economics 310 chapter 3: budget lines, indifference curves, demand and the theory of consumer...

Economics 310Economics 310

Chapter 3: Budget Lines, Indifference Curves, Demand and the Theory of Consumer Choice.

Department of Economics

College of Business and Economics

California State University-Northridge

Professor Kenneth NgThursday, February 22, 2001

Administrative Details

Exam on Thursday, Oct. 4th.– Chapters 1-5

Homework due on Tuesday, Oct. 1st.– Not available yet.

In Class Problems.– Old Exam Problems.– Link on webpage.

Want a deeper understanding of the economic forces underlying the demand curve.

The plan for the remainder of the class is to look closer at the economic forces underlying the supply and demand curves.

The demand curve shows how much of a good a person or group of people will buy at any given price ceteris paribus (other things equal).

What happens when “other things” change.– Income.– Prices of related goods.– Preferences.– Taxes.

Want to be able to make positive statement like, “if income changes then …..”

To answer these questions must take an in depth look at the economic forces underlying the demand curve.

This is done using budget lines and indifference curves.

The Budget Constraint or Budget Line

The Budget Line shows the combinations of goods the consumer can afford given his or her income and the prices of the two goods.– Defined by 3 things: income and the price

of two goods.

The Budget ConstraintPints ofPepsi

Number ofPizzas

Spending onPepsi

Spending onPizza

TotalSpending

0 100 $ 0 $1,000 $1,00050 90 100 900 1,000100 80 200 800 1,000150 70 300 700 1,000200 60 400 600 1,000250 50 500 500 1,000300 40 600 400 1,000350 30 700 300 1,000400 20 800 200 1,000450 10 900 100 1,000500 0 1,000 0 1,000

The Budget Line

Any point on the budget line indicates the consumer’s combination or tradeoff between two goods.

For example, if the consumer buys no pizzas, he can afford 500 pints of Pepsi. If he buys no Pepsi, he can afford 100 pizzas.

Alternately, the consumer can buy 50 pizzas and 250 pints of Pepsi.

These points can be graphed.

The Budget Constraint Line

Quantityof Pizza

Quantityof Pepsi

50 100

Quantityof Pizza

Quantityof Pepsi

50 100

Quantityof Pizza

Quantityof Pepsi

50 100

Consumer’sbudget constraint

Quantityof Pizza

Quantityof Pepsi

50 100

Two things to know about the Budget Line. The slope of the budget line equals the relative price of the two goods,

that is, the price of one good compared to the price of the other.

– The relative price of a good is defined as the number of units of the other good that must be given up in order to get enough income to buy one more unit of the good,

• The relative price of pizza (which costs $10 each) is how many pints of Pepsi must be not consumed to save enough money to but one more pizza.

– Relative price measures the rate at which the consumer can trade one good for the other.

– The steeper the budget line the greater the relative price of the good on the horizontal axis.

The position of the budget line represents income.

– The farther out the budget line on a ray from the origin, the greater the income level it represents.

Position of the BL represents income

Suppose the persons income was reduced to $500. What would the BL look like?

Quantityof Pizza

Quantityof Pepsi

50 100

A parallel shift of the budget line represents a change in income.

The farther out budget line on a ray from the origin the more income it represents.

Slope of the BL represents relative price

Suppose the price of good B was raised from $2 to $4?

What would the new BL look like?

Quantityof Pizza

Quantityof Pepsi

50 100

Has the relative price of pizza increased or decreased?

Explain.

The relative price of pizza has decreased because the amount of Pepsi that must be given up to get one more pizza has gone down.

Budget Line Exercise (1); Draw 2 budget lines given the income and prices below.

Budget Line Exercise (1) What is the slope of the red and purple budget lines?

The slope of the budget line and relative price.

What does it mean in terms of relative price of opportunity cost to say that on the red budget line the relative price is 5/2 and on the purple budget line, the relative price is 5/8?

Which good, A or B, has a higher relative price?

In order for a person to get more good B, how much good A must the give up for each extra unit of B the get?

That amount is the relative price of opportunity cost of B.

The slope of the budget line is the relative price of the good on the horizontal axis.

By definition the relative price of good B is the amount of good A that must be given up to get one more unit of good B.

Practice Exam QuestionPoint A represents a bundle that can be purchased with $1000 whether the price of goods A and B are $2 and $5 or $ and $2.50.

A=166.67, B=133.33

Budget Line exercises The first step in using Budget Lines in economic analysis is to

be able to show how a budget line changes when there is a change in the world.

