1. Economics 310
Chapter 3: Budget Lines, Indifference Curves, Demand and the Theory of Consumer Choice.
Department of Economics
College of Business and Economics
California State University-Northridge
Professor Kenneth Ng
Thursday, February 22, 2001 1 1 1 1

2. Administrative Details
Exam on Thursday, Oct. 4th.
Chapters 1-5
Homework due on Tuesday, Oct. 1st.
Not available yet.
In Class Problems.
Old Exam Problems.
Link on webpage.

3. Want a deeper understanding of the economic forces underlying the demand curve.
The plan for the remainder of the class is to look closer at the economic forces underlying the supply and demand curves.
The demand curve shows how much of a good a person or group of people will buy at any given price ceteris paribus (other things equal).
What happens when “other things” change.
Income.
Prices of related goods.
Preferences.
Taxes.
Want to be able to make positive statement like, “if income changes then …..”
To answer these questions must take an in depth look at the economic forces underlying the demand curve.
This is done using budget lines and indifference curves. 2 2 2 2

4. The Budget Constraint or Budget Line
The Budget Line shows the combinations of goods the consumer can afford given his or her income and the prices of the two goods.
Defined by 3 things: income and the price of two goods. 4 4 4 4

5. The Budget Constraint 4 5 5 5

6. The Budget Line
Any point on the budget line indicates the consumer’s combination or tradeoff between two goods.
For example, if the consumer buys no pizzas, he can afford 500 pints of Pepsi. If he buys no Pepsi, he can afford 100 pizzas.
Alternately, the consumer can buy 50 pizzas and 250 pints of Pepsi.
These points can be graphed. 9 6 6 6

7. The Budget Constraint Line
Quantity
of Pepsi
500
250 50
100
Quantity
of Pizza 5 7 7 7

8. The Budget Constraint Line
Quantity
of Pepsi B
500
250 A 50
100
Quantity
of Pizza 5 8 8 8

9. The Budget Constraint Line
Quantity
of Pepsi B
500
250
Consumer’s
budget constraint A 50
100
Quantity
of Pizza 5 9 9 9

10. The Budget Constraint Line
Quantity
of Pepsi B
500 C
250
Consumer’s
budget constraint A 50
100
Quantity
of Pizza 5 11 11 11

11. Two things to know about the Budget Line.
The slope of the budget line equals the relative price of the two goods, that is, the price of one good compared to the price of the other.
The relative price of a good is defined as the number of units of the other good that must be given up in order to get enough income to buy one more unit of the good,
The relative price of pizza (which costs $10 each) is how many pints of Pepsi must be not consumed to save enough money to but one more pizza.
Relative price measures the rate at which the consumer can trade one good for the other.
The steeper the budget line the greater the relative price of the good on the horizontal axis.
The position of the budget line represents income.
The farther out the budget line on a ray from the origin, the greater the income level it represents. 10 12 12 12

12. Position of the BL represents income
Suppose the persons income was reduced to $500. What would the BL look like?
Quantity
of Pepsi B
500
A parallel shift of the budget line represents a change in income.
The farther out budget line on a ray from the origin the more income it represents. C
250
Consumer’s
budget constraint A 50
100
Quantity
of Pizza

13. Slope of the BL represents relative price
Suppose the price of good B was raised from $2 to $4?
What would the new BL look like?
Quantity
of Pepsi
Has the relative price of pizza increased or decreased?
Explain.
The relative price of pizza has decreased because the amount of Pepsi that must be given up to get one more pizza has gone down. B
500 C
250
Consumer’s
budget constraint A 50
100
Quantity
of Pizza

14. Budget Line Exercise (1); Draw 2 budget lines given the income and prices below.

15. Budget Line Exercise (1) What is the slope of the red and purple budget lines?

16. The slope of the budget line and relative price.
What does it mean in terms of relative price of opportunity cost to say that on the red budget line the relative price is 5/2 and on the purple budget line, the relative price is 5/8?
Which good, A or B, has a higher relative price?
In order for a person to get more good B, how much good A must the give up for each extra unit of B the get?
That amount is the relative price of opportunity cost of B.
The slope of the budget line is the relative price of the good on the horizontal axis.
By definition the relative price of good B is the amount of good A that must be given up to get one more unit of good B.

17. Practice Exam Question
Point A represents a bundle that can be purchased with $1000 whether the price of goods A and B are $2 and $5 or $ and $2.50.
A=166.67, B=133.33

18. Budget Line exercises
The first step in using Budget Lines in economic analysis is to be able to show how a budget line changes when there is a change in the world.
Consider the following exercises:
Suppose an individual has $500 of income. The price of good A was $25 and the price of good B was $50.
Suppose someone gave you a non-transferable voucher for 10 units of good B, what will budget line look like?
Suppose someone gave you a coupon for B that said 2 for the price of 1, limit free 3 units.
Advanced problem:
the McDonald’s Value Meal Problem. Suppose an individual had $10. Big Macs cost $2 and fries cost $1. What does the budget line look like. Suppose McDonald’s has a value meal which includes a Big Mac and Fries for $2.50?

19. Suppose an individual has $500 of income
Suppose an individual has $500 of income. The price of good A was $25 and the price of good B was $50.

20. Suppose someone gave you a coupon for B that said 2 for the price of 1, limit free 3 units.

21. Advanced problem:the McDonald’s Value Meal Problem
Advanced problem:the McDonald’s Value Meal Problem. Suppose an individual had $10. Big Macs cost $2 and fries cost $1. What does the budget line look like. Suppose McDonald’s has a value meal which includes a Big Mac and Fries for $2.50?

