Lecture03 - Lecture 3: Consumer Choice Perlo/ Chapter 3...

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Unformatted text preview: Lecture 3: Consumer Choice Perlo/ Chapter 3 Vladimir Petkov VUW 08 March 2009 Vladimir Petkov (VUW) Lecture 3: Consumer Choice 08 March 2009 1 26 Budget Constraint Suppose that we cannot borrow or save. Then we cannot spend more than our income. Assume there are 2 goods, q 1 and q 2 , with prices p 1 and p 2 , respectively. The available income is Y . The set of bundles we can buy is de&ned by p 1 q 1 + p 2 q 2 6 Y q 1 > 0, q 2 > . The constraint p 1 q 1 + p 2 q 2 6 Y is known as the budget constraint . The line with equation p 1 q 1 + p 2 q 2 = Y is known as the budget line . The set of a/ordable bundles is called the feasible set (or the opportunity set). Vladimir Petkov (VUW) Lecture 3: Consumer Choice 08 March 2009 2 26 Budget Constraint (Continued) Imagine that p 1 = $1, p 2 = $2, Y = $500 . The graph below illustrates the opportunity set. Vladimir Petkov (VUW) Lecture 3: Consumer Choice 08 March 2009 3 / 26 Budget Constraint (Continued) We can rewrite the budget line as q 2 = ( Y & p 1 q 1 ) / p 2 . Thus, the slope of the budget line is & p 1 / p 2 . The vertical intercept (at q 1 = ) is Y / p 2 . The horizontal intercept (at q 2 = ) is Y / p 1 . q 1 q 2 2 p Y 1 p Y Slope is 2 1 1 2 p p dq dq- = Budget line equation is 1 2 1 2 2 q P p p Y q- = Vladimir Petkov (VUW) Lecture 3: Consumer Choice 08 March 2009 4 / 26 Budget Constraint (Continued) If the consumer&s budget Y increases while prices stay the same, there will be an outward parallel shift of the budget line. This will happen also if all prices fall by the same proportion, while Y remains the same. q 1 q 2 2 1 p Y 1 1 p Y 1 2 p Y 2 2 p Y 1 2 Y Y Vladimir Petkov (VUW) Lecture 3: Consumer Choice 08 March 2009 5 / 26 Budget Constraint (Continued) If the price of good 1 falls while the price of good 2 and Y remain the same, the budget line rotates outwards around the vertical intercept. q 1 q 2 1 p Y ' 1 p Y 2 p Y ' 1 1 p p Vladimir Petkov (VUW) Lecture 3: Consumer Choice 08 March 2009 6 / 26 Budget Constraint (Continued) If the price of good 2 falls while the price of good 1 and Y remain the same, the budget line rotates outwards around the horizontal intercept. q 1 q 2 1 p Y ' 2 p Y 2 p Y ' 2 2 p p Vladimir Petkov (VUW) Lecture 3: Consumer Choice 08 March 2009 7 / 26 Obtaining the Optimal Bundle Graphically Suppose that the consumer wants to choose the bundle which is: feasible (in the opportunity set); and brings the highest utility (lies on the farthest indierence curve). If this bundle is interior (both quantities are positive), it is given by the point of tangency of the budget line and the indierence curve: Vladimir Petkov (VUW) Lecture 3: Consumer Choice 08 March 2009 8 / 26 Obtaining the Optimal Bundle Graphically (Continued) However, if we have a corner solution, the indierence curve may not be tangent to the budget line....
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This note was uploaded on 05/24/2011 for the course ECON 201 taught by Professor Paulclacott during the Fall '10 term at Victoria Wellington.

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Lecture03 - Lecture 3: Consumer Choice Perlo/ Chapter 3...

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