SF Intermediate Economics 2005/06

1. SF Intermediate Economics2005/06 Francis O’Toole

2. CONSUMER THEORY We will look at • Scarcity: income and prices • Tastes • Combine scarcity and tastes (i) Individual demand (ii) Market demand

3. SCARCITY 2 Products (Goods or Services): X1 and X2 Fixed money income: M Given prices: p1 and p2 Income constraint: p1X1 + p2X2 = M Rearranging, X2=M/p2 – (p1/p2)X1 Slope: X2/ X1= - (p1/p2)

4. Budget Set and Constraint for Two Products x2 Budget constraint is p1x1 + p2x2 = m m /p2 x1 m /p1

5. Budget Set and Constraint for Two Products x2 Budget constraint is p1x1 + p2x2 = m m /p2 x1 m /p1

6. Budget Set and Constraint for Two Products x2 m /p2 Just affordable x1 m /p1

7. Budget Set and Constraint for Two Products x2 m /p2 Not affordable Just affordable x1 m /p1

8. Budget Set and Constraint for Two Products x2 m /p2 Not affordable Just affordable Affordable (irrational) x1 m /p1

9. Budget Set and Constraint for Two Products x2 m /p2 the collection of all affordable bundles. Budget Set x1 m /p1

10. Budget Set and Constraint for Two Products x2 p1x1 + p2x2 = m Re-arranging (as before) x2 = - (p1/p2)x1 + m/p2 so slope is – (p1/p2) m /p2 Budget Set x1 m /p1

11. SCARITY Budget Constraint M/p2 X2 p1X1+p2X2 = M Slope X2/ X1= - (p1/p2) M/p1 Budget Set X1 The slope of the income constraint represents society’s willingness to trade; to increase consumption of product 1 by 1 unit, an individual must decrease consumption of product 2 by P1/P2 units. “OPPPORTUNITY COST”

12. CHANGES IN INCOME CONSTRAINTINCOME CHANGES X2 A parallel shift in the budget constraint Note: Slope remains unchanged X1

13. INCOME CHANGES • No original choice is lost and new choices are added when income increases, so higher income will make a consumer better off. • Trade off between products [– (p1/p2)] remains unchanged. • An income decrease will make the consumer worse off.

14. How do the budget set and budget constraint change as p1decreases (from p10 to p11)? x2 m/p2 P11<P10 Ratio of P1/P2 changes Slope changes Original budget set m/p10 x1 m/p11

15. How do the budget set and budget constraint change as p1decreases from p10 to p11? x2 m/p2 -p10/p2 Original budget set m/p10 x1 m/p11

16. How do the budget set and budget constraint change as p1decreases from p10 to p11? x2 m/p2 New affordable choices -p10/p2 Original budget set m/p10 x1 m/p11

17. How do the budget set and budget constraint change as p1decreases from p10 to p1? x2 m/p2 New affordable choices Budget constraint pivots; slope flattens from -p10/p2 to -p11/p2 -p10/p2 Original budget set -p11/p2 m/p10 x1 m/p11

18. PRICE CHANGES • Reducing the price of one commodity pivots the constraint outward. No old choice is lost and new choices are added, so reducing one price cannot make the consumer worse off. • Trade off between products [– (p1/p2)] is changed. • Similarly, increasing one price pivots the constraint inwards, reduces choice and cannot make the consumer better off.

19. PRICE CHANGES II Claim: A doubling of all prices is equivalenttohalving income. P1X1+P2X2=M Let all prices change by a factor of t (e.g. t = 2) (tP1)X1+(tP2)X2=M  P1X1+P2X2=M/t (i.e. equivalent to a parallel shift in the income constraint) (Relatuve prices remain unchanged.)

20. COMPOSITE PRODUCT n products? P1X1 + P2X2 + …….. + PnXn=M P1X1+ [P2X2 + P3X3 + …….. + PnXn]=M [P2X2 + P3X3 + …….. + PnXn]representsincome spent on all products other than product 1, that is, income spent on a composite product.

21. COMPOSITE PRODUCT X2 Composite product X1

22. INCOME CONSTRAINT and TAXES Excise tax: (P1+t)X1+P2X2=M Value added tax: (1+T)P1X1+P2X2=M Lump Sum tax: P1X1+P2X2=M - (LumpSum) Think about • Income constraint and subsidies • Income constraint and rationing