Consider the following exercises:– Suppose an individual has $500 of income. The price of

good A was $25 and the price of good B was $50.• Suppose someone gave you a non-transferable voucher

for 10 units of good B, what will budget line look like? • Suppose someone gave you a coupon for B that said 2

for the price of 1, limit free 3 units.– Advanced problem:

• the McDonald’s Value Meal Problem. Suppose an individual had $10. Big Macs cost $2 and fries cost $1. What does the budget line look like. Suppose McDonald’s has a value meal which includes a Big Mac and Fries for $2.50?

Suppose an individual has $500 of income. The price of good A was $25 and the price of good B was $50.

Suppose someone gave you a coupon for B that said 2 for the price of 1, limit free 3 units.

Advanced problem:the McDonald’s Value Meal Problem. Suppose an individual had $10. Big Macs cost $2 and fries cost $1. What does the budget line look like. Suppose McDonald’s has a value meal which includes a Big Mac and Fries for $2.50?

Indifference Curves

Quantityof Pizza

Quantityof Pepsi

A Indifferencecurve, I1

A Budget Line shows the bundles of goods which are attainable by an individual given his income and prices. A consumer’s preference among bundles of goods may be illustrated with indifference curves.An indifference curve shows bundles of goods that leave the consumer equally satisfied.

–Show bundles of goods, where if the consumer was given a choice between those bundles he wouldn’t care which bundle he receives.–The consumer is indifferent, or equally happy, with the combination of goods shown at points A, B, and C because they are all on the same indifference curve.

Indifference Curves

Quantityof Pizza

Quantityof Pepsi

Indifferencecurve, I1

The position of an indifference curve represents satisfaction, utility or happiness. The farther out an IC from the origin the happier the individual will be if he can attain a bundle on that IC.

D is preferred to A, because at D the person has more of both pepsi and pizza.

D is preferred to C, because C is equivalent to A and D is preferred to A.

The Marginal Rate of Substitution

Quantityof Pizza

Quantityof Pepsi

Indifferencecurve, I1

The slope at any point on an indifference curve is the marginal rate of substitution.

–In the broadest terms, it the value of one unit of a good to a person. –In more technical terms, it is the rate at which a consumer is willing to trade one good for another.–It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.

•Ask the person, what is the minimum number of units of the other good they must receive to get them to voluntarily give up one unit of a good—that is the goods marginal rate of substitution.

Optimization: Predicting consumer behavior.

Can use budget lines and indifference curves to generate positive statements.

Using indifference curves and budget lines, the behavior of the consumer can be stated in alternative but equivalent ways:– Choose the point on the budget line that is on the highest

indifference curve that has at least one point in common with the budget line.

– Choose the IC that is tangent to the BL. – Choose the bundle where the MRS equals the Relative

Price. • If the MRS < relative price, the person could be made

happier by consuming less of the good and more of the other good.

• If the MRS > relative price, the person could be made happier by consuming more of the good and less of the other good.

The Consumer’s Optimal Choice

Quantityof Pizza

Quantityof Pepsi

Quantityof Pizza

Quantityof Pepsi

Quantityof Pizza

Quantityof Pepsi

Quantityof Pizza

Quantityof Pepsi

Budget constraint

Quantityof Pizza

Quantityof Pepsi

Optimum

Budget constraint

MRS must equal relative price at the optimum.

Quantityof Pizza

Quantityof Pepsi

Optimum

Budget constraint

This consumer will not choose this point becausewith this bundle, the MRS is less than the relative price.Explain.

Quantityof Pizza

Quantityof Pepsi

Optimum

Budget constraint

What is the slope of the IC and BL at this point?

MRS=rise/run

For each pizza taken away, the person must receive ½ pepsi to keep him just as well off.

Relative Price=rise/run

For each pizza the person gives up, he can get 1 pepsi.

Quantityof Pizza

Quantityof Pepsi

Optimum

Budget constraint

If the person is consuming 10 pizzas and 4 Pepsis, theMRS<Relative Price.½<1

MRS: If you took away 4 units of pizza and gave him 2 units of Pepsi in exchange the person’ happiness would be unchanged.

Quantityof Pizza

Quantityof Pepsi

Optimum

Budget constraint

Relative Price of Pizza: If the person gave up 4 pizzas, he could get 4 Pepsis.

Quantityof Pizza

Quantityof Pepsi

Optimum

Budget constraint

Why does moving to the optimum make the person better off?

If you take away 4 pizzas and give him 2 Pepsis he would be indifferent, but if he game up 4 pizzas he could actually get 4 Pepsis.

How a change in income will affect the bundle of goods chosen by a person.