22. Indifference Curves Quantity of Pepsi C B A Indifference curve, I1
A Budget Line shows the bundles of goods which are attainable by an individual given his income and prices.
A consumer’s preference among bundles of goods may be illustrated with indifference curves.
An indifference curve shows bundles of goods that leave the consumer equally satisfied.
Show bundles of goods, where if the consumer was given a choice between those bundles he wouldn’t care which bundle he receives.
The consumer is indifferent, or equally happy, with the combination of goods shown at points A, B, and C because they are all on the same indifference curve.
Indifference Curves
Quantity
of Pepsi C B A
Indifference
curve, I1
Quantity
of Pizza 12 21 21 21

23. Indifference Curves Quantity of Pepsi C B D I2 A Indifference
The position of an indifference curve represents satisfaction, utility or happiness.
The farther out an IC from the origin the happier the individual will be if he can attain a bundle on that IC.
D is preferred to A, because at D the person has more of both pepsi and pizza.
D is preferred to C, because C is equivalent to A and D is preferred to A.
Quantity
of Pepsi C B D I2 A
Indifference
curve, I1
Quantity
of Pizza 12 32 32 32

24. The Marginal Rate of Substitution
The slope at any point on an indifference curve is the marginal rate of substitution.
In the broadest terms, it the value of one unit of a good to a person.
In more technical terms, it is the rate at which a consumer is willing to trade one good for another.
It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.
Ask the person, what is the minimum number of units of the other good they must receive to get them to voluntarily give up one unit of a good—that is the goods marginal rate of substitution.
Quantity
of Pepsi
MRS 1
Indifference
curve, I1
Quantity
of Pizza 12 26 26 26

25. Optimization: Predicting consumer behavior.
Can use budget lines and indifference curves to generate positive statements.
Using indifference curves and budget lines, the behavior of the consumer can be stated in alternative but equivalent ways:
Choose the point on the budget line that is on the highest indifference curve that has at least one point in common with the budget line.
Choose the IC that is tangent to the BL.
Choose the bundle where the MRS equals the Relative Price.
If the MRS < relative price, the person could be made happier by consuming less of the good and more of the other good.
If the MRS > relative price, the person could be made happier by consuming more of the good and less of the other good. 30 50 50 50

26. The Consumer’s Optimal Choice
Quantity
of Pepsi I1
Quantity
of Pizza 32 57 57 57

27. The Consumer’s Optimal Choice
Quantity
of Pepsi I2 I1
Quantity
of Pizza 32 58 58 58

28. The Consumer’s Optimal Choice
Quantity
of Pepsi I3 I2 I1
Quantity
of Pizza 32 59 59 59

29. The Consumer’s Optimal Choice
Quantity
of Pepsi I3 I2 I1
Budget constraint
Quantity
of Pizza 32 60 60 60

30. The Consumer’s Optimal Choice
Quantity
of Pepsi
Optimum I3 I2 I1
Budget constraint
Quantity
of Pizza 32 61 61 61

31. MRS must equal relative price at the optimum.
Quantity
of Pepsi
This consumer will not
choose this point because
with this bundle, the
MRS is less than the
relative price.
Explain.
Optimum I3 I2 I1
Budget constraint
Quantity
of Pizza 32 61 61 61

32. MRS must equal relative price at the optimum.
What is the slope of the
IC and BL at this point?
Quantity
of Pepsi
MRS=rise/run
=2/4
=1/2
For each pizza taken away, the person must receive ½ pepsi to keep him just as well off.
Relative Price=rise/run
=4/4 =1
For each pizza the person gives up, he can get 1 pepsi.
Optimum 8 6 I2 4 I1
Budget constraint
Quantity
of Pizza 6 10 32 61 61 61

33. MRS must equal relative price at the optimum.
If the person is consuming
10 pizzas and 4 Pepsis, the
MRS<Relative Price.
½<1
Quantity
of Pepsi
Optimum
MRS: If you took away 4 units of pizza and gave him 2 units of Pepsi in exchange the person’ happiness would be unchanged. 8 6 I2 4 I1
Budget constraint
Quantity
of Pizza 6 10 32 61 61 61

34. MRS must equal relative price at the optimum.
If the person is consuming
10 pizzas and 4 Pepsis, the
MRS<Relative Price.
½<1
Quantity
of Pepsi
Optimum
Relative Price of Pizza: If the person gave up 4 pizzas, he could get 4 Pepsis. 8 6 I2 4 I1
Budget constraint
Quantity
of Pizza 6 10 32 61 61 61

35. MRS must equal relative price at the optimum.
If the person is consuming
10 pizzas and 4 Pepsis, the
MRS<Relative Price.
½<1
Quantity
of Pepsi
Optimum
Why does moving to the optimum make the person better off?
If you take away 4 pizzas and give him 2 Pepsis he would be indifferent, but if he game up 4 pizzas he could actually get 4 Pepsis. 8 6 I2 4 I1
Budget constraint
Quantity
of Pizza 6 10 32 61 61 61

36. An increase in income shifts the budget constraint outward.
How a change in income will affect the bundle of goods chosen by a person.
An increase in income shifts the budget constraint outward.
The consumer is able to choose a better combination of goods on a higher indifference curve. 35 62 62 62

37. Changes in Income Affect Consumer Choices
Quantity
of Pepsi
Quantity
of Pizza 37 64 64 64

38. Changes in Income Affect Consumer Choices
Quantity
of Pepsi I1
Quantity
of Pizza 37 65 65 65

39. Changes in Income Affect Consumer Choices
Quantity
of Pepsi I1
Quantity
of Pizza 37 66 66 66

40. Changes in Income Affect Consumer Choices
Quantity
of Pepsi
New budget constraint I1
Quantity
of Pizza 37 67 67 67

41. Changes in Income Affect Consumer Choices
Quantity
of Pepsi
New budget constraint I2 I1
Quantity
of Pizza 37 68 68 68

42. Changes in Income Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
New optimum I2 I1
Quantity
of Pizza 37 69 69 69

43. Changes in Income Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1. An increase in income shifts
the budget constraint outward…
New optimum I2 I1
Quantity
of Pizza 37 70 70 70

