1. Budget Constraint AB 0__ P A = $12 P B = $2.40 Income = $

Choices are based on Comparisons of MU per $ spent on each good MU A PAPA = MU B PBPB =...= MU N PNPN

Would a person maximize satisfaction by buying a $15 product that adds twice as much satisfaction as a $5 product?

ItemPriceUtility Pants$60125 Shirt$40100 Wallet$2050

Number Bought With Constraint Domestic MU/$ ____ Domestic $1 MU Marginal Utility per $ Imported $2 MU Without Income Constraint? Imported MU/$ ____ With $12?

2. Budget Increase AB P A = $12 P B = $2.40 Income = $72 $84

3. Price Change AB P A = $12 P B = $2.40 $3 Income = $72

At a lower price consumers can switch to the cheaper good, substituting the cheaper for the more expensive. Substitution Effect Why the Demand Curve slopes down One Reason:

A lower price of a good will increase purchasing power of the consumer. They can buy more than before. Income Effect A Second Reason: Why the Demand Curves slopes down

Diminishing Utility Consumers get less satisfaction as they buy more of a good. For the consumer to buy more the price must be reduced. A Third Reason: Why the Demand Curves slopes down

$2.50 $2.00 Price Frozen pizzas per week $3.00 $3.50 MB 4 MB 3 MB 2 MB 1 <<< MU 4 MU 3 MU 2 MU 1 <<< because d MB = The demand for frozen pizzas reflects the law of diminishing marginal utility. Because marginal utility (MU) falls with increased consumption, so does a consumer’s maximum willingness to pay -- marginal benefit (MB). A consumer will purchase until MB = Price... so at $2.50 they would purchase 3 frozen pizzas and receive a consumer surplus shown by the shaded area (above the price line and below the demand curve). Price = $2.50 The Pizza Demand Curve John’s demand curve for frozen pizza MB 4 MB 3 MB 2 MB 1

JonesSmith2-Person market Price Weekly frozen pizza consumption At $3.50 Jones demands 1 pizza … and so on … At $3.50 Smith demands 2 pizzas … and so on … $3.50 $2.50 $3.50 $2.50 d $3.50 $2.50 D d Consider Jones’s demand for frozen pizza. at $ pizzas … Consider Smith’s demand for frozen pizza. at $ pizzas … The market demand curve is merely the horizontal sum of the individual demand curves (here Jones and Smith). The market demand curve will slope downward to the right, just as the individual demand curves do. Individual and Market Demand Curves

4. Labor-Leisure Budget Constraint WorkIncome (550?) (700?) (850?) a. 70 hour week, $10 per hour wages b. $12 per hour wages

5. Present versus Future Consumption a. 6% annual rate of return b. 9% annual rate of return.

a. 6% annual rate of return b. 9% annual rate of return. Present Present Future Consumption Future Consumption Consumption Savings (6% annual return) (9% annual return) $1,000, $900,000 $100,000 $574,000 $1,327,000 $800,000 $200,000 $1,148,000 $2,654,000 $700,000 $300,000 $1,722,000 $3,981,000 $600,000 $400,000 $2,296,000 $5,308,000 $400,000 $600,000 $3,444,000 $7,962,000 $200,000 $800,000 $4,592,000 $10,616,000 0 $1,000,000 $5,740,000 $13,270,000

PV where i = 6 % = PV = Receipts 1 year from now interest rate + 1 $ Present Value The interest rate connects the value of dollars today with the value of dollars in the future. The present value (PV) of a single ($100) payment to be received one year from now is: = $ $ =

PV where i = 6 % and n = 3 = PV = Receipts n years from now (interest rate + 1) n $ Present Value n Years in the Future The present value (PV) of that single ($100) payment to be received n years from now is: = $ 100 (1.06) 3 $ 100 (1 +.06) 3 = The present value of the future payment is inversely related to: the interest rate, and, how far in the future the payment will be received.

PV = where i = 6 % and n = 3 and R = $100 PV = R1R1 (1 + i) + R2R2 (1 + i) 2 R nR n (1 + i) n + R3R3 (1 + i) Present Value n Years in the Future The present value (PV) of a stream of payments (each of nominal magnitude R) to be received each year for n years is: $100 (1.06) + (1.06) 2 $100 + (1.06) 3 $100 = $ PV = $ $89 + $83.96 = $

CoCo CdCd Age Annual earnings or costs 22 $ Earnings w/o college Earnings w/ college Investing in Human Capital Consider a somewhat simplified example of a human- capital investment decision confronting Juanita, an 18-year old who just finished high-school. We have graphed Juanita’s expected earnings both with … and without college. Should Juanita attend college or not? If Juanita chooses to attend college, she will incur both the direct cost of a college education (tuition, books, etc) C d … and the opportunity cost of earnings forgone while in college C o.