An increase in income shifts the budget constraint outward.– The consumer is able to choose a better

combination of goods on a higher indifference curve.

Changes in Income Affect Consumer Choices

Quantityof Pizza

Quantityof Pepsi

Quantityof Pizza

Quantityof Pepsi

Quantityof Pizza

Quantityof Pepsi

Quantityof Pizza

Quantityof Pepsi

New budget constraint

Quantityof Pizza

Quantityof Pepsi

Quantityof Pizza

Quantityof Pepsi

New optimum

Quantityof Pizza

Quantityof Pepsi

New optimum

1. An increase in income shifts the budget constraint outward…

Quantityof Pizza

Quantityof Pepsi

New optimum

2. …raising pizza consumption…

Quantityof Pizza

Quantityof Pepsi

New optimum

3. …and Pepsiconsumption.

2. …raising pizza consumption…

An increase in income can cause the consumption of a good to increase or decrease.

If a consumer buys more of a good when his or her income rises, the good is called a normal good.

If a consumer buys less of a good when his or her income rises, the good is called an inferior good.

Consider the previous example. Are Pepsis and Pizzas normal or inferior?

An Inferior Good

Quantityof Pizza

Quantityof Pepsi

An Inferior Good

Quantityof Pizza

Quantityof Pepsi

An Inferior Good

Quantityof Pizza

Quantityof Pepsi

Initial budget

constraint I1

An Inferior Good

Quantityof Pizza

Quantityof Pepsi

Initialoptimum

Initial budget

constraint

An Inferior Good

Quantityof Pizza

Quantityof Pepsi

Initial budget

constraint

Initialoptimum

An Inferior Good

Quantityof Pizza

Quantityof Pepsi

Initialoptimum

Initial budget

constraint

An Inferior Good

Quantityof Pizza

Quantityof Pepsi

Initialoptimum

New optimum

Initial budget

constraint

An Inferior Good

Quantityof Pizza

Quantityof Pepsi

New optimum

1. When an increase in income shifts the budget constraint outward...

Initial budget

constraint

Initialoptimum

An Inferior Good

Quantityof Pizza

Quantityof Pepsi

Initialoptimum

New optimum

2. ... pizza consumption rises, making pizza a normal good...

Initial budget

constraint

An Inferior Good

Quantityof Pizza

Quantityof Pepsi

Initialoptimum

New optimum

3. ... but Pepsi consumption falls, making Pepsi an inferior good.

2. ... pizza consumption rises, making pizza a normal good...

Initial budget

constraint

How a change in price will affect the bundle of goods chosen by a person.

A fall in the price of any good a compound change:– A rotation of the budget constraint.

• Change in Slope or Relative Price.– A change in position.

• Change in income-broadly defined.• The budget line shifts outward.

Changes in Prices Affect Consumer Choices

Quantity of Pizza

Quantityof Pepsi

Quantity of Pizza100

Quantityof Pepsi

I1Initial budget constraint

Quantityof Pepsi

Initial optimum

Initial budget constraint

Quantityof Pepsi

1. A fall in the price of Pepsi rotates the budget constraint outward…

Quantityof Pepsi

New optimum

Quantityof Pepsi

New optimum

2. …reducing pizza consumption…

Quantityof Pepsi

New optimum

2. …reducing pizza consumption…

3. …and raising Pepsiconsumption.

Income and Substitution Effects

A price change causes a compound effect—both the slope and position of the BL are changed. – A substitution effect-change in the slope of the BL.

• The substitution effect is the change in consumption that results from a change in the relative price of a good.

• Shown by drawing a budget line with the new relative price tangent to the original indifference curve.

– An income effect-change in the position of the BL.• The income effect is the change in consumption that

results from the change in income, broadly defined, from a change in price.

– A decrease in the price of goods and services is the same as an increase in income.

– Shown as a parallel movement of the budget line used to figure the substitution effect to the final budget line.

Quantity of Pizza

Quantityof Pepsi

Quantity of Pizza

Quantityof Pepsi

Quantity of Pizza

Quantityof Pepsi

Initial optimum

Quantity of Pizza

Quantityof Pepsi

Initial optimum

Quantity of Pizza

Quantityof Pepsi

Initial optimum

The purple budget line has the new slope but is tangent to the original indifference curve.

Quantity of Pizza

Quantityof Pepsi

Substitution effect A

Initial optimum

Substitution effect

A price change first causes the consumer to move from one point on a indifference curve to another on the indifference curve.

