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Economics 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 Ng
Thursday, 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 Constraint
Pints of
Pepsi
0
50
100
150
200
250
300
350
400
450
500
Number of Spending on Spending on
Pizzas
Pepsi
Pizza
100
90
80
70
60
50
40
30
20
10
0
$ 0
100
200
300
400
500
600
700
800
900
1,000
$1,000
900
800
700
600
500
400
300
200
100
0
Total
Spending
$1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
1,000
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
Quantity
of Pepsi
500
250
0
50
100
Quantity
of Pizza
The Budget Constraint Line
Quantity
of Pepsi
500
B
250
0
50
A
100
Quantity
of Pizza
The Budget Constraint Line
Quantity
of Pepsi
500
B
250
Consumer’s
budget constraint
0
50
A
100
Quantity
of Pizza
The Budget Constraint Line
Quantity
of Pepsi
500
250
B
C
Consumer’s
budget constraint
0
50
A
100
Quantity
of Pizza
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?
Quantity
of Pepsi
500
250
B
A parallel shift of the budget line
represents a change in income.
C
The farther out budget line on a
ray from the origin the more
income it represents.
Consumer’s
budget constraint
0
50
A
100
Quantity
of Pizza
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?
Quantity
of Pepsi
500
Has the relative price of pizza
increased or decreased?
B
Explain.
250
C
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.
Consumer’s
budget constraint
0
50
A
100
Quantity
of Pizza
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 Question
Point 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?
A Budget
Indifference
Curves
Quantity
of Pepsi
C
B
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.
A
0
Indifference
curve, I1
Quantity
of Pizza
Indifference
Curves
Quantity
of Pepsi
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.
C
B
D
I2
A
0
Indifference
curve, I1
Quantity
of Pizza
The Marginal Rate of
Substitution
Quantity
of Pepsi
MRS
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.
1
Indifference
curve, I1
0
Quantity
of Pizza
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
Quantity
of Pepsi
I1
0
Quantity
of Pizza
The Consumer’s Optimal Choice
Quantity
of Pepsi
I1
0
I2
Quantity
of Pizza
The Consumer’s Optimal Choice
Quantity
of Pepsi
I3
I1
0
I2
Quantity
of Pizza
The Consumer’s Optimal Choice
Quantity
of Pepsi
I3
I1
I2
Budget constraint
0
Quantity
of Pizza
The Consumer’s Optimal Choice
Quantity
of Pepsi
Optimum
I3
I1
I2
Budget constraint
0
Quantity
of Pizza
MRS must equal relative price at the
optimum.
Quantity
of Pepsi
This consumer will not
choose this point because
with this bundle, the
MRS is less than the
relative price.
Explain.
Optimum
I3
I1
I2
Budget constraint
0
Quantity
of Pizza
MRS must equal relative price at the
optimum.
What is the slope of the
IC and BL at this point?
Quantity
of Pepsi
MRS=rise/run
Relative
Price=rise/run
Optimum
=2/4
=4/4
=1/2
=1
For each pizza the
taken
person
away,gives
the he
up,
person
can get
must
1 receive
pepsi. ½
pepsi to keep him just as well
off.
8
6
4
I1
I2
Budget constraint
0
6
10
Quantity
of Pizza
MRS must equal relative price at the
optimum.
If the person is consuming
Quantity
of Pepsi
Optimum
10 pizzas and 4 Pepsis, the
MRS<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.
8
6
4
I1
I2
Budget constraint
0
6
10
Quantity
of Pizza
MRS must equal relative price at the
optimum.
If the person is consuming
Quantity
of Pepsi
Optimum
10 pizzas and 4 Pepsis, the
MRS<Relative Price.
½<1
Relative Price of Pizza: If
the person gave up 4
pizzas, he could get 4
Pepsis.
8
6
4
I1
I2
Budget constraint
0
6
10
Quantity
of Pizza
MRS must equal relative price at the
optimum.
