Consumer Choices are Constrained Unconstrained choice: infinite amount of food and clothing

1
Consumer Choices are ConstrainedUnconstrained
choice infinite amount of food and clothing
Heaven on Earth
clothing
B
A
U1
C
U0
U-1
food
2
Constraint is the consumers budget
Heaven on Earth
clothing
unaffordable
B
A
U1
C
U0
U-1
food
3
Budget Constraint

• Y PF F PC C
• Given
• Y income level
• PF Price of Food
• PC Price of Clothing
• Choices
• F Quantity of Food
• C Quantity of Clothing

4
Deriving a graphical representationThe budget
line

• Y PF F PC C
• To put this into the same space with C on the
  vertical axis and F on the horizontal axis, solve
  for C
• PC C Y - PF F
• C (Y/ PC ) - (PF / PC )F

Slope
Constant
5
Deriving a graphical representation (continued)

• C (Y/ PC ) - (PF / PC )F
• Suppose Y 100
• PF 5
• PC 1
• C (100/ 1 ) - (5/ 1 )F
• C 100 - 5 F

Constant
Slope
6
C (Y/ PC ) - (PF / PC )FY100 PC 1 PF 5
C
Note slope is (opportunity cost of food)
-(PF/PC) -amount of clothing given up to buy
food -5 units of clothing
100
C 100 - 5 F
20
F
7
Budget Set All combinations of goods that lie
on or inside the budget line
C
100
Not affordable
affordable
20
F
8
Budget Set All combinations of goods that lie
on or inside the budget line
Budget constraint Consumption Possibility
Frontier
C
100
Consumer options Picture of purchasing power of
income
20
F
9
What happens when income rises?
C
100
C 100 - 5 F
20
F
10
What happens when income rises?C (Y/ PC ) -
(PF / PC )FY200 PC 1 PF 5
200
C
C 200 - 5 F
100
C 100 - 5 F
40
20
F
11
What happens when income rises?Parallel shift
outward in budget line
200
C
C 200 - 5 F
100
Gain in consumer options
C 100 - 5 F
40
20
F
12
What happens when price of food rises?
C
100
C 100 - 5 F
20
F
13
What happens when price of food rises?C (Y/
PC ) - (PF / PC )FY100 PC 1 PF 10
C
100
C 100 - 5 F
C 100 - 10 F
20
10
F
14
What happens when price of food rises?Slope -
(PF / PC ) gets bigger in magnitudefrom -(5/1)
to -(10/1)
C
100
C 100 - 5 F
C 100 - 10 F
Loss of consumer options
20
10
F
15
What happens when price of clothing falls?
C
100
C 100 - 5 F
20
F
16
What happens when price of clothing falls?C
(Y/ PC ) - (PF / PC )FY100 PC 0.5 PF 5
200
C
C 200 - 10 F
100
C 100 - 5 F
20
F
17
What happens when price of clothing falls?Slope
of budget line steepens from -(5/1) to -(5/0.5)
200
C
C 200 - 10 F
100
Gain of consumer options
C 100 - 5 F
20
F
18
Recall that indifference curves represent a
relationship between C and F
C
Heaven on Earth
100
U2
U1
U0
20
F
19
Combine budget line with indifference curve
C
100
C
B
U2
U1
A
U0
20
F
20
Optimum slope of the budget line slope of
the indifference curve
C
100
(PF / PC) (MUF / MUC)
B
U1
20
F
21
Response to an income increase both goods normal
C
100
(PF / PC) (MUF / MUC) at new income level
B
U1
20
35
F
22
Income effects
C Normal F inferior
C
100
Both F and C Normal
B
F Normal C inferior
U1
20
35
F
23
Response to a price change Price of food rises
Substitution effect A to B Incentive to consume
more of other goods when the price of food
rises As price of food rises, substitute toward
Clothing and away from Food
C
100
B
A
U1
20
F
24
Response to a price change Price of food rises
Income effect As price of food rises, budget set
shrinks REAL Income falls Tend to reduce
consumption of both goods if they are normal
C
100
B
C
U1
20
F
25
Response to a price change Price of food rises
Income effect B to C Cant afford Point A anymore
C
100
B
A
C
U1
Lost real income
20
F
26
Response to a price change Price of food rises
Total effect Income effect substitution
effect A to C Substitution effect toward C,
away from F Income effect away from C, away from
F Total effect income effect subst effect
C
100
B
A
C
U1
20
F
27
Response to a price change Price of food rises
Total effect Income effect substitution
effect A to C Substitutes Substitution effect
dominates the income effect so clothing demand
rises when price of food rises
C
100
C1
A
C
C0
U1
20
F
28
Response to a price change Price of food rises
Total effect Income effect substitution
effect A to C Complements Income effect
dominates the substitution effect so clothing
demand falls when price of food rises
C
100
A
C
C0
C1
U1
20
F
29
Application Response to a housing price
differential, Ames and San Francisco
All other goods
A
OA
UAmes
HA
Housing
30
Deriving an individual demand curve Let price of
food rise
C
P F 5 14 10 7 15 4
F
4
7
14
31
Individual demand
15
10
Demand
5
F
4 7 14
32
From individual to market demand

• Draw several individual demands and add up
  quantities

Market (12)
2
P
P
P
1
F
17
F
7
F
10