Quantity of Pizza

Quantityof Pepsi

Substitution effect

Initial optimum

Substitution effect

Quantity of Pizza

Quantityof Pepsi

Substitution effect

Initial optimum

Substitution effect

Quantity of Pizza

Quantityof Pepsi

Substitution effect

Initial optimum

Substitution effect

Quantity of Pizza

Quantityof Pepsi

Substitution effect

C New optimum

Initial optimum

Substitution effect

Quantity of Pizza

Quantityof Pepsi

Income effect

Substitution effect

C New optimum

Initial optimum

Substitution effect

Income effect

After moving from one point to another on the same curve, the consumer will move to another indifference curve.

Practice Exam Question.

Draw budget lines and indifference curves that show the effect of a price change when one good is normal and the other good is inferior.

Income and Substitution Effects: Inferior Good

Quantity of Pizza

Quantityof Pepsi

Quantity of Pizza

Quantityof Pepsi

Income and Substitution Effects: Inferior Good

Quantity of Pizza

Quantityof Pepsi

Initial optimum

Income and Substitution Effects: Inferior Good--Substitution Effect

Quantity of Pizza

Quantityof Pepsi

Initial optimum

Quantity of Pizza

Quantityof Pepsi

Initial optimum

The Substitution Effect shows the effect ofthe change in the relative price on the combination of the two goods chosen. It is derived by drawing a budget line witha slope incorporating the new relative pricebut tangent to the original indifference curve.

Quantity of Pizza

Quantityof Pepsi

Substitution effect A

Initial optimum

Substitution effect

A price change first causes the consumer to move from one point on a indifference curve to another on the same curve.

Income and Substitution Effects: Inferior Good--Income Effect

Quantity of Pizza

Quantityof Pepsi

Substitution effect

Initial optimum

Substitution effect

Quantity of Pizza

Quantityof Pepsi

Substitution effect

Initial optimum

Substitution effect

Quantity of Pizza

Quantityof Pepsi

Substitution effect

Initial optimum

Substitution effect

Quantity of Pizza

Quantityof Pepsi

Substitution effect

CNew optimum

Initial optimum

Substitution effect

Quantity of Pizza

Quantityof Pepsi

Income effect

Substitution effect

C New optimum

Initial optimum

Substitution effect

Income effect

Pepsi is an inferior good because the parallel shift outward of budgetline (income change) caused theconsumption of Pepsi to decline.

Deriving the Demand Curve The demand curve shows the amount of a good

purchased by a person at different prices. – The relationship between price and quantity

purchased. Budget lines and indifference curves can be used to

show how a change in the price of a good affects the amount purchased.

Budget lines and indifference curves can be used to derive a person’s demand curve.

Deriving the Demand Curve:

The Consumer’s Optimum

Quantityof Pizza

Quantityof Pepsi

The Demand Curve for Pepsi

50 Quantityof Pepsi

Price ofPepsi

Demand

At a price of $2, the person buys 50 Pepsis.

What would happen if the price of Pepsi fell to $1?

Substitution and Income Effects: Review Graphical Analysis: Showing the substitution and income Effects

of a price change.– Substitution Effect first.

– Draw a BL with the new slope tangent to the original IC.• Why is this the effect of a change in the relative price?

– Income Effect is the rest. Theoretical Points.

– The Substitution Effect is always the same.• When a goods relative price falls, the Substitution Effect causes a

increase in the amount of the good purchased.

– The Income Effect varies depending on whether the good is normal or inferior.

• A drop in price causes an increase in income, broadly defined. This increase income will cause an increase in the amount of a good purchased if the good is normal and a decrease if the good is inferior.

• An increase in price causes a decrease in income, broadly defined. This decrease income will cause a decrease in the amount of a good purchased if the good is normal and an increase if the good is inferior.

Substitution and Income Effects: Review (2) Operational Significance: Why do we care about the

Substitution and Income Effects.– Because the Substitution and Income effects can work in

opposition, it is possible that the effect of a price change can be counter-intuitive i.e. a drop in price can cause an increase in consumption.

– This can only occur if one good is inferior.

Budget Line and Indifference Curve Analysis: Example 1.

Budget lines and indifference curves are flexible analytical tools that can be used to analyze many questions.

For instance, how do wages affect the supply of labor?– Question: can an increase in a person’s wage

make him work less? If the substitution effect is greater than the income

effect for the worker, he or she works more. If income effect is greater than the substitution effect,

he or she works less.

Hours of Leisure0

Consumption

Optimum

$5,000

•The first step in any analysis using budget lines and indifference curves is deciding what goes on the axes.Setting up the problem: What goes on the axes?

