Budget lines

Consumer Theory (Consumer Theory (BudgetsBudgets))
The Budget LineThe Budget Line

Change in the BudgetChange in the Budget
The Budget Line
Change in the PriceChange in the Price
Income and Substitution EffectsIncome and Substitution Effects
Parts to learn in this PPT:Parts to learn in this PPT:
Combine Budget line andCombine Budget line and
Indifference curveIndifference curve

- describes the limits to consumption
choices and depends on a consumer’s
budget and the prices of goods and
services.
Not the same thing as aNot the same thing as a
Marginal Utility CurveMarginal Utility Curve oror Demand CurveDemand Curve,,
it is more like ait is more like a PPF curvePPF curve
Budget LineBudget Line

Example ofExample of
buying gum orbuying gum or
waterwater

Ian has 8¥ a day to spend on two
goods: bottled water and gum.
The price of water is 2¥ a bottle.
The price of gum is 1¥ a pack.
Example:

Ian’s income: 8¥
Prices: PF = 2¥ per water bottle
PM = 1¥ per pack of gum
A. If Ian spends all his income on water,
how many bottle does he buy?
A. 8¥ / 2¥
= 4 bottles of water
Question practice:Question practice:

Ian’s income: 8¥
Prices: PF = 2¥ per water bottle
PM = 1¥ per pack of gum
B. If Ian spends all his income on gum,
how many packs does he buy?
B. 8¥ / 1¥
= 8 packs of gum

Ian has 8¥ a day to spend on two goods: bottled water and gum.
The price of water is 2¥ a bottle.
The price of gum is 1¥ a pack.

The budget line separates combinations that are
affordable from combinations that are unaffordable.

Any point outside of this
curve is impossible
The shaded area
represents all possible
combinations of
production possible if it
is perfectly efficient or
not.
The Production Possibilities Frontier (PPF)
What it shows…
Similar ideaSimilar idea
as thisas this

The slope of the budget constraint equalsThe slope of the budget constraint equals
- the rate at which a person- the rate at which a person
can trade one good for another.can trade one good for another.
- the opportunity cost of a good in terms- the opportunity cost of a good in terms
of another goodof another good
(continued…)(continued…)

The slope of the budget constraint equalsThe slope of the budget constraint equals
 The rate at which IanThe rate at which Ian
can trade gum for water.can trade gum for water.
 The opportunity cost of a water inThe opportunity cost of a water in
terms of gum.terms of gum.
 The relative price of each:The relative price of each:
Price of water
Price of gum =
2¥
1¥ =
2 gum packs per
water bottles

Prices and the Slope of the Budget LinePrices and the Slope of the Budget Line
You can think of the slope of the budget line as anYou can think of the slope of the budget line as an
opportunity cost.opportunity cost.
Another name for opportunity cost is:Another name for opportunity cost is:
- Which is the price of one
good in terms of another
good.
- It equals the price of one
good divided by the price of
another good and equals the
slope of the budget line.
Relative PriceRelative Price

When a budget decreases, consumption possibilities shrink.When a budget decreases, consumption possibilities shrink.

Budget – 8rmbBudget – 8 ¥
Budget – 4¥
An decrease in the budget
shifts the budget line leftward.
The slope of the
budget line doesn’t
change because
prices have not
changed.
Consumer Theory (BudgetsBudgets)

When a budget decreases, consumption possibilities shrink.When a budget decreases, consumption possibilities shrink.
When a budget increases, consumption possibilities expandWhen a budget increases, consumption possibilities expand

An increase in the
budget
shifts the budget
line rightward.
Again, the slope of the
budget line doesn’t
change because
prices have not
changed.
Budget – 8¥
Budget – 4 ¥
Budget – 12¥

If it is aIf it is a NORMAL GOODNORMAL GOOD
Rise in income = rise in quantity demanded
of that good

If it is anIf it is an INFERIOR GOODINFERIOR GOOD
Rise in income = fall in quantity demanded
of that good

Budget – 8 ¥
Budget – 4 ¥
Budget – 12 ¥
When a budget
decreases,
consumption
possibilities
shrink.
When a budget
increases,
consumption
possibilities
expand

Continuing thisContinuing this
example of buyingexample of buying
gum or watergum or water

Change in the price of waterChange in the price of water

If the price of one good falls and the budget remain theIf the price of one good falls and the budget remain the
same, consumption possibilities expand.same, consumption possibilities expand.

