economics for managers gtu mba sem 1 chapter 21

7/31/2019 Economics For Managers GTU MBA Sem 1 Chapter 21

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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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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


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.

economics for managers gtu mba sem 1 chapter 21

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