44. Changes in Income Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1. An increase in income shifts
the budget constraint outward…
New optimum I2 I1
Quantity
of Pizza
2. …raising pizza consumption… 37 71 71 71

45. Changes in Income Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1. An increase in income shifts
the budget constraint outward…
New optimum
3. …and Pepsi
consumption. I2 I1
Quantity
of Pizza
2. …raising pizza consumption… 37 72 72 72

46. An increase in income can cause the consumption of a good to increase or decrease.
If a consumer buys more of a good when his or her income rises, the good is called a normal good.
If a consumer buys less of a good when his or her income rises, the good is called an inferior good.
Consider the previous example. Are Pepsis and Pizzas normal or inferior? 73 73 73

47. An Inferior Good 42 74 74 74

48. An Inferior Good
Quantity
of Pepsi
Quantity
of Pizza 42 75 75 75

49. An Inferior Good
Quantity
of Pepsi I1
Quantity
of Pizza 42 76 76 76

50. An Inferior Good Quantity of Pepsi Initial budget constraint I1
Quantity
of Pizza 42 77 77 77

51. An Inferior Good Quantity of Pepsi Initial optimum
Initial budget constraint I1
Quantity
of Pizza 42 78 78 78

52. An Inferior Good Quantity of Pepsi New budget constraint Initial
optimum
Initial budget constraint I1
Quantity
of Pizza 42 79 79 79

53. An Inferior Good Quantity of Pepsi New budget constraint Initial
optimum
Initial budget constraint I1 I2
Quantity
of Pizza 42 80 80 80

54. An Inferior Good Quantity of Pepsi New budget constraint Initial
optimum
New optimum
Initial budget constraint I1 I2
Quantity
of Pizza 42 81 81 81

55. An Inferior Good Quantity of Pepsi New budget constraint
1. When an increase in income shifts the budget constraint outward...
Initial
optimum
New optimum
Initial budget constraint I1 I2
Quantity
of Pizza 42 82 82 82

56. An Inferior Good Quantity of Pepsi New budget constraint
1. When an increase in income shifts the budget constraint outward...
Initial
optimum
New optimum
Initial budget constraint I1 I2
Quantity
of Pizza
pizza consumption rises,
making pizza a normal good... 42 83 83 83

57. An Inferior Good Quantity of Pepsi New budget constraint
but Pepsi consumption falls, making Pepsi an inferior good.
1. When an increase in income shifts the budget constraint outward...
Initial
optimum
New optimum
Initial budget constraint I1 I2
Quantity
of Pizza
pizza consumption rises,
making pizza a normal good... 42 84 84 84

58. How a change in price will affect the bundle of goods chosen by a person.
A fall in the price of any good a compound change:
A rotation of the budget constraint.
Change in Slope or Relative Price.
A change in position.
Change in income-broadly defined.
The budget line shifts outward. 41 85 85 85

59. Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
Quantity of Pizza 43 86 86 86

60. Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
500 I1
100
Quantity of Pizza 43 87 87 87

61. Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
500 I1
Initial budget constraint
100
Quantity of Pizza 43 88 88 88

62. Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
500
Initial optimum I1
Initial budget constraint
100
Quantity of Pizza 43 89 89 89

63. Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
1. A fall in the price of Pepsi rotates the budget constraint outward…
500 I1
Initial budget constraint
100
Quantity of Pizza 43 90 90 90

64. Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1,000
1. A fall in the price of Pepsi rotates the budget constraint outward…
500 I1
Initial budget constraint
100
Quantity of Pizza 43 91 91 91

65. Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1,000
1. A fall in the price of Pepsi rotates the budget constraint outward…
500 I2 I1
Initial budget constraint
100
Quantity of Pizza 43 92 92 92

66. Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1,000
New optimum
1. A fall in the price of Pepsi rotates the budget constraint outward…
500 I2 I1
Initial budget constraint
100
Quantity of Pizza 43 93 93 93

67. Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1,000
New optimum
1. A fall in the price of Pepsi rotates the budget constraint outward…
500 I2 I1
Initial budget constraint
100
Quantity of Pizza
2. …reducing pizza consumption… 43 94 94 94

68. Changes in Prices Affect Consumer Choices
Quantity
of Pepsi
New budget constraint
1,000
New optimum
1. A fall in the price of Pepsi rotates the budget constraint outward…
500
3. …and raising Pepsi
consumption. I2 I1
Initial budget constraint
100
Quantity of Pizza
2. …reducing pizza consumption… 43 95 95 95

69. Income and Substitution Effects
A price change causes a compound effect—both the slope and position of the BL are changed.
A substitution effect-change in the slope of the BL.
The substitution effect is the change in consumption that results from a change in the relative price of a good.
Shown by drawing a budget line with the new relative price tangent to the original indifference curve.
An income effect-change in the position of the BL.
The income effect is the change in consumption that results from the change in income, broadly defined, from a change in price.
A decrease in the price of goods and services is the same as an increase in income.
Shown as a parallel movement of the budget line used to figure the substitution effect to the final budget line. 44 96 96 96

70. Income and Substitution Effects
Quantity
of Pepsi
Quantity of Pizza 50
102
102
102

71. Income and Substitution Effects
Quantity
of Pepsi
Initial budget constraint I1
Quantity of Pizza 50
103
103
103

72. Income and Substitution Effects
Quantity
of Pepsi
Initial optimum A
Initial budget constraint I1
Quantity of Pizza 50
104
104
104

73. Income and Substitution Effects
Quantity
of Pepsi
Initial optimum A
Initial budget constraint I1
Quantity of Pizza 50
105
105
105

74. Income and Substitution Effects
Quantity
of Pepsi
The purple budget line has the new slope but is tangent to the original indifference curve. B
Initial optimum A
Initial budget constraint I1
Quantity of Pizza 50
106
106
106