Price water = 2 ¥¥ Price gum = 1 ¥¥ Budget = 8 ¥¥
Price – 2 ¥
P= 2 ¥

Fall in the price of water..
P=2 ¥
P=1 ¥
P= 2 ¥ P= 1 ¥
When the price of
water falls from 2
to 1, the budget line
rotates outward and
becomes less
steep.

If the price of one good falls and the budget remain theIf the price of one good falls and the budget remain the
same, consumption possibilities expand.same, consumption possibilities expand.
If the price of one good rises and budget remain the same,If the price of one good rises and budget remain the same,
consumption possibilities shrink.consumption possibilities shrink.

P= 2 ¥
P=2 ¥
Price water =Price water = 2 ¥2 ¥ Price gum =Price gum = 1 ¥1 ¥ Budget =Budget = 8 ¥8 ¥

Rise in the price of water.Rise in the price of water.
P= 4 ¥ P= 2 ¥
P=2 ¥
P=4 ¥
When the price of
water rises from 2
to 4, the budget line
rotates inward and
becomes steeper.

Prices and the Slope of the Budget LinePrices and the Slope of the Budget Line
You’ve just seen that when the price of one good changes and theYou’ve just seen that when the price of one good changes and the
price of the other good remains the same, the slope of the budget lineprice of the other good remains the same, the slope of the budget line
changes.changes.
when the price of water falls, the budget line becomes lesswhen the price of water falls, the budget line becomes less
steep.steep.
when the price of water rises, the budget line becomes steeper.when the price of water rises, the budget line becomes steeper.
You can think of the slope of the budget line as an opportunity cost.You can think of the slope of the budget line as an opportunity cost.
The slope tells us how many packs of gum a bottle of water costs.The slope tells us how many packs of gum a bottle of water costs.

((IncomeIncome and SubstitutionSubstitution Effects)Effects)
If the price of a good increases there are two effects:
2.) The increase in price reduces disposable income and this lower
income may reduce demand.
1.) The good is relatively more expensive than alternative
goods and people can switch to other goods.
Both effects can happen at the same time. They can
both move in the same direction, or they can move
in opposite directions, with the net effect of one
being strong then the other.

IncomeIncome and Substitution EffectsSubstitution Effects
The SubstitutionThe Substitution
EffectEffect
- measures how much the higher
price encourages consumers to use
other goods, assuming the same level
of income.
- It will encourage consumers to
buy alternative goods.
If the price of a good increases:

If the price of a water increases (and normal goods):
Relatively less expensive so buy more
Relatively more expensive so buy less
Gum =
Water =
Substitution EffectsSubstitution Effects Gum and Water example:Gum and Water example:

IncomeIncome and Substitution EffectsSubstitution Effects
The SubstitutionThe Substitution
EffectEffect
- measures how much the higher
price will lead to lower demand overall
- Consumers feel poorer
therefore buy less
(if it’s a normal good)
If the price of a good increases:
The Income
Effect

If the price of a water increases (and normal goods):
Gum =
person feels relatively “poorer” so buy lessWater =
person feels relatively “poorer” might buy less
Income EffectsIncome Effects Gum and Water example:Gum and Water example:
*** Real Income was
decreased

GoodGood Income EffectIncome Effect Substitution effectSubstitution effect total effecttotal effect
Gum
Water
Poorer
= buy
less
Poorer
= buy
less
Relatively
cheaper so buy
more
Relatively more
expensive so buy
less
Income and
Substitution
effect act in
opposite
direction =
ambiguous
Income and
Substitution
effect act in same
direction = buy
less
SummarySummary
If the price of a water increases:

