ECO201 Intermediate Microeconomics-Topic 2-Fall 2024 PDF

ECO201 Intermediate Microeconomics Dr Amir Jahan Khan [email protected] Topic 2 Department of Economics Institute of Business Administration, Karachi Fall 2024...

ECO201 Intermediate Microeconomics Dr Amir Jahan Khan [email protected] Topic 2 Department of Economics Institute of Business Administration, Karachi Fall 2024 1 Formalities: Timetable Two lecture per week Monday & Wednesday. Lecture Slides Lecture slides/reading list will be uploaded on the LMS in advance of the lecture. (weekly plan file). Office Hours My office hours are Tuesday 08:30am to 10:30am Fauji Foundation Building. Other appointments by email only (not guaranteed). TA office hours (Ms Quratulain ) Monday 11:30am to 12:30pm Breakout 10 - Adamjee Ground Floor. 2 4 Consumption Choice Sets A consumption choice set is the collection of all consumption choices available to the consumer. What constrains consumption choice??? Budgetary, time, and other resource limitations. Copyright © 2019 Hal R. Varian Budget Constraints – 1 A consumption bundle containing x1 units of commodity 1, x2 units of commodity 2, and so on up to xn units of commodity n is denoted by the vector (x1, x2,... , xn). For two goods, the consumption bundle is (x1, x2). WLOG Commodity prices are denoted by the vector (p1, p2,... , pn). For two goods, the price vector is (p1, p2). Copyright © 2019 Hal R. Varian Budget Constraints – 2 When is a bundle (x1,... , xn) affordable at prices (p1,... , pn)? When where m is the consumer’s (disposable) income. For 2 goods, Copyright © 2019 Hal R. Varian Budget Constraints – 3 The bundles that are only just affordable form the consumer’s budget constraint. This is the set Just affordable and Bundle here m shows coonsumers budget and b shows budget set The consumer’s budget set is the set of all affordable bundles; and The budget constraint is the upper boundary of the budget set. Copyright © 2019 Hal R. Varian Budget Set and Constraint for Two Commodities – 1 Copyright © 2019 Hal R. Varian  Budget Set and Constraint for Two Commodities – 2 Banana Suppose it as a good e.g: orange Copyright © 2019 Hal R. Varian Budget Set and Constraint for Two Commodities – 3 x2 Budget constraint is m/p2 p1x1 + p2x2 = m (slope is -p1 /p2). The collection of all affordable bundles m/p1 x1 Copyright © 2019 Hal R. Varian Budget Constraints – 6 For n = 2 and x1 on the horizontal axis, the constraint’s slope is –p1/p2. What does it mean? p1 m x2 = − x1 + p2 p2 Increasing x1 by 1 must reduce x2 by p1/p2.Slope. The opportunity cost of an extra unit of commodity 1 is p1/p2 units foregone of commodity 2. Copyright © 2019 Hal R. Varian Budget Constraints – 7 Copyright © 2019 Hal R. Varian  Budget Sets & Constraints: Income and Price Changes The budget constraint and budget set depend upon prices and income. What happens as prices or income change? when income increases then budget constraint shifts towards the rights causing an increase in just affordability of quantities of both x1 and x2, increase in new affordable consumption choices. Increase in price of one good (suppose x1) shifts the budget constraint (slope) inward, reducing the amount of that good the consumer can afford while holding the price and amount of the other good constant. Copyright © 2019 Hal R. Varian How Do the Budget Set & Constraint Change as Income m Changes? Copyright © 2019 Hal R. Varian Higher Income Gives More Choice Copyright © 2019 Hal R. Varian Lower Income Shrinks the Budget Set Copyright © 2019 Hal R. Varian Budget Constraints: Income Changes – 1 Increases in income m shift the constraint outward in a parallel manner, thereby enlarging the budget set and improving choice. Decreases in income m shift the constraint inward in a parallel manner, thereby shrinking the budget set and reducing choice. No original choice is lost and new choices are added when income increases, so higher income cannot make a consumer worse off. An income decrease may (typically will) make the consumer worse off. Copyright © 2019 Hal R. Varian Budget Constraints: Price Changes – 1 What happens if just one price decreases? Suppose p1 decreases. Copyright © 2019 Hal R. Varian How Do the Budget Set & Constraint Change as p1 Decreases from p1ʹ to p1ʺ? – 1 Copyright © 2019 Hal R. Varian How Do the Budget Set & Constraint Change as p1 Decreases from p1ʹ to p1ʺ? – 2 Copyright © 2019 Hal R. Varian Budget Constraints: Price Changes – 2 Reducing the price of one commodity pivots the constraint outward. No old choice is lost and new choices are added, so reducing one price cannot make the consumer worse off. Similarly, increasing one price pivots the constraint inward, reduces choice and may (typically will) make the consumer worse off. Copyright © 2019 Hal R. Varian Uniform Ad Valorem Sales Taxes – 1 An ad valorem sales tax levied at a rate of t increases all prices by tp from p to (1+ t)p. A uniform