75. Income and Substitution Effects
Quantity
of Pepsi
A price change first causes the
consumer to move from one point
on a indifference curve to another
on the indifference curve. B
Initial optimum
Substitution effect A
Initial budget constraint I1
Quantity of Pizza
Substitution effect 50
107
107
107

76. Income and Substitution Effects
Quantity
of Pepsi
New budget constraint B
Initial optimum
Substitution effect A
Initial budget constraint I1
Quantity of Pizza
Substitution effect 50
108
108
108

77. Income and Substitution Effects
Quantity
of Pepsi
New budget constraint B
Initial optimum
Substitution effect A
Initial budget constraint I1
Quantity of Pizza
Substitution effect 50
109
109
109

78. Income and Substitution Effects
Quantity
of Pepsi
New budget constraint B
Initial optimum
Substitution effect A I2
Initial budget constraint I1
Quantity of Pizza
Substitution effect 50
110
110
110

79. Income and Substitution Effects
Quantity
of Pepsi
New budget constraint C
New optimum B
Initial optimum
Substitution effect A I2
Initial budget constraint I1
Quantity of Pizza
Substitution effect 50
111
111
111

80. Income and Substitution Effects
After moving from one point to another
on the same curve, the consumer
will move to another indifference curve.
Quantity
of Pepsi
New budget constraint C
New optimum
Income effect B
Initial optimum
Substitution effect A I2
Initial budget constraint I1
Quantity of Pizza
Substitution effect
Income effect 50
112
112
112

81. Practice Exam Question.
Draw budget lines and indifference curves that show the effect of a price change when one good is normal and the other good is inferior.

82. Income and Substitution Effects: Inferior Good
Quantity
of Pepsi
Quantity of Pizza 50
102
102
102

83. Income and Substitution Effects: Inferior Good
Quantity
of Pepsi
Initial budget constraint I1
Quantity of Pizza 50
103
103
103

84. Income and Substitution Effects: Inferior Good
Quantity
of Pepsi
Initial optimum A
Initial budget constraint I1
Quantity of Pizza 50
104
104
104

85. Income and Substitution Effects: Inferior Good--Substitution Effect
Quantity
of Pepsi
Initial optimum A
Initial budget constraint I1
Quantity of Pizza 50
105
105
105

86. Income and Substitution Effects: Inferior Good--Substitution Effect
Quantity
of Pepsi
The Substitution Effect shows the effect of
the change in the relative price on the
combination of the two goods chosen.
It is derived by drawing a budget line with
a slope incorporating the new relative price
but tangent to the original indifference curve. B
Initial optimum A
Initial budget constraint I1
Quantity of Pizza 50
106
106
106

87. Income and Substitution Effects: Inferior Good--Substitution Effect
Quantity
of Pepsi
A price change first causes the
consumer to move from one point
on a indifference curve to another
on the same curve.
A price change first causes the
consumer to move from one point
on a indifference curve to another
on the same curve. B
Initial optimum
Substitution effect A
Initial budget constraint I1
Quantity of Pizza
Substitution effect 50
107
107
107

88. Income and Substitution Effects: Inferior Good--Income Effect
Quantity
of Pepsi
New budget constraint B
Initial optimum
Substitution effect A
Initial budget constraint I1
Quantity of Pizza
Substitution effect 50
108
108
108

89. Income and Substitution Effects: Inferior Good--Income Effect
Quantity
of Pepsi
New budget constraint B
Initial optimum
Substitution effect A
Initial budget constraint I1
Quantity of Pizza
Substitution effect 50
109
109
109

90. Income and Substitution Effects
Quantity
of Pepsi
New budget constraint B
Initial optimum
Substitution effect A I2
Initial budget constraint I1
Quantity of Pizza
Substitution effect 50
110
110
110

91. Income and Substitution Effects: Inferior Good--Income Effect
Quantity
of Pepsi
New budget constraint B
New optimum C
Substitution effect
Initial optimum A I2
Initial budget constraint I1
Quantity of Pizza
Substitution effect 50
111
111
111

92. Income and Substitution Effects: Inferior Good--Income Effect
Quantity
of Pepsi
New budget constraint
Pepsi is an inferior good because
the parallel shift outward of budget
line (income change) caused the
consumption of Pepsi to decline. B
Income effect
New optimum C
Substitution effect
Initial optimum A I2
Initial budget constraint I1
Quantity of Pizza
Substitution effect
Income effect 50
112
112
112

93. Deriving the Demand Curve
The demand curve shows the amount of a good purchased by a person at different prices.
The relationship between price and quantity purchased.
Budget lines and indifference curves can be used to show how a change in the price of a good affects the amount purchased.
Budget lines and indifference curves can be used to derive a person’s demand curve. 54
116
116
116

94. Deriving the Demand Curve:
The Consumer’s Optimum
The Demand Curve for Pepsi
Quantity
of Pepsi
Price of
Pepsi B I2
150
New budget constraint
At a price of $2, the person buys 50 Pepsis.
What would happen if the price of Pepsi fell to $1?
150
Demand B A $2 1 A 50 I1
Quantity
of Pizza
Initial budget
constraint 50
Quantity
of Pepsi 54
117
117
117

95. Substitution and Income Effects: Review
Graphical Analysis: Showing the substitution and income Effects of a price change.
Substitution Effect first.
Draw a BL with the new slope tangent to the original IC.
Why is this the effect of a change in the relative price?
Income Effect is the rest.
Theoretical Points.
The Substitution Effect is always the same.
When a goods relative price falls, the Substitution Effect causes a increase in the amount of the good purchased.
The Income Effect varies depending on whether the good is normal or inferior.
A drop in price causes an increase in income, broadly defined. This increase income will cause an increase in the amount of a good purchased if the good is normal and a decrease if the good is inferior.
An increase in price causes a decrease in income, broadly defined. This decrease income will cause a decrease in the amount of a good purchased if the good is normal and an increase if the good is inferior.

