 4 (between B and D) to 2 (between D and E) to 1 (between E and G). Convexity The decline in the MRS reflects a diminishing marginal rate of substitution. When the MRS diminishes along an indifference curve, the curve is convex. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 39 of 52 3.1 CONSUMER PREFERENCES Perfect Substitutes and Perfect Complements perfect substitutes Two goods for which the marginal rate of substitution of one for the other is a constant. Chapter 2 The Basics of Supply and Demand Ex- 2000 and 10 notes of 200, Amul butter and Britannia butter, fruits produced by different vendors perfect complements Two goods for which the MRS is infinite; the indifference curves are shaped as right angles. Ex- Right and left glove, Mobile phones and sim cards, Wicket and stumps Bads bad Good for which less is preferred rather than more. Ex- Pollution, Risk, Imprisonment term, Stress Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 40 of 52 3.1 CONSUMER PREFERENCES Perfect Substitutes and Perfect Complements Figure 3.6 Perfect Substitutes and Perfect Complements Chapter 2 The Basics of Supply and Demand In (a), Bob views orange juice and In (b), Jane views left shoes and apple juice as perfect substitutes: right shoes as perfect complements: He is always indifferent between a An additional left shoe gives her no glass of one and a glass of the extra satisfaction unless she also other. obtains the matching right shoe. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 41 of 52 3.1 CONSUMER PREFERENCES Utility and Utility Functions utilityNumerical score representing the satisfaction that a consumer gets from a given market basket. utility function Formula that assigns a level of utility to individual market baskets. Chapter 2 The Basics of Supply and Demand Figure 3.8 Utility Functions and Indifference Curves A utility function can be represented by a set of indifference curves, each with a numerical indicator. This figure shows three indifference curves (with utility levels of 25, 50, and 100, respectively) associated with the utility function: u(F,C) = FC Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 42 of 52 3.2 BUDGET CONSTRAINTS The Budget Line (Ex- 3 hours of study and watch time) budget constraints Constraints that consumers face as a result of limited incomes. budget line All combinations of goods for which the total amount of money spent is equal to income. Chapter 2 The Basics of Supply and Demand TABLE 3.2 Market Baskets and the Budget Line Market Basket Food (F) Clothing (C) Total Spending A 0 40 $80 B 20 30 $80 D 40 20 $80 E 60 10 $80 G 80 0 $80 Market baskets associated with the budget line F + 2C = $80 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 43 of 52 3.2 BUDGET CONSTRAINTS The Budget Line Figure 3.10 A Budget Line A budget line describes the combinations of goods that can be Chapter 2 The Basics of Supply and Demand purchased given the consumer’s income and the prices of the goods. Line AG (which passes through points B, D, and E) shows the budget associated with an income of $80, a price of food of PF = $1 per unit, and a price of clothing of PC = $2 per unit. The slope of the budget line (measured between points B and D) is −PF/PC = −10/20 = −1/2. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 44 of 52 3.2 BUDGET CONSTRAINTS The Effects of Changes in Income and Prices Figure 3.11 Effects of a Change in Income on the Budget Line Chapter 2 The Basics of Supply and Demand Income changes A change in income (with prices unchanged) causes the budget line to shift parallel to the original line (L1). When the income of $80 (on L1) is increased to $160, the budget line shifts outward to L2. If the income falls to $40, the line shifts inward to L3. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 45 of 52 3.2 BUDGET CONSTRAINTS The Effects of Changes in Income and Prices Figure 3.12 Effects of a Change in Price on the Budget Line Chapter 2 The Basics of Supply and Demand Price changes A change in the price of one good (with income unchanged) causes the budget line to rotate about one intercept. When the price of food falls from $1.00 to $0.50, the budget line rotates outward from L1 to L2. However, when the price increases from $1.00 to $2.00, the line rotates inward from L1 to L3. What happens when price of both the goods double? What happens when income and both prices double? Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 46 of 52 Understanding Budget constraints better Videos- Link for budget set- Chapter 2 The Basics of Supply and Demand https://www.econgraphs.org/graphs/micro/consumer_theory/budget_set/budget _set_affordability Link 2- https://www.econgraphs.org/graphs/micro/consumer_theory/budget_set/budget _line_intercepts Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 47 of 52 3.3 CONSUMER CHOICE The maximizing market basket must satisfy two conditions: 1. It must be located on the budget line. 2. It must give the consumer the most preferred combination of goods and services. Figure 3.13 Chapter 2 The Basics of Supply and Demand Maximizing Consumer Satisfaction A consumer maximizes satisfaction by choosing market basket A. At this point, the budget line and indifference curve U2 are tangent. No higher level of satisfaction (e.g., market basket D) can be attained. At A, the point of maximization, the MRS between the two goods equals the price ratio. At B, however, because the MRS [− (−10/10) = 1] is greater than the price ratio (1/2), satisfaction is not maximized. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 48 of 52 3.3 CONSUMER CHOICE Satisfaction is maximized (given the budget constraint) at the point where MRS = PF/PC. marginal benefit Benefit from the consumption of one Chapter 2 The Basics of Supply and Demand additional unit of a good. marginal cost Cost of one additional unit of a good. Using these definitions, we can then say that satisfaction is maximized when the marginal benefit—the benefit associated with the consumption of one additional unit of food—is equal to the marginal cost—the cost of the additional unit of food. The marginal benefit is measured by the MRS. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 49 of 52 3.3 CONSUMER CHOICE Figure 3.14 Consumer Choice of Automobile Attributes Chapter 2 The Basics of Supply and Demand The consumers in (a) are willing to trade off a considerable amount of interior space for some additional acceleration. Given a budget constraint, they will choose a car that emphasizes acceleration. The opposite is true for consumers in (b). Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 50 of 52 3.3 CONSUMER CHOICE Corner Solutions corner solution Situation in which the marginal rate of substitution for one good in a chosen market basket is not equal to the slope of the budget line. Figure 3.15 Chapter 2 The Basics of Supply and Demand A Corner Solution When a corner solution arises, the consumer maximizes satisfaction by consuming only one of the two goods. Given budget line AB, the highest level of satisfaction is achieved at B on indifference curve U1, where the MRS (of ice cream for frozen yogurt) is greater than the ratio of the price of ice cream to the price of frozen yogurt. Ex- Perfect substitutes! Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 51 of 52 * Some practice problems Chapter 2 The Basics of Supply and Demand 1. Draw indifference curves that represent the following individuals’ preferences for hamburgers and soft drinks. Indicate the direction in which the individuals’ satisfaction (or utility) is increasing. (a) Joe has convex preferences and dislikes both hamburgers and soft drinks. (b) Molly loves hamburgers and soft drinks, but insists on consuming exactly one soft drink for every two hamburgers that she eats. (c) Bill likes hamburgers but neither likes nor dislikes soft drinks (d) Mary always gets twice as much satisfaction from an extra hamburger as she does from an extra soft drink. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 8e. 52 of 52