If the person is consuming
Quantity
of Pepsi
Optimum
If you take away 4 pizzas
and give him 2 Pepsis he
would be indifferent, but
if he game up 4 pizzas
I2
he could actually get 4
I1
Pepsis.
Budget constraint
8
6
4
0
10 pizzas and 4 Pepsis, the
MRS<Relative Price.
½<1
Why does moving to the
optimum make the
person better off?
6
10
Quantity
of Pizza
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
Quantity
of Pepsi
0
Quantity
of Pizza
Changes in Income Affect
Consumer Choices
Quantity
of Pepsi
I1
0
Quantity
of Pizza
Changes in Income Affect
Consumer Choices
Quantity
of Pepsi
I1
0
Quantity
of Pizza
Changes in Income Affect
Consumer Choices
Quantity
of Pepsi
New budget constraint
I1
0
Quantity
of Pizza
Changes in Income Affect
Consumer Choices
Quantity
of Pepsi
New budget constraint
I2
I1
0
Quantity
of Pizza
Changes in Income Affect
Consumer Choices
Quantity
of Pepsi
New budget constraint
New optimum
I2
I1
0
Quantity
of Pizza
Changes in Income Affect
Consumer Choices
Quantity
of Pepsi
New budget constraint
1. An increase in income shifts
the budget constraint outward…
New optimum
I2
I1
0
Quantity
of Pizza
Changes in Income Affect
Consumer Choices
Quantity
of Pepsi
New budget constraint
1. An increase in income shifts
the budget constraint outward…
New optimum
I2
I1
0
2. …raising pizza consumption…
Quantity
of Pizza
Changes in Income Affect
Consumer Choices
Quantity
of Pepsi
New budget constraint
1. An increase in income shifts
the budget constraint outward…
New optimum
3. …and Pepsi
consumption.
I2
I1
0
2. …raising pizza consumption…
Quantity
of Pizza
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
An Inferior Good
Quantity
of Pepsi
0
Quantity
of Pizza
An Inferior Good
Quantity
of Pepsi
I1
0
Quantity
of Pizza
An Inferior Good
Quantity
of Pepsi
Initial budget
constraint
I1
0
Quantity
of Pizza
An Inferior Good
Quantity
of Pepsi
Initial
optimum
Initial budget
constraint
I1
0
Quantity
of Pizza
An Inferior Good
Quantity
of Pepsi
New budget constraint
Initial
optimum
Initial budget
constraint
I1
0
Quantity
of Pizza
An Inferior Good
Quantity
of Pepsi
New budget constraint
Initial
optimum
Initial budget
constraint
I1
0
I2
Quantity
of Pizza
An Inferior Good
Quantity
of Pepsi
New budget constraint
Initial
optimum
New optimum
Initial budget
constraint
I1
0
I2
Quantity
of Pizza
An Inferior Good
Quantity
of Pepsi
New budget constraint
Initial
optimum
1. When an increase in income shifts
the budget constraint outward...
New optimum
Initial budget
constraint
I1
0
I2
Quantity
of Pizza
An Inferior Good
Quantity
of Pepsi
New budget constraint
Initial
optimum
1. When an increase in income shifts
the budget constraint outward...
New optimum
Initial budget
constraint
I1
I2
0
2. ... pizza consumption rises,
making pizza a normal good...
Quantity
of Pizza
An Inferior Good
Quantity
of Pepsi
3. ... but Pepsi
consumption
falls, making
Pepsi an
inferior good.
New budget constraint
Initial
optimum
1. When an increase in income shifts
the budget constraint outward...
New optimum
Initial budget
constraint
I1
I2
0
2. ... pizza consumption rises,
making pizza a normal good...