96. Substitution and Income Effects: Review (2)
Operational Significance: Why do we care about the Substitution and Income Effects.
Because the Substitution and Income effects can work in opposition, it is possible that the effect of a price change can be counter-intuitive i.e. a drop in price can cause an increase in consumption.
This can only occur if one good is inferior.

97. Budget Line and Indifference Curve Analysis: Example 1.
Budget lines and indifference curves are flexible analytical tools that can be used to analyze many questions.
For instance, how do wages affect the supply of labor?
Question: can an increase in a person’s wage make him work less?
If the substitution effect is greater than the income effect for the worker, he or she works more.
If income effect is greater than the substitution effect, he or she works less.
120
120
120

98. The first step in any analysis using budget lines and indifference curves is deciding what goes on the axes.Setting up the problem: What goes on the axes?
The second step is to show the change in the world as a shift in budget lines or indifference curves.
Consumption
Optimum I 3
$5,000
100
2,000 60 I 2 I 1
Hours of Leisure 13
144
144
144

99. Show indifference curves and budget lines for a person whose supply curve is upward sloping, i.e. an increase in the wage makes him work more hours.
(a) For a person with these preferences…
. . . the labor supply curve slopes upward. 3.
and hours of labor increase.
Consumption
Wage 2
2. …hours of leisure decrease… BC
1. When the wage rises… BC 1 I I 1
Hours of Labor
Hour of
Leisure
Supplied 14
145
145
145

100. Show indifference curves and budget lines for a person whose supply curve is upward sloping, i.e. and increase in the wage makes him work more hours.
Hours of
Leisure I 1 2 BC
Consumption
(a) For a person with these preferences…
2. …hours of leisure increase…
1. When the wage rises…
Hours of Labor
Supplied
Wage
. . . the labor supply curve slopes backward. 3.
and hours of labor decrease.
146
146
146

101. How do interest rates affect household saving—another example of substitution and income effects.
Can use indifference curves and budget lines to analyze consumption decisions made over time.
Can an increase in interest rates cause a decrease in savings?
If the substitution effect of a higher interest rate is greater than the income effect, households save more.
If the income effect of a higher interest rate is greater than the substitution effect, households save less.
Thus, an increase in the interest rate could either encourage or discourage saving. 57
121
121
121

102. Consumption when Old Budget constraint $110,000 100,000 55,000 $50,000
Consider a person who makes $100,000 when young and nothing when old.
What does his budget constraint between consumption when young and old look like?
What goes on the axes?
when Old
Budget
constraint
$110,000
100,000
55,000
$50,000
Optimum
At the optimum, is the person borrowing or lending money?
What is the interest rate?
Lending at 10%. I 1
Consumption
when Young 15
147
147
147

103. (a) Higher Interest Rate Raises Saving (b) Higher Interest Rate
Lowers Saving
Consumption
Consumption
when Old
when Old
How will an increase in interest rates affect the BL?
Consumption
when Young
Practice Exam Question (Part 1): Show BL’s and IC’s that depict a person who saves more when interest rates rise and a person who saves less when interest rates rise. 16
148
148
148

104. (a) Higher Interest Rate Raises Saving (b) Higher Interest Rate
Lowers Saving
Consumption
Consumption
when Old
when Old BC 2 BC 2
1. A higher interest rate
rotates the budget
constraint outward . . .
1. A higher interest rate
rotates the budget
constraint outward . . . BC 1 BC 1 I 2 I I 2 1 I 1
Consumption
resulting in lower
consumption when young
and, thus, higher saving.
resulting in higher
consumption when young
and, thus, lower saving.
when Young
Practice Exam Question (Part 2): How can a the person in (b) be saving less but have more Consumption When Old? 16
148
148
148

105. (a) Higher Interest Rate Raises Saving (b) Higher Interest Rate
Lowers Saving
Consumption
Consumption
when Old
when Old BC 2 BC 2
Income
Effect
Income
Effect BC 1 I 2 I I 2 1 1 I
Consumption
when Young
Practice Exam Question (Part 3): On which graph (a) or (b) is Consumption when old an inferior good? Explain and show graphically. 16
148
148
148

106. Do the poor prefer to receive cash or in-kind transfers?
Examples of in-kind transfers:
Food Stamps.
“Free” public schools.
Subsidized student loans.
Free college tuition.
If an in-kind transfer of a good forces the recipient to consume more of the good than he would on his own, then the recipient prefers the cash transfer.
If the recipient does not consume more of the good than he would on his own, then the cash and in-kind transfer have exactly the same effect on his consumption and welfare.
It would always be better to give a poor person a cash transfer rather than an in-kind transfer because the cash transfer would at worst leave everyone the same as a transfer in-kind and would leave some people better off. 58
123
123
123

107. Cash Transfer
In-Kind Transfer
(a) The Constraint Is Not Binding
Nonfood
Consumption
$1,000
Food A B I 2 1 BC
(with $1,000 cash)
I 2
(with $1,000 food stamps)
If the constraint is not binding, the fact that the person received an in-kind transfer rather than a cash transfer with equivalent value, does not lower his utility, happiness, or the indifference curve he can get onto.
Therefore, if the constraint is not binding, the person doesn’t care whether he receives an in-kind or cash transfer. 17
149
149
149

108. (a) The Constraint Is Not Binding
Cash Transfer
In-Kind Transfer
(a) The Constraint Is Not Binding
Nonfood
Consumption
$1,000
Food A B I 2 1 BC
(with $1,000 cash)
I 2
(with $1,000 food stamps)
Nonfood
Consumption
$1,000
Cash Transfer
(b) The Constraint Is Binding
In-Kind Transfer
Food A B I 2 1 BC
(with $1,000 cash) C
(with $1,000 food stamps) 3
150
150
150

109. Homework Available on website. Due Oct. 2nd. Two versions.
Do the version for the class where you will hand the homework in.
No late homeworks.