P=2¥
P=4¥
Equimarginal Principle
- Rise in price changes
consumption from A to B
AA
B

P=2¥
P=4¥
AA
B
Income Effect
(Keeps prices constant)
Decrease in purchasing power
changes consumption from A
to C

P=2¥
P=4¥
AA
B
Substitution Effect
(Keep income constant)
-Rise in price changes
consumption from C to B
Income Effect
(Keeps prices constant)
Decrease in purchasing power
changes consumption from A
to C
C

P=2¥
P=4¥
AA
B
C
You may be asking?
Why does it look like
point C is floating in
this nowhere space.

P=2¥
P=4¥
AA
B
C
Both substitution and income
effects are happening at the
same time. What is not
included on this graph is the
indifference curves based on
the equimarginal principle at
each price point.

If the price of a good increases and assuming in is a normal
good there are two effects:
2.) Income - The increase in price reduces disposable income and
this lower income may reduce demand.
1.) Substitution - The good is relatively more expensive
than alternative goods and people can switch to other goods.
If price goes down, then it’s just all opposite
Summary so farSummary so far
If the good is an inferior good be careful to realize
what is the correct change.

One moreOne more
example:example:

Hurley’s income: $Hurley’s income: $12001200
Prices:Prices: PPFF = $= $44 per fishper fish
PPMM = $= $11 per mangoper mango
A.A. If Hurley spends all his income on fish,If Hurley spends all his income on fish,
how many fish does he buy?how many fish does he buy?
A.A. $$12001200/$/$44
== 300300 fishfish

Hurley’s income: $Hurley’s income: $12001200
Prices:Prices: PPFF = $= $44 per fishper fish
PPMM = $= $11 per mangoper mango
B.B. If Hurley spends all his income on mangos,If Hurley spends all his income on mangos,
how many mangos does he buy?how many mangos does he buy?
B.B. $$12001200/$/$11
== 12001200 mangosmangos

Hurley’s income: $1200
Prices: PF = $4 per fish
PM = $1 per mango
C. If Hurley buys 100 fish, how many mangos can he buy?
C. 100 fish cost $400,
$800 left buys 800 mangos

Q of Fish
Q of
Mangos
A
B
C
Hurley’s budget
constraint
shows the
bundles he can
afford.
Hurley’s budget
constraint
shows the
bundles he can
afford.
A.A. $$12001200/$/$44
== 300300 fishfish
B.B. $$12001200/$/$11
== 12001200
mangosmangos
C.C. 100100 fishfish
cost $cost $400400,,
$$800800 leftleft
buysbuys 800800
mangosmangos
Budget example:Budget example:

Q of Fish
Q of
Mangos
A fall in income shifts
the budget constraint
down.
A fall in income shifts
the budget constraint
down.
Now,Now,
HurleyHurley
can buycan buy
$$800800/$/$44
== 200200 fishfish
oror
$$800800/$/$11
== 800800 mangosmangos
or anyor any
combinationcombination
in between.in between.
Income Change example:Income Change example:

Q of Fish
Q of
Mangos An increase in the
price of one good
pivots the budget
constraint inward.
An increase in the
price of one good
pivots the budget
constraint inward.
HurleyHurley
can still buycan still buy
300300 fish.fish.
But now heBut now he
can only buycan only buy
$$12001200/$/$22 ==
600600 mangos.mangos.
Notice:Notice:
slope is smaller,slope is smaller,
relative price ofrelative price of
fish is now onlyfish is now only
2 mangos.2 mangos.
Price Change example:Price Change example:

Q of Fish
Q of
Mangos Both Income and Sub
effect may happen at
the same time.
Both Income and Sub
effect may happen at
the same time.
Both Change example:Both Change example:
Have to find theHave to find the
newnew MU perMU per
dollar pointdollar point
(new(new
IndifferenceIndifference
curvecurve) to know) to know
whatwhat
combination tocombination to
buy now.buy now.