B CdCd CoCo Age Annual earnings or costs 22 $ Earnings w/o college Earnings w/ college Investing in Human Capital With a college education, though, Juanita can expect higher future earnings (B) during her career (even though they may begin lower, they end higher). If the discounted present value of the additional future earnings exceeds the discounted value of the direct and indirect costs of a college education, then the college degree will be a profitable investment for Juanita.

Less than 9th grade High School Some college Bachelor’s degree Master’s degree Doctoral degree The earnings of both men and women increase with education. Note, though, that women’s earnings were only about 2/3 those of similarly educated men. Level of Education and Earnings (and Discrimination) 24,595 35,12142,946 62,543 75, ,988 23,498 29,500 49,635 69,08540,263 18,578 Women Men Mean earnings ($) of year-round-full-time workers (2000) 56% of men’s

Less than high school High school Some college Bachelor’s degree Master’s degree Doctoral degree Both still increase with education. Updated in 2001 Women’s earnings still about 2/3 those of similarly educated men. Level of Education and Earnings 27,190 37,36245,271 70,253 87, ,853 26,660 32,511 57,770 71,60845,290 22,361 Women Men Mean earnings ($) of year-round-full-time workers (2001) 10% above % above % of men’s

Less than high school High school Some college Bachelor’s degree Master’s degree Doctoral degree Level of Education and Earnings 28,415 40,11249,537 75,130 95, ,567 28,657 35,521 59,569 92,65049,326 20,508 Women Men Mean earnings ($) of year-round-full-time workers (2005) Both still increase with education. Updated in 2005 Women’s earnings still about 2/3 those of similarly educated men. 14.9% from % of men’s

Less than high school High school Some college Bachelor’s degree Master’s degree Doctoral degree The earnings of both men & women increase with education. Updated in 2007 Women’s earnings still only about 2/3 those of similarly educated men. Level of Education and Earnings 30,602 42,04250,103 77,536 94, ,706 30,657 38,396 63,156 85,19052,857 21,906 Women Men

Bachelor’s Degree Comparison over time 77,536 52,857 Women Men 62,543 40, ,253 45,290 75,130 49,326

If Mr. Smith thinks the last dollar spent on shirts yields less satisfaction than the last dollar spent on cola, and Smith is a utility- maximizing consumer, he should a.decrease his spending on cola. b.decrease his spending on cola and increase his spending on shirts. c.increase his spending on shirts. d.increase his spending on cola and decrease his spending on shirts. Which of the following would be the best example of consumer surplus? a.Jane does not get cell-phone service because she feels that it is worth less than the $30 a month fee. b.Sam pays $8 for a haircut that is worth $10 to him. c.Ralph buys a house for $104,000, the maximum amount that he would be willing to pay for it. d.Sue purchases a book for $20 and uses a credit card to pay for it.

“ I like ice cream, but after eating homemade ice cream last night, I want to have something else for dessert today. ” This statement most clearly reflects a.the budget constraint. b.consumer irrationality. c.the second law of demand: Price elasticity increases with time. d.the law of diminishing marginal utility. If Sarah ’ s income rises by 20 percent, and, as a result, she purchases 40 percent more designer clothing, her income elasticity for designer clothing is a.0.5. b.1.0. c.2.0. d.seriously distorted. Suppose the state of New York imposes a one dollar per pack tax on cigarettes, which increases their price by 30 percent, and as a result, the quantity sold declines by 20 percent. The price elasticity of demand for cigarettes is equal to a. – b. – c. – d. – 3.00.

Studies indicate that the demand for fresh tomatoes is much more elastic than the demand for salt. These findings reflect that a.tomatoes are a necessity while salt is a luxury. b.it takes longer for consumers to adjust to a change in the price of salt than to a change in the price of tomatoes. c.salt will not spoil as easily as fresh tomatoes. d.more good substitutes exist for fresh tomatoes than for salt. If a Krispy Kreme doughnut shop near campus increases its prices by 5 %, but revenues from its sales are unchanged, the price elasticity of demand for the services offered by the doughnut shop must be a.elastic. b.of unitary elasticity. c.inelastic. d.equal to 0.5. If the price of gasoline goes up, and Dan now buys fewer candy bars because he has to spend more on gas, this would best be explained by a.the substitution effect. b.the income effect. c.the highly elastic demand for gasoline. d.weight watchers effect.

Which of the following is true for this demand curve? a.An increase in price from $2 to $3 will reduce total expenditures on the product. b.In the $2 to $3 range, the price elasticity of the demand curve is approximately unitary. c.At a price of $2, the price elasticity of the demand curve equals approximately – 2.5. d.In the $2 to $3 range, the demand curve is inelastic.