110. Problem
China earns $1000 a month dealing poker at the Hustler casino. She lives with her boyfriend and he pays for rent and food when they eat at home. Her only monthly expenses are clothing and eating out. Eating out costs $20 and a new outfit costs $200.  
Draw China’s budget line and indifference curves between clothing and eating out if she eats out every day of the month (assume there are 30 days in the month). Put eating out on the vertical axis and clothing on the horizontal axis.
At the end of November, China gets on the scale and finds she has gained 10 lbs. (too much greasy Asian food). She looks in the mirror and is disgusted with how she looks.
Depict on you graph how her budget lines and/or indifference curves would shift.
What has happened to the marginal rate of substitution at her current consumption bundle? Explain.
Using the marginal rate of substitution and the relative price explain and depict how looking in the mirror will affect China’s behavior.
At the end of December, China gets on the scale again and finds she has lost 20 lbs. She looks in the mirror and can’t keep a smile off her face. She looks in her closet and decides that her clothing is way too conservative for such a fly girl.
In January, she wins a $1000 jackpot while playing poker. In the same month, her sister graduates from FIDM (The Fashion and Design Merchandising School) and gets a job as an assistant designer in the Los Angeles fashion industry. This means she can get clothing at a 50% discount.
Depict the change if eating out is an inferior good.
Label on your graph all income and substitution effects.
Is it possible that China could get thinner, better looking, and more fashionable in January? Explain and depict.

111. Draw China’s budget line and indifference curves between clothing and eating out if she eats out every day of the month (assume there are 30 days in the month).

112. Draw China’s budget line and indifference curves between clothing and eating out if she eats out every day of the month (assume there are 30 days in the month).

113. At the end of November, China gets on the scale and finds she has gained 10 lbs. (too much greasy Asian food). She looks in the mirror and is disgusted with how she looks. Depict on you graph how her budget lines and/or indifference curves would shift. What has happened to the marginal rate of substitution at her current consumption bundle? Explain. Using the marginal rate of substitution and the relative price explain and depict how looking in the mirror will affect China’s behavior.

114. At point A, the IC has become steeper.
At the end of November, China gets on the scale and finds she has gained 10 lbs. (too much greasy Asian food). She looks in the mirror and is disgusted with how she looks. Depict on you graph how her budget lines and/or indifference curves would shift. What has happened to the marginal rate of substitution at her current consumption bundle? Explain. Using the marginal rate of substitution and the relative price explain and depict how looking in the mirror will affect China’s behavior.
At point A, the IC has become steeper.
The value of clothing has increased relative to eating out.
The MRS of eating out has gone done, i.e. food is less valued.
China adjusts her consumption bundle from A to B, consuming less food and more clothing.

115. In January, she wins a $1000 jackpot while playing poker
In January, she wins a $1000 jackpot while playing poker. In the same month, her sister graduates from FIDM (The Fashion and Design Merchandising School) and gets a job as an assistant designer in the Los Angeles fashion industry. This means she can get clothing at a 50% discount. Depict the change if eating out is an inferior good. Label on your graph all income and substitution effects. Is it possible that China could get thinner better looking and more fashionable in January? Explain and depict.

116. In January, she wins a $1000 jackpot while playing poker
In January, she wins a $1000 jackpot while playing poker. In the same month, her sister graduates from FIDM (The Fashion and Design Merchandising School) and gets a job as an assistant designer in the Los Angeles fashion industry. This means she can get clothing at a 50% discount. Depict the change if eating out is an inferior good. Label on your graph all income and substitution effects. Is it possible that China could get thinner better looking and more fashionable in January? Explain and depict.
The parallel movement of the budget line from green to purple depicts the effect of winning of the $1000 jackpot.
When the budget line shifts out, China moves from consumption bundle B to C.
Since eating out is an inferior good, her consumption of food falls as she moves from B to C.

117. The rotation causes a substitution and an income effect.
In January, she wins a $1000 jackpot while playing poker. In the same month, her sister graduates from FIDM (The Fashion and Design Merchandising School) and gets a job as an assistant designer in the Los Angeles fashion industry. This means she can get clothing at a 50% discount. Depict the change if eating out is an inferior good. Label on your graph all income and substitution effects. Is it possible that China could get thinner better looking and more fashionable in January? Explain and depict.
The rotation of the budget line depicts the effect be able to get clothing at a 50% discount.
The rotation causes a substitution and an income effect.
The S-effect is depicted by drawing an IC with the new slope tangent to the old IC (C to D).
The I-effect is depicted as the parallel shift of the budget line from dotted brown to solid black (D to E).
Because eating out is an inferior good, eating out declines as a result of the I-effect.

118. Problem
Suntaree is a dealer at the Hollywood Park Casino in Inglewood. Her two great joys in life are playing poker (Texas Hold Em) and wearing designer clothes. Working as a dealer she makes $10 per hour and works 40 hours a week for 4 weeks a month. A complete designer outfit, including shoes, costs $400. Unfortunately, she is a lousy card player and loses every time she plays.
 When Suntaree plays in a low stakes poker game she loses $10 an hour. Draw Suntaree's monthly budget line between designer outfits and hours playing poker and her indifference curves if you observe her playing 20 hours of poker a week. remember you are drawing her monthly budget line). Assume there are 4 weeks in each month.
 As a dealer Suntaree meets all the regular players most of whom are scrubs. One week she is approached by one of the regulars. He is old, ugly, has a nasty personality but has lots of cash. He offers to give Suntaree $50 in chips each day to play poker if she would date him. Draw her monthly budget line if you observe her dating the player and notice her wearing 4 new designer outfits in the next month. Assume there are 28 days in each month. Is poker a normal or inferior good? Show on your budget line and indifference curve graph. Assume that the chips can be redeemed for cash.
The next month one of other regular players, who is younger, good looking, and has a pleasant personality, approaches Suntaree and asks why such a nice girl is dating such a loser. Suntaree answers, "I don't like him much, but I like wearing designer clothing and playing poker more." The good looking player thinks long and hard and then makes the following offer. If Suntaree dumps her boyfriend and dates him, he will take her to the mall once a month and she can buy as many designer outfits as she wants and he will pick up 87.5% of the cost, i.e. she pays $50 and he pays $350 of the cost of each outfit. Will Suntaree switch boyfriends? Explain using budget lines and indifference curves.
Show on your graph how much it would cost her original boyfriend to keep from getting dumped. 