•The second step is to show the change in the world as a shift in budget lines or indifference curves.

Hours of LaborSupplied

Hour ofLeisure

Consumption

(a) For a person with these preferences…

. . . the labor supply curve slopes upward.

3. and hours of labor increase.

1. When the wage rises…

2. …hours of leisure decrease…

Show indifference curves and budget lines for a person whose supply curve is upward sloping, i.e. an increase in the wage makes him work more hours.

Hours ofLeisure

I 2BC2

Consumption

(a) For a person with these preferences…

2. …hours of leisure increase…

1. When the wage rises…

Hours of LaborSupplied

. . . the labor supply curve slopes backward.

3. and hours of labor decrease.

Show indifference curves and budget lines for a person whose supply curve is upward sloping, i.e. and increase in the wage makes him work more hours.

How do interest rates affect household saving—another example of substitution and income effects.

Can use indifference curves and budget lines to analyze consumption decisions made over time.

Can an increase in interest rates cause a decrease in savings?– If the substitution effect of a higher interest rate is greater than the

income effect, households save more.

– If the income effect of a higher interest rate is greater than the substitution effect, households save less.

Thus, an increase in the interest rate could either encourage or discourage saving.

Consumptionwhen Young

Consumptionwhen Old

$110,000

100,000

55,000

$50,000

Optimum

Budgetconstraint

Consider a person who makes $100,000 when young and nothing when old.

What does his budget constraint between consumption when young and old look like?

What goes on the axes?

At the optimum, is the person borrowing or lending money?

What is the interest rate?

Lending at 10%.

(a) Higher Interest Rate Raises Saving

(b) Higher Interest Rate Lowers Saving

Consumptionwhen Old

Practice Exam Question (Part 1): Show BL’s and IC’s that depict a person who saves more when interest rates rise and a person who saves less when interest rates rise.

How will an increase in interest rates affect the BL?

Consumptionwhen Old

1. A higher interest rate rotates the budget constraint outward . . .

2. . . . resulting in lower consumption when youngand, thus, higher saving.

2. . . . resulting in higherconsumption when youngand, thus, lower saving.

Practice Exam Question (Part 2): How can a the person in (b) be saving less but have more Consumption When Old?

Consumptionwhen Old

Practice Exam Question (Part 3): On which graph (a) or (b) is Consumption when old an inferior good? Explain and show graphically.

IncomeEffect

Income

Effect

Do the poor prefer to receive cash or in-kind transfers?

Examples of in-kind transfers:– Food Stamps.– “Free” public schools.– Subsidized student loans. – Free college tuition.

If an in-kind transfer of a good forces the recipient to consume more of the good than he would on his own, then the recipient prefers the cash transfer.

If the recipient does not consume more of the good than he would on his own, then the cash and in-kind transfer have exactly the same effect on his consumption and welfare.

It would always be better to give a poor person a cash transfer rather than an in-kind transfer because the cash transfer would at worst leave everyone the same as a transfer in-kind and would leave some people better off.

Cash Transfer In-Kind Transfer(a) The Constraint Is Not Binding

NonfoodConsumption

$1,000

BC2 (with $1,000 cash)

BC2 (with $1,000 food stamps)

NonfoodConsumption

If the constraint is not binding, the fact that the person received an in-kind transfer rather than a cash transfer with equivalent value, does not lower his utility, happiness, or the indifference curve he can get onto.

Therefore, if the constraint is not binding, the person doesn’t care whether he receives an in-kind or cash transfer.

NonfoodConsumption

$1,000

Cash Transfer(b) The Constraint Is Binding

$1,000

In-Kind TransferFood

A BI 2I 1

I 2I 1

NonfoodConsumption

Cash Transfer In-Kind Transfer(a) The Constraint Is Not Binding

NonfoodConsumption

$1,000

NonfoodConsumption

Homework

Available on website. Due Oct. 2nd. Two versions.

– Do the version for the class where you will hand the homework in.

No late homeworks.

Problem China earns $1000 a month dealing poker at the Hustler casino. She lives with her boyfriend and he pays for rent and food

when they eat at home. Her only monthly expenses are clothing and eating out. Eating out costs $20 and a new outfit costs $200.

– Draw China’s budget line and indifference curves between clothing and eating out if she eats out every day of the month (assume there are 30 days in the month). Put eating out on the vertical axis and clothing on the horizontal axis.

– At the end of November, China gets on the scale and finds she has gained 10 lbs. (too much greasy Asian food). She looks in the mirror and is disgusted with how she looks.