Quantity
of Pizza
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 Pepsi
0
Quantity of Pizza
Changes in Prices Affect
Consumer Choices
Quantity
of Pepsi
500
I1
0
100
Quantity of Pizza
Changes in Prices Affect
Consumer Choices
Quantity
of Pepsi
500
Initial budget constraint
0
I1
100
Quantity of Pizza
Changes in Prices Affect
Consumer Choices
Quantity
of Pepsi
500
Initial optimum
Initial budget constraint
0
I1
100
Quantity of Pizza
Changes in Prices Affect
Consumer Choices
Quantity
of Pepsi
1. A fall in the price of Pepsi
rotates the budget constraint
outward…
500
Initial budget constraint
0
I1
100
Quantity of Pizza
Changes in Prices Affect
Consumer Choices
Quantity
of Pepsi
1,000
New budget constraint
1. A fall in the price of Pepsi
rotates the budget constraint
outward…
500
Initial budget constraint
0
I1
100
Quantity of Pizza
Changes in Prices Affect
Consumer Choices
Quantity
of Pepsi
1,000
New budget constraint
1. A fall in the price of Pepsi
rotates the budget constraint
outward…
500
Initial budget constraint
0
I1
100
I2
Quantity of Pizza
Changes in Prices Affect
Consumer Choices
Quantity
of Pepsi
1,000
New budget constraint
New optimum
1. A fall in the price of Pepsi
rotates the budget constraint
outward…
500
Initial budget constraint
0
I1
100
I2
Quantity of Pizza
Changes in Prices Affect
Consumer Choices
Quantity
of Pepsi
1,000
New budget constraint
New optimum
1. A fall in the price of Pepsi
rotates the budget constraint
outward…
500
Initial budget constraint
0
I1
I2
Quantity of Pizza
100
2. …reducing pizza consumption…
Changes in Prices Affect
Consumer Choices
Quantity
of Pepsi
1,000
New budget constraint
New optimum
1. A fall in the price of Pepsi
rotates the budget constraint
outward…
500
3. …and
raising Pepsi
consumption.
Initial budget constraint
0
I1
I2
Quantity of Pizza
100
2. …reducing pizza consumption…
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.
Income and Substitution Effects
Quantity
of Pepsi
0
Quantity of Pizza
Income and Substitution Effects
Quantity
of Pepsi
Initial budget
constraint
I1
0
Quantity of Pizza
Income and Substitution Effects
Quantity
of Pepsi
Initial optimum
A
Initial budget
constraint
I1
0
Quantity of Pizza
Income and Substitution Effects
Quantity
of Pepsi
Initial optimum
A
Initial budget
constraint
I1
0
Quantity of Pizza
Income and Substitution Effects
Quantity
of Pepsi
The purple budget line
has the new slope but is
tangent to the original
indifference curve.
B
Initial optimum
A
Initial budget
constraint
I1
0
Quantity of Pizza
Income and Substitution Effects
Quantity
of Pepsi
A price change first causes the
consumer to move from one point
on a indifference curve to another
on the indifference curve.
B
Substitution
effect
Initial optimum
A
Initial budget
constraint
I1
0
Quantity of Pizza
Substitution effect
Income and Substitution Effects
Quantity
of Pepsi
New budget constraint
B
Substitution
effect
Initial optimum
A
Initial budget
constraint
I1
0
Quantity of Pizza
Substitution effect
Income and Substitution Effects
Quantity
of Pepsi
New budget constraint
B
Substitution
effect
Initial optimum
A
Initial budget
constraint
I1
0
Quantity of Pizza
Substitution effect
Income and Substitution Effects
Quantity
of Pepsi
New budget constraint
B
Substitution
effect
Initial optimum
A
I2
Initial budget
constraint
I1
0
Quantity of Pizza
Substitution effect
Income and Substitution Effects
Quantity
of Pepsi
New budget constraint
C New optimum
B
Substitution
effect
Initial optimum
A
I2
Initial budget
constraint
I1
0
Quantity of Pizza
Substitution effect
Income and Substitution Effects
After moving from one point to another
on the same curve, the consumer
will move to another indifference curve.
