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PPA 723: Managerial Economics

PPA 723: Managerial Economics. Lecture 6: Household Budget Constraints. Managerial Economics, Lecture 6: Budget Constraints. Outline Household Budget Constraints Price Indexes. Managerial Economics, Lecture 6: Budget Constraints. The Household Budget Constraint

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PPA 723: Managerial Economics

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  1. PPA 723: Managerial Economics Lecture 6: Household Budget Constraints

  2. Managerial Economics, Lecture 6: Budget Constraints Outline • Household Budget Constraints • Price Indexes

  3. Managerial Economics, Lecture 6: Budget Constraints The Household Budget Constraint • A household budget constraint sets income equal to spending • We do not consider savings or borrowing, but the analysis could be extended to them.

  4. Managerial Economics, Lecture 6: Budget Constraints Graphing the Budget Constraint • In this equation, the Q’s are variables, Y and the P’s are fixed constants. • The usual forms for a line with variables x (horizontal axis) and y (vertical axis) are:

  5. Managerial Economics, Lecture 6: Budget Constraints • To express a budget constraint in this form, • Step 1: Switch sides: • Step 2: SubtractPBQB from both sides • Step 3: Divide both sides by PA

  6. Managerial Economics, Lecture 6: Budget Constraints Budget Constraint QA Y P / Infeasible set A Slope = -PB/PA Opportunity set Y / P QB B

  7. Managerial Economics, Lecture 6: Budget Constraints Interpretation • A intercept = maximum possible amount of A • B intercept = maximum possible amount of B

  8. Managerial Economics, Lecture 6: Budget Constraints • Slope = trade-off between the two goods: • Slope shows units of A one can obtain by giving up a unit of B at market prices: • If a household gives up one unit of A (the rise is -1), it frees up PA of income. • $1 of income buys 1/PB units of B. • So giving up one unit of A allows the household to buy PA/PB units of B (the run). • Hence, the rise over the run (the slope!) is -PB/PA.

  9. Managerial Economics, Lecture 6: Budget Constraints Budget Constraint (from Textbook) • Lisa spends all her income, Y, on pizza and burritos • Her budget constraint is • pB B= expenditure on B (burritos) • pz Z = expenditure on Z (pizzas)

  10. Managerial Economics, Lecture 6: Budget Constraints Figure 4.6 Budget Constraint B , Burritos per semester a = 25 Y / p B b 20 1 L ( p = $1, Y = $50) Z c 10 Opportunity set d 0 10 30 50 = Y / p Z Z , Pizzas per semester

  11. Managerial Economics, Lecture 6: Budget Constraints Slope of Budget Constraint, Cont. • Textbook calls the slope the marginal rate of transformation • In the book’s example:

  12. Managerial Economics, Lecture 6: Budget Constraints Figure 4.7a Changes in the Budget Constraint (a) Price of Pizza Doubles B , Burritos per semester 25 1 L ( p = $1) Z Loss 2 L ( p = $2) Z 0 25 50 Z , Pizzas per semester

  13. Managerial Economics, Lecture 6: Budget Constraints Figure 4.7b Changes in the Budget Constraint (b) Income Doubles B , Burritos per semester 50 3 = L ( Y $100) 25 Gain 1 = L ( Y $50) 0 50 100 Z , Pizzas per semester

  14. Managerial Economics, Lecture 6: Budget Constraints Changes in the Budget Constraint—Case c (c) Free Pizza B , Burritos per semester 50 4 L ( Y = $50, 50 Free Pizzas) 25 Gain 1 = L ( Y $50) 0 50 100 Z , Pizzas per semester

  15. Managerial Economics, Lecture 6: Budget Constraints Inflation • Inflation is a general rise in prices. • It affects commodity prices and input prices, such as wages. • What happens to the budget constraint if income and prices increase by the same percentage? • Answer: Nothing!!!

  16. Managerial Economics, Lecture 6: Budget Constraints • General inflation therefore has no effect on real opportunities. • Inflation may still have real consequences: • Inflation tends to increase uncertainty and thereby lower investment and slow growth. • In some cases inflation can help promote a country’s trade – and hence its economic development. • Inflation redistributes toward those who anticipated it or are insured against it.

  17. Managerial Economics, Lecture 6: Budget Constraints Price Indexes • Although general inflation does not shift the budget constraint, income and prices do not always move together. • So how can one compare possibilities for consumption in two different years? • Answer: Construct a price index, and use it to calculate real income.

  18. Managerial Economics, Lecture 6: Budget Constraints • Start with consumption by a typical household (quantity for each of N goods and services), called a market basket. • Figure out how much it costs to buy this market basket at the prices in year t:

  19. Managerial Economics, Lecture 6: Budget Constraints • A price index is the amount a household must spend for the market basket in year t relative to some (arbitrary) base year, say 2000. • All price indexes have a base year. • The 100 is just for convenience.

  20. Managerial Economics, Lecture 6: Budget Constraints • To translate a dollar variable between nominal and real terms, divide by the price index: • Example: Nominal income is $30,000 in 2010 and $20,000 in 2000. The price index (with a 2000 base) is 150 in 210. So real income (in 2000 dollars) is $20,000 in both years.

  21. Managerial Economics, Lecture 6: Budget Constraints Extensions • Changing the base year • The index number problem • Which price index to use

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