119. When Suntaree plays in a low stakes poker game she loses $10 an hour
When Suntaree plays in a low stakes poker game she loses $10 an hour. Draw Suntaree's monthly budget line between designer outfits and hours playing poker and her indifference curves if you observe her playing 20 hours of poker a week. remember you are drawing her monthly budget line). Assume there are 4 weeks in each month

120. Max Outfits=$1600/400=4 outfits Max Poker=$1600/10=160 hrs.
When Suntaree plays in a low stakes poker game she loses $10 an hour. Draw Suntaree's monthly budget line between designer outfits and hours playing poker and her indifference curves if you observe her playing 20 hours of poker a week. remember you are drawing her monthly budget line). Assume there are 4 weeks in each month
Income=40*4*10=$1600
Max Outfits=$1600/400=4 outfits
Max Poker=$1600/10=160 hrs.

121. As a dealer Suntaree meets all the regular players most of whom are scrubs. One week she is approached by one of the regulars. He is old, ugly, has a nasty personality but has lots of cash. He offers to give Suntaree $50 in chips each day to play poker if she would date him. Draw her monthly budget line if you observe her dating the player and notice her wearing 4 new designer outfits in the next month. Assume there are 28 days in each month. Is poker a normal or inferior good? Show on your budget line and indifference curve graph. Assume that the chips can be redeemed for cash.

122. Income while dating scrub=$1600+$1400=$3000
As a dealer Suntaree meets all the regular players most of whom are scrubs. One week she is approached by one of the regulars. He is old, ugly, has a nasty personality but has lots of cash. He offers to give Suntaree $50 in chips each day to play poker if she would date him. Draw her monthly budget line if you observe her dating the player and notice her wearing 4 new designer outfits in the next month. Assume there are 28 days in each month. Is poker a normal or inferior good? Show on your budget line and indifference curve graph. Assume that the chips can be redeemed for cash.
Scrub’s Offer=$50*28=$1400
Income while dating scrub=$1600+$1400=$3000
Max outfits=$3000/400=7.5
Poker and Outfits are normal goods because when her income increased, her consumption of designer outfits and poker playing increased.

123. The next month one of other regular players, who is younger, good looking, and has a pleasant personality, approaches Suntaree and asks why such a nice girl is dating such a loser. Suntaree answers, "I don't like him much, but I like wearing designer clothing and playing poker more." The good looking player thinks long and hard and then makes the following offer. If Suntaree dumps her boyfriend and dates him, he will take her to the mall once a month and she can buy as many designer outfits as she wants and he will pick up 87.5% of the cost, i.e. she pays $50 and he pays $350 of the cost of each outfit. Will Suntaree switch boyfriends? Explain using budget lines and indifference curves.

124. The next month one of other regular players, who is younger, good looking, and has a pleasant personality, approaches Suntaree and asks why such a nice girl is dating such a loser. Suntaree answers, "I don't like him much, but I like wearing designer clothing and playing poker more." The good looking player thinks long and hard and then makes the following offer. If Suntaree dumps her boyfriend and dates him, he will take her to the mall once a month and she can buy as many designer outfits as she wants and he will pick up 87.5% of the cost, i.e. she pays $50 and he pays $350 of the cost of each outfit. Will Suntaree switch boyfriends? Explain using budget lines and indifference curves.
With either players offer, Suntaree can afford 4 outfits and 140 hours of playing poker.

125. Show on your graph how much it would cost her original boyfriend to keep from getting dumped

126. Show on your graph how much it would cost her original boyfriend to keep from getting dumped

127. Problem
John earns $60,000 a year and lives in Los Angeles. His girlfriend lives in New York. A round trip ticket from Los Angeles to New York costs $500. John usually flies to New York once a month to see his girlfriend.
Draw budget lines and indifference curves to illustrate John's situation. (hint: do everything based on a year's consumption).
Suppose a new low cost carrier begins service on the Los Angeles to New York route. The new carrier charges only $300 for a round trip ticket. Show how the low cost carrier affects John's budget line. Is it possible for the cheaper price of seeing his girlfriend to reduce the number of visits John makes? Illustrate this situation on you graph.
Suppose the original airline institutes a frequent flier program. A round trip from New York to Los Angeles is 6000 miles. If John flies 24,000 miles he will get one free round trip ticket. If he flies 42,000 miles he will get 2 free tickets. For every 12,000 miles he flies above 42,000 miles he will get one additional ticket. Draw budget lines and indifference curves (if possible) showing John staying with the original airline. Draw budget lines and indifference curves showing John switching to the low cost airlines even after the frequent flier program is started.  

128. John earns $60,000 a year and lives in Los Angeles
John earns $60,000 a year and lives in Los Angeles. His girlfriend lives in New York. A round trip ticket from Los Angeles to New York costs $500. John usually flies to New York once a month to see his girlfriend. Draw budget lines and indifference curves to illustrate John's situation. (hint: do everything based on a year's consumption).
Using the All Other Goods idea when analyzing changes in just one good.

129. Draw Budget Line and Indifference Curves.

130. The drop in the price creates an income and substitution effect.
Suppose a new low cost carrier begins service on the Los Angeles to New York route. The new carrier charges only $300 for a round trip ticket. Show how the low cost carrier affects John's budget line. Is it possible for the cheaper price of seeing his girlfriend to reduce the number of visits John makes? Illustrate this situation on you graph.
When airfare drops to $300, if the person spent all of his income on airfare he could make 200 trips instead of 120.
The drop in the price creates an income and substitution effect.

