2. Read Chapter 4

3. Ch 4. How Consumers Make Choice

4. The Budget Constraint  Budget constraint: The set of baskets that a consumer can purchase with a limited amount of income. The set of baskets that a consumer can purchase with a limited amount of income.  Budget line: The set of baskets that a consumer can purchase when spending all of his or her available income. The set of baskets that a consumer can purchase when spending all of his or her available income.

5. The Budget Line  Example: Px X + Py Y = I Px X + Py Y = I Px = price of food Px = price of food Py = price of clothing Py = price of clothing X = number of food purchased X = number of food purchased Y = number of clothing purchased Y = number of clothing purchased I = income I = income

6. The Budget Line (continued)  Example: I = 800 I = 800 Px = 20 Px = 20 Py = 40 Py = 40 Budget line Figure 4.1. Page 99 Budget line Figure 4.1. Page 99 Slope budget line = - (Px/Py) Slope budget line = - (Px/Py)

7. Effect Of A Change In Income On The Budget Line  Px = 20 Py = 40 Py = 40 I1 = 800 I1 = 800 Budget line when I1? Budget line when I1? Budget line when I2 = 1000? Budget line when I2 = 1000? Figure 4.2. Page 101. Figure 4.2. Page 101. Note: - an increase in income shifts the budget line outward in parallel fashion. outward in parallel fashion.

8. How Does A Change In Price Affect The Budget Line?  Px1 = 20 Py1 = 40 Py1 = 40 I1 = 800 I1 = 800 What happened: What happened: Px2 = 25 Px2 = 25 Py2 = 40 Py2 = 40 I2 = 800 I2 = 800 Figure 4.3. Page 102 Figure 4.3. Page 102

9. Optimal Choice  Optimal choice: Consumer choice of a basket of goods that: Consumer choice of a basket of goods that: 1. maximize satisfaction (utility) while 1. maximize satisfaction (utility) while 2. allowing him to live within his budget 2. allowing him to live within his budget constraint. constraint.

10. Optimal Choice (continued)  Let: U (x, y) : represent the consumer’s utility U (x, y) : represent the consumer’s utility from purchasing x units of food from purchasing x units of food and y units of clothing. and y units of clothing. with the budget constraint: with the budget constraint: Px X + Py Y equals or less than I Px X + Py Y equals or less than I

11. Optimal Choice (continued)  The optimal choice: Max U(x,y) Max U(x,y) subject to: Px X + Py Y equals or less I subject to: Px X + Py Y equals or less I Figure 4.4. Page 104. Figure 4.4. Page 104.

12. Optimal Choice (continued)  - MUx / MUy = - MRS  MUx / MUy = Px / Py  MRS x,y = Px / Py  MUx / Px = MUy / Py

13. Finding Optimum  U(x,y) = XY I = 800 I = 800 Px = 20 Px = 20 Py = 40 Py = 40 Find optimal consumption bundle? Find optimal consumption bundle? MUx = ? MUx = ? MUy = ? MUy = ?

14. Finding Optimum (continued)  Px X + Py Y = I 20X + 40Y = 800 20X + 40Y = 800 MUx / MUy = Px / Py MUx / MUy = Px / Py

15. Two Ways Of Thinking 1.Max Utility = U(x,y) subject to: Px X + Py Y equals or less I subject to: Px X + Py Y equals or less I 2.Min Expenditure = Px X + Py Y subject to: U(x,y) = U2 subject to: U(x,y) = U2

16. Exercise:  The utility that Ann receives by consuming food (F) and clothing (C) is given by: U(F,C) = FC + F U(F,C) = FC + F The marginal utilities of food and clothing are: The marginal utilities of food and clothing are: MUf = ? MUf = ? MUc = ? MUc = ? Food cost $ 1 a unit, and clothing costs $ 2 a unit. Ann’s income is $ 22. Food cost $ 1 a unit, and clothing costs $ 2 a unit. Ann’s income is $ 22. a. Ann is currently spending all of her income. She is a. Ann is currently spending all of her income. She is buying 8 units of food. How many units of clothing is buying 8 units of food. How many units of clothing is she consuming? she consuming?

17. Exercise (continued): b.Graph her budget line. Place the number of units of clothing on the vertical axis, and the number of units of food on the horizontal axis. Plot her current consumption basket. c.Find the utility maximizing choice of food and clothing.

18. Homework:  4.3. Page 129