• Depict on you graph how her budget lines and/or indifference curves would shift.• What has happened to the marginal rate of substitution at her current consumption bundle? Explain.• Using the marginal rate of substitution and the relative price explain and depict how looking in the mirror will

affect China’s behavior.– At the end of December, China gets on the scale again and finds she has lost 20 lbs. She looks in the mirror and

can’t keep a smile off her face. She looks in her closet and decides that her clothing is way too conservative for such a fly girl.

• Depict on you graph how her budget lines and/or indifference curves would shift.• What has happened to the marginal rate of substitution at her current consumption bundle? Explain.• Using the marginal rate of substitution and the relative price explain and depict how looking in the mirror will

affect China’s behavior.– In January, she wins a $1000 jackpot while playing poker. In the same month, her sister graduates from FIDM (The

Fashion and Design Merchandising School) and gets a job as an assistant designer in the Los Angeles fashion industry. This means she can get clothing at a 50% discount.

• Depict the change if eating out is an inferior good. • Label on your graph all income and substitution effects.• Is it possible that China could get thinner, better looking, and more fashionable in January? Explain and depict.

Draw China’s budget line and indifference curves between clothing and eating out if she eats out every day of the month (assume there are 30 days in the month).

At the end of November, China gets on the scale and finds she has gained 10 lbs. (too much greasy Asian food). She looks in the mirror and is disgusted with how she looks.Depict on you graph how her budget lines and/or indifference curves would shift.What has happened to the marginal rate of substitution at her current consumption bundle? Explain.Using the marginal rate of substitution and the relative price explain and depict how looking in the mirror will affect China’s behavior.

At point A, the IC has become steeper.

The value of clothing has increased relative to eating out.

The MRS of eating out has gone done, i.e. food is less valued.

China adjusts her consumption bundle from A to B, consuming less food and more clothing.

In January, she wins a $1000 jackpot while playing poker. In the same month, her sister graduates from FIDM (The Fashion and Design Merchandising School) and gets a job as an assistant designer in the Los Angeles fashion industry. This means she can get clothing at a 50% discount. Depict the change if eating out is an inferior good. Label on your graph all income and substitution effects.Is it possible that China could get thinner better looking and more fashionable in January? Explain and depict.

The parallel movement of the budget line from green to purple depicts the effect of winning of the $1000 jackpot.

When the budget line shifts out, China moves from consumption bundle B to C.

Since eating out is an inferior good, her consumption of food falls as she moves from B to C.

In January, she wins a $1000 jackpot while playing poker. In the same month, her sister graduates from FIDM (The Fashion and Design Merchandising School) and gets a job as an assistant designer in the Los Angeles fashion industry. This means she can get clothing at a 50% discount. Depict the change if eating out is an inferior good. Label on your graph all income and substitution effects.Is it possible that China could get thinner better looking and more fashionable in January? Explain and depict.

The rotation of the budget line depicts the effect be able to get clothing at a 50% discount.

The rotation causes a substitution and an income effect.

The S-effect is depicted by drawing an IC with the new slope tangent to the old IC (C to D).

The I-effect is depicted as the parallel shift of the budget line from dotted brown to solid black (D to E).

Because eating out is an inferior good, eating out declines as a result of the I-effect.

Problem Suntaree is a dealer at the Hollywood Park Casino in Inglewood. Her two great joys in life are playing

poker (Texas Hold Em) and wearing designer clothes. Working as a dealer she makes $10 per hour and works 40 hours a week for 4 weeks a month. A complete designer outfit, including shoes, costs $400. Unfortunately, she is a lousy card player and loses every time she plays.

– When Suntaree plays in a low stakes poker game she loses $10 an hour. Draw Suntaree's monthly budget line between designer outfits and hours playing poker and her indifference curves if you observe her playing 20 hours of poker a week. remember you are drawing her monthly budget line). Assume there are 4 weeks in each month.

– As a dealer Suntaree meets all the regular players most of whom are scrubs. One week she is approached by one of the regulars. He is old, ugly, has a nasty personality but has lots of cash. He offers to give Suntaree $50 in chips each day to play poker if she would date him. Draw her monthly budget line if you observe her dating the player and notice her wearing 4 new designer outfits in the next month. Assume there are 28 days in each month. Is poker a normal or inferior good? Show on your budget line and indifference curve graph. Assume that the chips can be redeemed for cash.