Q of Fish
Q of
Mangos
Change in budget line
= new point based on
income and sub effect
AAC
Income Effect
A to C

Q of Fish
Q of
Mangos
AAC
Income Effect
A to C
B
Substitution Effect
C to B

{{ Use this example
again, and use
indifference curves to
see this floating issue
better.

Ian is Morpheus from the Matrix, 黑客帝国 He will open you
mind

Optimum pointOptimum point
Budget + Indifference curveBudget + Indifference curve
- the point on the budget line that
touches the highest possible
indifference curve

Optimum pointOptimum point
Budget + Indifference curveBudget + Indifference curve
- the point on the budget line that
touches the highest possible
indifference curve
MRS = Pgood 1
Pgood 2
Marginal Rate ofMarginal Rate of
SubstitutionSubstitution
- the rate at which a consumer
is willing to trade one good for
another.

Optimization: What the Consumer ChoosesOptimization: What the Consumer Chooses
Quantity
of Water
Quantity
of Gum
120
60
3015
A is the optimum:
the point on the
budget line that
touches the
highest possible
indifference curve.
Ian prefers B to A, but
he cannot afford B. A
C
D
Ian can afford C
and D,
but A is on a higher
indifference curve.
B
The optimum
is the bundle
Ian most
prefers out of
all the bundles
he can afford.
The optimum
is the bundle
Ian most
prefers out of
all the bundles
he can afford.

Optimization: What the Consumer ChoosesOptimization: What the Consumer Chooses
Quantity
of Water
Quantity
of Gum
120
60
3015
At the optimum,
slope of the
indifference curve
equals
slope of the budget
line:
MRS = PW/PG
A
marginal
value of
water
(in terms of
gum)
price of
gum (in
terms of
water)
Consumer
optimization is
another example of
“thinking at the
margin.”
Consumer
optimization is
another example of
“thinking at the
margin.”

Quantity
of Water
Quantity
of GumAn increase in
income shifts the
budget line
outward.
If both goods are
normal goods, Ian
buys more of each.
A
B
Example = Increase in IncomeExample = Increase in Income

Quantity
of Water
Quantity
of GumIf gum is an inferior
good, the new
optimum point will
contain fewer gum.
A
B
Example = Increase in IncomeExample = Increase in Income

50
35
Quantity
of Water
Quantity
of Gum
120
60
3015 60
initial
optimum
new
optimum
If Initially,
PW = $4
PG = $1
PW falls to $2
budget line rotates
outward,
Ian buys
more water and
fewer gum.
Example = Increase in PriceExample = Increase in Price

The Income and Substitution EffectsThe Income and Substitution Effects
InitialInitial
optimumoptimum atat AA..
PPFF falls.falls.
Substitution effect:
fromfrom AA toto BB,,
buy more water andbuy more water and
fewer gum.fewer gum.
Quantity
of Water
Quantity
of Gum
A
B
C
In this example,
the net effect on
gum is negative.
In this example,
the net effect on
gum is negative.

The Income and Substitution EffectsThe Income and Substitution Effects
InitialInitial
optimumoptimum atat AA..
PPFF falls.falls.
Substitution effect:
fromfrom AA toto BB,,
buy more water andbuy more water and
fewer gum.fewer gum.
Income effect:Income effect:
fromfrom BB toto CC,,
buy more of bothbuy more of both
goods.goods. Quantity
of Water
Quantity
of Gum
A
B
C
In this example,
the net effect on
gum is negative.
In this example,
the net effect on
gum is negative.

Example Question:Example Question:
The consumer is originally consuming his or her optimal consumption
bundle at point A in the figure when the price of Good K falls. The
movement from K1 to K2 reflects:
a.the total change in quantity demanded due to the decrease in the price of
Good K.
b.the income effect of the price decrease of Good K.
c.the substitution effect of the price decrease of Good K.
d.the income effect of the price decrease of Good K and the substitution
effect of the price decrease of Good K.
That’s it.That’s it.
Bye ByeBye Bye 

Budget lines

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