For example, if the consumer buys no pizzas, he can afford pints of Pepsi point B. If he buys no Pepsi, he can afford pizzas point A. It measures the rate at which the consumer can trade one good for the other. An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction. The Consumers Preferences The consumer is indifferent, or equally happy, with the combinations shown at points A, B, and C because they are all on the same curve.
The Marginal Rate of Substitution The slope at any point on an indifference curve is the marginal rate of substitution. 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. Four Properties of Indifference Curves Higher indifference curves are preferred to lower ones. Indifference curves are downward sloping.
Indifference curves do not cross. Indifference curves are bowed inward. Property 1: Higher indifference curves are preferred to lower ones. Consumers usually prefer more of something to less of it.
Higher indifference curves represent larger quantities of goods than do lower indifference curves. Property 2: Indifference curves are downward sloping. A consumer is willing to give up one good only if he or she gets more of the other good in order to remain equally happy. If the quantity of one good is reduced, the quantity of the other good must increase. For this reason, most indifference curves slope downward. Property 3: Indifference curves do not cross. Points A and B should make the consumer equally happy.
Points B and C should make the consumer equally happy. This implies that A and C would make the consumer equally happy. Each of us has a budget that limits the extent of our consumption.
Economists call this limit a budget constraint. Any additional money spent on gasoline is money that is not available for other goods and services and vice-versa. This is why the budget constraint is called a constraint. The budget constraint is governed by income on the one hand, how much money a consumer has available to spend on consumption, and the prices of the goods the consumer purchases on the other.
What are some of the budget implications for a consumer who owns a hybrid car? What purchase decisions might this consumer make given his or her savings on gas, and how does this, in turn, affect the goals of the tax subsidy policy?
LO1: Define a budget constraint, conceptually, mathematically, and graphically. LO2: Interpret the slope of the budget line. LO3: Illustrate how changes in prices and income alter the budget constraint and budget line. LO4: Illustrate how coupons, vouchers, and taxes alter the budget constraint and budget line. We assume that the consumer has a budget — an amount of money available to spend on bundles.
For now, we do not worry about where this money or income comes from, we just assume a consumer has a budget. So what can a consumer afford? Answering this depends on the prices of the goods in question. Suppose you go to the campus store to purchase energy bars and vitamin water. Mathematically, the total amount the consumer spends on two goods, A and B, is:.
If the money the consumer has to spend on the two goods, his income, is given as I, then the budget constraint is:. Note the inequality: This equation states that the consumer cannot spend more than his income but can spend less. We can simplify this assumption by restricting the consumer to spending all of his income on the two goods. This will allow us to focus on the frontier of the budget constraint.
As we shall see in Module 4, this assumption is consistent with the more-is-better assumption — if you can consume more if your income allows it you should because you will make yourself better off. With this assumption in place, we can write the budget constraint as:.
Graphically, we can represent this budget constraint as in Figure 3. We call this the budget line : The line that indicates the possible bundles the consumer can buy when spending all his income.
Figure 3. From the graph of the budget constraint in section 3. This makes intuitive sense: If you buy more of one good, you are going to have to buy less of the other good. We can find the slope of the budget line easily by rearranging equation 3. Note that in our graph, B is the good on the vertical axis, so we will rearrange our equation to look like a standard function with B as the dependent variable:.
Note that the slope of the budget line is simply the ratio of the prices, also known as the price ratio. This is the rate at which you can trade one good for the other in the marketplace. The Slope Effect : The relative price of movies is now higher, while the relative price of T-shirts is now lower.
The last type of change is when both price and income change. To plot the new budget line, follow the same steps as before:. These changes have interesting effects. While the slope effect has clearly made the relative price of T-shirts lower, the size effect is uncertain.
These effects are implicit in the income and substitution effects we will explore shortly. Though we understand the different ways by which consumers can exhaust their income, we have not yet discussed how to determine which bundles of goods different consumers prefer.
In the diagram below, a consumer maximizes utility by choosing point A, given BL1. Suppose that both good x is normal and good y is inferior, and the budget line shifts to BL2. Which of the following could be the new optimal consumption choice? Skip to content Topic 6: Consumer Theory. Learning Objectives By the end of this section, you will be able to:.
Understand budget lines Explain price ratios Recreate budget lines after prices and income changes.
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