Quantity
of Pepsi
New budget constraint
C New optimum
Income effect
B
Substitution
effect
Initial optimum
A
I2
Initial budget
constraint
I1
0
Quantity of Pizza
Substitution effect
Income effect
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 Pepsi
0
Quantity of Pizza
Income and Substitution Effects: Inferior Good
Quantity
of Pepsi
Initial budget
constraint
I1
0
Quantity of Pizza
Income and Substitution Effects: Inferior Good
Quantity
of Pepsi
Initial optimum
A
Initial budget
constraint
I1
0
Quantity of Pizza
Income and Substitution Effects: Inferior Good--Substitution Effect
Quantity
of Pepsi
Initial optimum
A
Initial budget
constraint
I1
0
Quantity of Pizza
Income and Substitution Effects: Inferior Good--Substitution Effect
Quantity
of Pepsi
The Substitution Effect shows the effect of
the change in the relative price on the
combination of the two goods chosen.
It is derived by drawing a budget line with
a slope incorporating the new relative price
but tangent to the original indifference curve.
B
Initial optimum
A
Initial budget
constraint
I1
0
Quantity of Pizza
Income and Substitution Effects: Inferior Good--Substitution Effect
Quantity
of Pepsi
A price change first causes the
consumer to move from one point
on a indifference curve to another
on the same curve.
B
Substitution
effect
Initial optimum
A
Initial budget
constraint
I1
0
Quantity of Pizza
Substitution effect
Income and Substitution Effects: Inferior Good--Income Effect
Quantity
of Pepsi
New budget constraint
B
Substitution
effect
Initial optimum
A
Initial budget
constraint
I1
0
Quantity of Pizza
Substitution effect
Income and Substitution Effects: Inferior Good--Income Effect
Quantity
of Pepsi
New budget constraint
B
Substitution
effect
Initial optimum
A
Initial budget
constraint
I1
0
Quantity of Pizza
Substitution effect
Income and Substitution Effects
Quantity
of Pepsi
New budget constraint
B
Substitution
effect
Initial optimum
A
I2
Initial budget
constraint
I1
0
Quantity of Pizza
Substitution effect
Income and Substitution Effects: Inferior Good--Income Effect
Quantity
of Pepsi
New budget constraint
B
C
Substitution
effect
New optimum
A
Initial optimum
I2
Initial budget
constraint
I1
0
Quantity of Pizza
Substitution effect
Income and Substitution Effects: Inferior Good--Income Effect
Quantity
of Pepsi
New budget constraint
Pepsi is an inferior good because
the parallel shift outward of budget
line (income change) caused the
consumption of Pepsi to decline.
B
Income effect
Substitution
effect
Initial budget
constraint
A
C New optimum
Initial optimum
I2
I1
0
Quantity of Pizza
Substitution effect
Income effect
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
Quantity
of Pepsi
The Demand Curve for Pepsi
Price of
Pepsi
New budget constraint
150
B
I2
50
A
At a price of $2,
the person buys 50
Pepsis.
$2
What would
happen if the price
of Pepsi fell to $1?
1
A
B
Demand
I1
0 Initial budget
constraint
Quantity
of Pizza
0
50
150 Quantity
of Pepsi
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.
•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?
Consumption
$5,000
•The second step is to show the
change in the world as a shift in
budget lines or indifference curves.
Optimum
2,000
I 3
I2
I 1
0
60
100
Hours of Leisure
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.
(a) For a person with these
preferences…
Wage
Consumption
. . . the labor supply curve slopes upward.
1. When the
wage rises…
BC1
BC2 I2
I1
0
2. …hours of leisure
decrease…
Hour of
Leisure
0
Hours of Labor
Supplied
3. and hours of labor increase.
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.
(a) For a person with these
preferences…
Consumption
BC1
. . . the labor supply curve slopes backward.