sales tax is applied uniformly to all commodities. An ad valorem sales tax (GST) levied at a rate of 17% increases all prices by 17%, from p to (1 + 0)p = 1p. Copyright © 2019 Hal R. Varian Uniform Ad Valorem Sales Taxes – 2 A uniform sales tax levied at rate t changes the constraint from to Or equivalently, Also case of balanced inflation. Copyright © 2019 Hal R. Varian Uniform Ad Valorem Sales Taxes – 3 decreasing income or budget constraint Copyright © 2019 Hal R. Varian Uniform Ad Valorem Sales Taxes – 4 Copyright © 2019 Hal R. Varian Budget Constraints: Relative Prices – 1 “Numeraire” means “unit of account.” Suppose prices and income are measured in dollars. Say Then the constraint is: Copyright © 2019 Hal R. Varian Budget Constraints: Relative Prices – 2 If prices and income are measured in cents, then and the constraint is the same as Changing the numeraire changes neither the budget constraint nor the budget set. All that matters are relative prices and the budget we do these things for our ease in calculations (endowments). Copyright © 2019 Hal R. Varian Budget Constraints: Relative Prices – 3 The constraint for p1 = 2, p2 = 3, m = 12 is also the constraint for p1 = 1, p2 = 3/2, m = 6. Setting p1 = 1 makes commodity 1 the numeraire and defines all prices relative to p1. E.g., 3/2 is the price of commodity 2 relative to the price of commodity 1. Copyright © 2019 Hal R. Varian Budget Constraints: Relative Prices – 4 Any commodity can be chosen as the numeraire without changing the budget set or the budget constraint. Copyright © 2019 Hal R. Varian  Budget Constraints: Relative Prices – 5 Suppose p1 = 2, p2 = 3, and p3 = 6. orange banana apple banana orange Price of commodity 2 relative to commodity 1 is 3/2, apple price of commodity 3 relative to commodity 1 is 3. Relative prices are the rates of exchange of commodities 2 and 3 for units of commodity 1. For example: 2 oranges can be exchanged with 3 bananas and 1 apple can be exchanged with 3 bananas, p1x1 + x2 = m here x2 is dormatum. x2 = m - p1x1 it basically shows your budget for the second product. So, if u buy 1 Colgate then u will lose 2 dollars. Copyright © 2019 Hal R. Varian Shapes of Budget Constraints – 1 What makes a budget constraint a straight line? A straight line has a constant slope and the constraint is So, if prices are constants then a constraint is a straight line. Copyright © 2019 Hal R. Varian Shapes of Budget Constraints – 2 But what if prices are not constants? For example, bulk buying discounts, or price penalties for buying “too much.” Then constraints will be curved. Copyright © 2019 Hal R. Varian Shapes of Budget Constraints: Quantity Discounts Suppose p2 is constant at $1 but that p1 = $2 for 0  x1  20 and p1 = $1 for x1 > 20. Then the constraint’s slope is: for and for Copyright © 2019 Hal R. Varian Shapes of Budget Constraints with a Quantity Discount – 1 "kink" refers to a point on a graph where the slope changes abruptly, creating a noticeable change in the curve's direction. This change in slope shows increase in quantity which causes change in price Copyright © 2019 Hal R. Varian Shapes of Budget Constraints with a Quantity Discount – 2 At the start the graph is steep indicating that x1 has higher price as compared to x2. The slope becomes less steep beyond 20 units of x1, indicating that the price of x1 has decreased, possibly because of a quantity discount. Copyright © 2019 Hal R. Varian Shapes of Budget Constraints with a Quantity Penalty The first segment of the budget line (from the origin to the kink) is less steep implying that the price of x1 is lower initially. Beyond the kink, the budget line becomes steeper, indicating an increase in the price of x1. Copyright © 2019 Hal R. Varian Shapes of Budget Constraints: One Price Negative – 1 Commodity 1 is stinky garbage. You are paid $2 per unit to accept it; i.e., Income, other than from accepting commodity 1,is Then the constraint is or Copyright © 2019 Hal R. Varian Shapes of Budget Constraints: One Price Negative – 2 Copyright © 2019 Hal R. Varian Shapes of Budget Constraints: One Price Negative – 3 Copyright © 2019 Hal R. Varian More General Choice Sets Choices are usually constrained by more than a budget; e.g., time constraints and other resource constraints. A bundle is available only if it meets every constraint. Copyright © 2019 Hal R. Varian The Food Stamp Program – 1 Food stamps are coupons that can be legally exchanged only for food. How does a commodity-specific gift such as a food stamp alter a family’s budget constraint? Copyright © 2019 Hal R. Varian The Food Stamp Program – 2 Suppose and the price of “other goods” is The budget constraint is then Copyright © 2019 Hal R. Varian The Food Stamp Program – 3 Copyright © 2019 Hal R. Varian The Food Stamp Program – 4 till 40 free food is provided due to the stamps issued and the family's budget is increased. Copyright © 2019 Hal R. Varian