Review of the previous lecture
Price elasticity of demand measures how much the quantity demanded responds to
changes in the price.
Price elasticity of demand is calculated as the percentage change in quantity
demanded divided by the percentage change in price.
If a demand curve is elastic, total revenue falls when the price rises.
If it is inelastic, total revenue rises as the price rises.
The income elasticity of demand measures how much the quantity demanded
responds to changes in consumers income.
The cross-price elasticity of demand measures how much the quantity demanded of
one good responds to the price of another good.
The price elasticity of supply measures how much the quantity supplied responds to
changes in the price. .
Review of the previous lecture
In most markets, supply is more elastic in the long run than in the short run.
The price elasticity of supply is calculated as the percentage change in quantity
supplied divided by the percentage change in price.
The tools of supply and demand can be applied in many different types of markets.
Price Restrictions
Price Ceilings
The maximum legal price that can be charged.
Examples:
Gasoline prices in the 1970s.
Housing in New York City.
Proposed restrictions on ATM fees.
Price Floors
The minimum legal price that can be charged.
Examples:
Minimum wage.
Agricultural price supports.
Impact of a Price Ceiling
Price
PF
P*
Ceiling
Shortage
Qs
Qd
Quantity
Impact of a Price Floor
Price
Surplus
PF
P*
D
Quantity
Lecture 5
The theory of consumer choice - I
Instructor: Prof.Dr.Qaisar Abbas
Course code: ECO 400
Lecture Outline
1. Budget constraint
2. Indifference curve
3. Properties of indifference curve
Introduction
The theory of consumer choice addresses the following
questions:
1. Do all demand curves slope downward?
2. How do wages affect labor supply?
3. How do interest rates affect household saving?
The Budget Constraint: What The Consumer Can Afford
The budget constraint depicts the limit on the consumption bundles that a
consumer can afford.
People consume less than they desire because their spending is
constrained, or limited, by their income.
The budget constraint shows the various combinations of goods the
consumer can afford given his or her income and the prices of the two goods.
The Budget Constraint
Consumer budget constraint
Any point on the budget constraint line indicates the consumers combination
or tradeoff between two goods.
For example, if the consumer buys no pizzas, he can afford 500 pints of Pepsi
(point B). If he buys no Pepsi, he can afford 100 pizzas (point A).
The Budget Constraint
Consumer budget constraint
The Budget Constraint
Alternately, the consumer can buy 50 pizzas and 250 pints of Pepsi.
The Budget Constraint
The slope of the budget constraint line equals the relative price of the two goods, that
is, the price of one good compared to the price of the other.
It measures the rate at which the consumer can trade one good for the other.
Consumer preferences
A consumers preference among consumption bundles may be illustrated with
indifference curves.
An indifference curve is a curve that shows consumption bundles that give the
consumer the same level of satisfaction
Consumer preferences
The consumer is indifferent, or equally happy, with the combinations shown at
points A, B, and C because they are all on the same curve.
The Marginal Rate of Substitution
The slope at any point on an indifference curve is the marginal rate of
substitution.
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.
Properties of Indifference Curves
Four Properties of Indifference Curves
1.
2.
3.
4.
Higher indifference curves are preferred to lower ones.
Indifference curves are downward sloping.
Indifference curves do not cross.
Indifference curves are bowed inward.
Property 1: Higher indifference curves are preferred to lower ones.
Consumers usually prefer more of something to less of it.
Higher indifference curves represent larger quantities of goods than do lower
indifference curves.
Properties of Indifference Curves
Property 2: Indifference curves are downward sloping.
A consumer is willing to give up one good only if he or she gets more of the
other good in order to remain equally happy.
If the quantity of one good is reduced, the quantity of the other good must
increase.
For this reason, most indifference curves slope downward.
Properties of Indifference Curves
Property 3: Indifference curves do not cross.
Points A and B should make the consumer equally happy.
Points B and C should make the consumer equally happy.
This implies that A and C would make the consumer equally happy.
But C has more of both goods compared to A.
Properties of Indifference Curves
Property 4: Indifference curves are bowed inward.
People are more willing to trade away goods that they have in
abundance and less willing to trade away goods of which they have
little.
These differences in a consumers marginal substitution rates cause
his or her indifference curve to bow inward.
Properties of Indifference Curves
Two Extreme Examples of Indifference Curves
Perfect Substitutes
Two goods with straight-line indifference curves are perfect substitutes.
The marginal rate of substitution is a fixed number.
Properties of Indifference Curves
Perfect Complements
Two goods with right-angle indifference curves are perfect complements.
Consumer Equilibrium
The equilibrium
consumption
bundle is the
affordable
bundle that
yields the
highest level of
satisfaction.
Consumer
equilibrium occurs
at a point where
MRS = PX / PY.
Equivalently, the
slope of the
indifference curve
Y
M/PY
Consumer
Equilibrium
III.
II.
I.
M/PX
Summary
A consumers budget constraint shows the possible combinations of different goods
he can buy given his income and the prices of the goods.
The slope of the budget constraint equals the relative price of the goods.
The consumers indifference curves represent his preferences.
Points on higher indifference curves are preferred to points on lower indifference
curves.
The slope of an indifference curve at any point is the consumers marginal rate of
substitution.