Wage
1. When the
wage rises…
BC2 I 2
I1
0
2. …hours of leisure
increase…
Hours of
Leisure
0
Hours of Labor
Supplied
3. and hours of labor decrease.
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.
Consumption
when Old
Budget
constraint
Consider a person who makes
$100,000 when young and nothing
when old.
$110,000
What does his budget constraint
between consumption when young
and old look like?
What goes on the axes?
55,000
At the optimum,
is the person
borrowing or
lending money?
Optimum
What is the
interest rate?
I1
0
$50,000
100,000
Lending at 10%.
Consumption
when Young
(a) Higher Interest Rate
Raises Saving
Consumption
when Old
(b) Higher Interest Rate
Lowers Saving
Consumption
when Old
How will an increase
in interest rates affect
the BL?
0
0
Consumption
when Young
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.
(a) Higher Interest Rate
Raises Saving
Consumption
when Old
(b) Higher Interest Rate
Lowers Saving
Consumption
when Old
BC 2
BC 2
1. A higher interest rate
rotates the budget
constraint outward . . .
BC
1
1. A higher interest rate
rotates the budget
constraint outward . . .
BC1
I2
I1
0
2. . . . resulting in lower
consumption when young
and, thus, higher saving.
I
I
1
0
2. . . . resulting in higher
consumption when young
and, thus, lower saving.
2
Consumption
when Young
Practice Exam Question (Part 2): How can a the person in (b) be
saving less but have more Consumption When Old?
(a) Higher Interest Rate
Raises Saving
Consumption
when Old
(b) Higher Interest Rate
Lowers Saving
Consumption
when Old
BC 2
BC 2
Income
Effect
Income
BC
1
Effect
I2
I
I1
0
0
I
1
2
Consumption
when Young
Practice Exam Question (Part 3): On which graph (a) or (b)
is Consumption when old an inferior good? Explain and
show graphically.
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 inkind transfer because the cash transfer would at worst leave everyone the same
as a transfer in-kind and would leave some people better off.
(a) The Constraint Is Not Binding
Cash Transfer
In-Kind Transfer
Food
Food
BC2 (with $1,000 cash)
BC
$1,000
0
1
B
A
BC2 (with $1,000 food stamps)
BC
1
I2
$1,000
I1
Nonfood
0
Consumption
B
I2
A
I1
Nonfood
Consumption
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.
(a) The Constraint Is Not Binding
Cash Transfer
In-Kind Transfer
Food
BC2 (with $1,000 cash)
BC2 (with $1,000 food stamps)
Food
BC
1
$1,000
B
A
BC
1
I2
I2
$1,000
A
I1
0
B
I1
Nonfood 0
Consumption
Nonfood
Consumption
(b) The Constraint Is Binding
Cash Transfer
In-Kind Transfer
Food
BC 2 (with $1,000 cash)
BC 2 (with $1,000 food stamps)
Food
BC
BC
1
$1,000
C
$1,000
A
0
1
B
I1
A
I2
Nonfood 0
Consumption
B
I 1
I 3I 2
Nonfood
Consumption
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).
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 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.
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
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.
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.
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
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 4
Consider 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.
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.
All Other
Goods
0
Education
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.
All Other
Goods
Public School
$2000
Does this person prefer private
of public school?
Private School
0
$500
$800
2000
Education
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.
All Other
Goods
Public School
$2000
Does the person with the red IC’s
prefer public or private school?
Private School
0
$500
$800
2000
Education
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.
All Other
Goods
$2000
Public School
Private School
0
$800
2000
Education
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..
All Other
Goods
$2000
50% Reimbursement
$1500
$500 Voucher
0
$500 $1000
$2000
Education
$2500
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.
All Other
Goods
The $500 voucher would win because the green
budget line is everywhere farther out from the origin
than the red budget line.
$2000
50% Reimbursement
$1500
$500 Voucher
0
$500 $1000
$2000
Education
$2500
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.