131. Is it possible for reduced airfare to reduce the number of visits John makes?
It is possible for the decrease in airfare to cause John to visit his girlfriend less.
Visiting his girlfriend is an inferior good.
The substitution effect makes him visit more and the income effect makes him visit less. The income effect dominates so overall he visits his girlfriend less.

132. 4 trips=24,000 miles=>1 free trip
Suppose the original airline institutes a frequent flier program. A round trip from New York to Los Angeles is 6000 miles. If John flies 24,000 miles he will get one free round trip ticket. If he flies 42,000 miles he will get 2 free tickets. For every 12,000 miles he flies above 42,000 miles he will get one additional ticket. Draw budget lines and indifference curves (if possible) showing John staying with the original airline. Draw budget lines and indifference curves showing John switching to the low cost airlines even after the frequent flier program is started.
4 trips=24,000 miles=>1 free trip
7 trips=42,000 miles=>2 free trips
113 trips=678,000 miles =>56.5 more free trips.

133. Draw budget lines and indifference curves showing John switching to the low cost airlines even after the frequent flier program is started.  
The budget line for the $300 fare is everywhere farther out than the frequent flyer budget line, therefore, the John will always shift to the low cost airline.

134. Problem 4
Consider a person who earns $2000 a month and is considering whether to send their child to a public or a private school. Suppose the public school is a take it or leave it proposition. The state decides how much to spend per student and the parents have no control over curriculum, hiring and firing teachers, etc. At private schools, parents have more choice. By choosing among different private schools, they choose how much education their children receive. By choosing a more expensive school, they can buy their children more education.
Draw the budget line(s) facing this person. Now draw two sets of indifference curves. One set showing an individual who chooses to send their child to a public school where the state spends $500 per student and another set for an individual who would send their child to a private school that costs $800. Assume the private school costs $800 per month and attending private school precludes attending public school.
Read the article about donations to public schools. If parents can augment the money the state spends on the public schools how will this change the budget line you drew in part A? Draw the budget line if schools are free to accept voluntary contributions.
Suppose two competing initiatives are put on the ballot. One provides for a voucher which can be used to send your child to public school or can be used to pay for up to $500 of private schooling. Any cost of private schooling over $500 must be paid by the individual. The second provides for 50% reimbursement of the cost of private schooling up to $1000, i.e. if you spend $800 on private schooling, the government will reimburse you for $400. The total reimbursement cannot exceed $500. Draw budget lines depicting the two initiatives.
Who would vote for which initiative? Draw indifference curves showing a person who would prefer the voucher and indifference curves showing a person who prefers the 50% reimbursement up to $500.

135. All Other Goods Education
Draw the budget line(s) facing this person. Now draw two sets of indifference curves. One set showing an individual who chooses to send their child to a public school where the state spends $500 per student and another set for an individual who would send their child to a private school that costs $800. Assume the private school costs $800 per month and attending private school precludes attending public school.
All Other
Goods
Education

136. Does this person prefer private of public school?
Draw the budget line(s) facing this person. Now draw two sets of indifference curves. One set showing an individual who chooses to send their child to a public school where the state spends $500 per student and another set for an individual who would send their child to a private school that costs $800. Assume the private school costs $800 per month and attending private school precludes attending public school.
All Other
Goods
Public School
$2000
Does this person prefer private of public school?
Private School
2000
Education
$500
$800

137. Does the person with the red IC’s prefer public or private school?
Draw the budget line(s) facing this person. Now draw two sets of indifference curves. One set showing an individual who chooses to send their child to a public school where the state spends $500 per student and another set for an individual who would send their child to a private school that costs $800. Assume the private school costs $800 per month and attending private school precludes attending public school.
All Other
Goods
Public School
$2000
Does the person with the red IC’s prefer public or private school?
Private School
2000
Education
$500
$800

138. All Other Goods Public School $2000 Private School 2000 Education $800
Read the article about donations to public schools. If parents can augment the money the state spends on the public schools how will this change the budget line you drew in part A? Draw the budget line if schools are free to accept voluntary contributions.
All Other
Goods
Public School
$2000
Private School
$800
2000
Education

139. All Other Goods $2000 50% Reimbursement $1500 $500 Voucher Education
Suppose two competing initiatives are put on the ballot. One provides for a voucher which can be used to send your child to public school or can be used to pay for up to $500 of private schooling. Any cost of private schooling over $500 must be paid by the individual. The second provides for 50% reimbursement of the cost of private schooling up to $1000, i.e. if you spend $800 on private schooling, the government will reimburse you for $400. The total reimbursement cannot exceed $500. Draw budget lines depicting the two initiatives..
All Other
Goods
$2000
50% Reimbursement
$1500
$500 Voucher
Education
$500
$1000
$2000
$2500

140. All Other Goods $2000 50% Reimbursement $1500 $500 Voucher Education
Who would vote for which initiative? Draw indifference curves showing a person who would prefer the voucher and indifference curves showing a person who prefers the 50% reimbursement up to $500.
All Other
The $500 voucher would win because the green budget line is everywhere farther out from the origin than the red budget line.
Goods
$2000
50% Reimbursement
$1500
$500 Voucher
Education
$500
$1000
$2000
$2500

141. Study Guide Things to know.
Terminology: Comparative Advantage, Marginal Rate of Substitution, Specialization and Exchange, etc.
Results: Be able to demonstrate.
Effects of Free Exchange.
Effects of Exchange between more different people.
Substitution and Income Effects of a price change.
Income Effect of a Normal and Inferior good.
Cash vs. In-Kind Transfers.
Effect of an increase in interest rates or wages rates on savings and labor supply.
Analysis:
Use analytical tools, budget lines and indifference curves, to engage in economic analysis.