– The next month one of other regular players, who is younger, good looking, and has a pleasant personality, approaches Suntaree and asks why such a nice girl is dating such a loser. Suntaree answers, "I don't like him much, but I like wearing designer clothing and playing poker more." The good looking player thinks long and hard and then makes the following offer. If Suntaree dumps her boyfriend and dates him, he will take her to the mall once a month and she can buy as many designer outfits as she wants and he will pick up 87.5% of the cost, i.e. she pays $50 and he pays $350 of the cost of each outfit. Will Suntaree switch boyfriends? Explain using budget lines and indifference curves.

– Show on your graph how much it would cost her original boyfriend to keep from getting dumped.

When Suntaree plays in a low stakes poker game she loses $10 an hour. Draw Suntaree's monthly budget line between designer outfits and hours playing poker and her indifference curves if you observe her playing 20 hours of poker a week. remember you are drawing her monthly budget line). Assume there are 4 weeks in each month

Income=40*4*10=$1600

Max Outfits=$1600/400=4 outfits

Max Poker=$1600/10=160 hrs.

As a dealer Suntaree meets all the regular players most of whom are scrubs. One week she is approached by one of the regulars. He is old, ugly, has a nasty personality but has lots of cash. He offers to give Suntaree $50 in chips each day to play poker if she would date him. Draw her monthly budget line if you observe her dating the player and notice her wearing 4 new designer outfits in the next month. Assume there are 28 days in each month. Is poker a normal or inferior good? Show on your budget line and indifference curve graph. Assume that the chips can be redeemed for cash.

Scrub’s Offer=$50*28=$1400

Income while dating scrub=$1600+$1400=$3000

Max outfits=$3000/400=7.5

Poker and Outfits are normal goods because when her income increased, her consumption of designer outfits and poker playing increased.

The next month one of other regular players, who is younger, good looking, and has a pleasant personality, approaches Suntaree and asks why such a nice girl is dating such a loser. Suntaree answers, "I don't like him much, but I like wearing designer clothing and playing poker more." The good looking player thinks long and hard and then makes the following offer. If Suntaree dumps her boyfriend and dates him, he will take her to the mall once a month and she can buy as many designer outfits as she wants and he will pick up 87.5% of the cost, i.e. she pays $50 and he pays $350 of the cost of each outfit. Will Suntaree switch boyfriends? Explain using budget lines and indifference curves.

With either players offer, Suntaree can afford 4 outfits and 140 hours of playing poker.

Show on your graph how much it would cost her original boyfriend to keep from getting dumped

Problem John earns $60,000 a year and lives in Los Angeles. His girlfriend lives in

New York. A round trip ticket from Los Angeles to New York costs $500. John usually flies to New York once a month to see his girlfriend.

– Draw budget lines and indifference curves to illustrate John's situation. (hint: do everything based on a year's consumption).

– Suppose a new low cost carrier begins service on the Los Angeles to New York route. The new carrier charges only $300 for a round trip ticket. Show how the low cost carrier affects John's budget line. Is it possible for the cheaper price of seeing his girlfriend to reduce the number of visits John makes? Illustrate this situation on you graph.

– Suppose the original airline institutes a frequent flier program. A round trip from New York to Los Angeles is 6000 miles. If John flies 24,000 miles he will get one free round trip ticket. If he flies 42,000 miles he will get 2 free tickets. For every 12,000 miles he flies above 42,000 miles he will get one additional ticket. Draw budget lines and indifference curves (if possible) showing John staying with the original airline. Draw budget lines and indifference curves showing John switching to the low cost airlines even after the frequent flier program is started.

John earns $60,000 a year and lives in Los Angeles. His girlfriend lives in New York. A round trip ticket from Los Angeles to New York costs $500. John usually flies to New York once a month to see his girlfriend.Draw budget lines and indifference curves to illustrate John's situation. (hint: do everything based on a year's consumption).

Draw Budget Line and Indifference Curves.

Suppose a new low cost carrier begins service on the Los Angeles to New York route. The new carrier charges only $300 for a round trip ticket. Show how the low cost carrier affects John's budget line. Is it possible for the cheaper price of seeing his girlfriend to reduce the number of visits John makes? Illustrate this situation on you graph.

When airfare drops to $300, if the person spent all of his income on airfare he could make 200 trips instead of 120.

The drop in the price creates an income and substitution effect.

Is it possible for reduced airfare to reduce the number of visits John makes?

It is possible for the decrease in airfare to cause John to visit his girlfriend less.

Visiting his girlfriend is an inferior good.

The substitution effect makes him visit more and the income effect makes him visit less. The income effect dominates so overall he visits his girlfriend less.

