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Author:
Prof. Sharif Memon
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The budget constraint depicts theconsumption bundles that a consumer canafford.
People consume less than they desire becausetheir spending is constrained, or limited, bytheir income.
It shows the various combinations of goodsthe consumer can afford given his or herincome and the prices of the two goods.
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Pints ofPepsi Number ofPizzas Spendingon Pepsi Spendingon Pizza TotalSpending
0 100 $ 0 $1,000 $1,00050 90 100 900 1,000
100 80 200 800 1,000
150 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
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Any point on the budget constraint line
indicates the consumers combination or
tradeoff between two goods.
For example, if the consumer buys no
pizzas, he can afford 500 pints of Pepsi
(point B). If he buys no Pepsi, he canafford 100 pizzas (point A).
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Quantity
of Pizza
Quantityof Pepsi
0
Consumersbudget constraint
500 B
100
A
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Quantity
of Pizza
Quantityof Pepsi
0
250
50 100
500B
C
A
Consumersbudget constraint
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The slope of the budget constraint line
equals the relative price of the two goods,
that is, the price of one good compared tothe price of the other.
It measures the rate at which the
consumer will trade one good for theother.
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An indifference curve shows
bundles of goods that make the
consumer equally happy.
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Quantityof Pizza
Quantityof Pepsi
0
C
B
A Indifferencecurve, I1
D
I2
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The consumer is indifferent, or equally
happy, with the combinations shown at
points A, B, and C because they are all onthe same curve.
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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
substitute one good for another.
It is the amount of one good that a consumer
requires as compensation to give up one unitof the other good.
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Quantityof Pizza
Quantityof Pepsi
0
C
B
A
D
Indifferencecurve, I1
I21MRS
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Higher indifference curves are
preferred to lower ones.
Indifference curves are downward
sloping.
Indifference curves do not cross.
Indifference curves are bowed
inward.
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1MRS= 1
8
3
Indifferencecurve
A
Quantity
of Pizza
Quantityof Pepsi
0
14
2
3
7
B
1
MRS= 6
4
6
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Perfect substitutes
Perfect complements
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Two goods with straight-line
indifference curves are perfectsubstitutes.
The marginal rate of substitution is a fixed
number.
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Dimes0
Nickels
21
4
2
I1I2
6
3
I3
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Two goods with right-angle
indifference curves are perfect
complements.
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Right Shoes0
LeftShoes
75
7
5 I1
I2
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Consumers want to get the combination
of goods on the highest possible
indifference curve.
However, the consumer must also end
up on or below his budget constraint.
Consumer optimum occurs at the point
where the highest indifference curve andthe budget constraint are tangent.
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Quantity
of Pizza
Quantityof Pepsi
0
I1
I2
I3
Budget constraint
AB
Optimum
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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.
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Quantityof Pizza
Quantityof Pepsi
0
I1
I2
2. raising pizza consumption
3. and Pepsiconsumption.
Initialoptimum
New budget constraint
1. An increase in income shifts
the budget constraint outward
Initialbudget
constraint
New optimum
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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.
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New budget constraint
1. When an increase in income shifts
the budget constraint outward...
Quantityof Pizza
Quantity
of Pepsi
0
Initialoptimum
I1
New optimum
I2
2. ... pizza consumption rises,
making pizza a normal good...
3. ... but Pepsiconsumptionfalls, makingPepsi aninferior good.
Initialbudget
constraint
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A fall in the price of any good rotates the
budget constraint outward and changes
the slope of the budget constraint.
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Quantity of Pizza100
Quantityof Pepsi
1,000
500
0
I1
New budget constraint
3. and
raising Pepsiconsumption.
Initial budgetconstraint
2. reducing pizza consumption
1. A fall in the price of Pepsirotates the budget constraintoutward
New optimum
I2
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Economists use the term Giffen good to
describe a good that violates the law of
demand.
Giffen goods are inferior goods for which
the income effect dominates the
substitution effect.
They have demand curves that slope
upwards.
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Quantity
of Meat
A
Quantity ofPotatoes
0
E
C
I2
I1
Initial budget constraint
New budgetconstraint
D
B
Optimum with lowprice of potatoes
Optimum with high
price of potatoes
1. An increase in the price ofpotatoes rotates the budget...
2...whichincreasespotatoconsumption
if potatoesare a Giffengood.