Suppose the original airline institutes a frequent flier program. A round trip from New York to Los Angeles is 6000 miles. If John flies 24,000 miles he will get one free round trip ticket. If he flies 42,000 miles he will get 2 free tickets. For every 12,000 miles he flies above 42,000 miles he will get one additional ticket. Draw budget lines and indifference curves (if possible) showing John staying with the original airline. Draw budget lines and indifference curves showing John switching to the low cost airlines even after the frequent flier program is started.

4 trips=24,000 miles=>1 free trip

7 trips=42,000 miles=>2 free trips

113 trips=678,000 miles =>56.5 more free trips.

Draw budget lines and indifference curves showing John switching to the low cost airlines even after the frequent flier program is started.

The budget line for the $300 fare is everywhere farther out than the frequent flyer budget line, therefore, the John will always shift to the low cost airline.

Problem 4Consider a person who earns $2000 a month and is considering whether to send their child to a

public or a private school. Suppose the public school is a take it or leave it proposition. The state decides how much to spend per student and the parents have no control over curriculum, hiring and firing teachers, etc. At private schools, parents have more choice. By choosing among different private schools, they choose how much education their children receive. By choosing a more expensive school, they can buy their children more education.

A. Draw the budget line(s) facing this person. Now draw two sets of indifference curves. One set showing an individual who chooses to send their child to a public school where the state spends $500 per student and another set for an individual who would send their child to a private school that costs $800. Assume the private school costs $800 per month and attending private school precludes attending public school.

B. Read the article about donations to public schools. If parents can augment the money the state spends on the public schools how will this change the budget line you drew in part A? Draw the budget line if schools are free to accept voluntary contributions.

C. Suppose two competing initiatives are put on the ballot. One provides for a voucher which can be used to send your child to public school or can be used to pay for up to $500 of private schooling. Any cost of private schooling over $500 must be paid by the individual. The second provides for 50% reimbursement of the cost of private schooling up to $1000, i.e. if you spend $800 on private schooling, the government will reimburse you for $400. The total reimbursement cannot exceed $500. Draw budget lines depicting the two initiatives.

D. Who would vote for which initiative? Draw indifference curves showing a person who would prefer the voucher and indifference curves showing a person who prefers the 50% reimbursement up to $500.

Education

All OtherGoods

Draw the budget line(s) facing this person. Now draw two sets of indifference curves. One set showing an individual who chooses to send their child to a public school where the state spends $500 per student and another set for an individual who would send their child to a private school that costs $800. Assume the private school costs $800 per month and attending private school precludes attending public school.

Education2000

All OtherGoods

0 $800

Public School

Private School

Does this person prefer private of public school?

Draw the budget line(s) facing this person. Now draw two sets of indifference curves. One set showing an individual who chooses to send their child to a public school where the state spends $500 per student and another set for an individual who would send their child to a private school that costs $800. Assume the private school costs $800 per month and attending private school precludes attending public school.

Education2000

All OtherGoods

0 $800

Public School

Private School

Does the person with the red IC’s prefer public or private school?

Read the article about donations to public schools. If parents can augment the money the state spends on the public schools how will this change the budget line you drew in part A? Draw the budget line if schools are free to accept voluntary contributions.

Education2000

All OtherGoods

0 $800

Public School

Private School

Suppose two competing initiatives are put on the ballot. One provides for a voucher which can be used to send your child to public school or can be used to pay for up to $500 of private schooling. Any cost of private schooling over $500 must be paid by the individual. The second provides for 50% reimbursement of the cost of private schooling up to $1000, i.e. if you spend $800 on private schooling, the government will reimburse you for $400. The total reimbursement cannot exceed $500. Draw budget lines depicting the two initiatives..

Education$2000

All OtherGoods

0 $500

$500 Voucher

50% Reimbursement

$2500$1000

Who would vote for which initiative? Draw indifference curves showing a person who would prefer the voucher and indifference curves showing a person who prefers the 50% reimbursement up to $500.

Education$2000

All OtherGoods

0 $500

$500 Voucher

50% Reimbursement

$2500$1000

The $500 voucher would win because the green budget line is everywhere farther out from the origin than the red budget line.

Study Guide Things to know.

– Terminology: Comparative Advantage, Marginal Rate of Substitution, Specialization and Exchange, etc.

– Results: Be able to demonstrate.

• Effects of Free Exchange.

• Effects of Exchange between more different people.

• Substitution and Income Effects of a price change.

• Income Effect of a Normal and Inferior good.

• Cash vs. In-Kind Transfers.

• Effect of an increase in interest rates or wages rates on savings and labor supply.

– Analysis:

• Use analytical tools, budget lines and indifference curves, to engage in economic analysis.

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