BT-1210 – Economics course IBA
Week 1:
Lecture week 1 + chapter 1 & 2:
QUESTION: THE MARKET FOR BURRITOS
• Which of the following will result in an increase in the equilibrium price and a
decrease in the equilibrium quantity of burritos?
o A. An increase in the price of beans (an input)
o B. Introduction of “tastier” burritos
• Answer:
• The increase of quilibrium price is at both A and B
• However, the decrease in the equilibrium quantity is only at A (consumers are less
willing to buy burritos). Because for B, demand is shifting to the right, meaning that
the quantity will not decrease (So, price goes up and quantity goes up)
The intuition slide:
On the left, consumers are price-sensitive, therefore they will buy much more when the price
decreases a little bit. On the right, consumers are less price-sensitive.
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,Week 2:
Chapter 4 + 5:
We must start with some assumptions (again, to keep things simple, we focus on a model
with only two goods). We assume three things:
1. Each good has a fixed price, and any consumer can buy as much of a good as she
wants at that price if she has the income to pay for it.
2. The consumer has a fixed amount of income available to spend.
3. For now, the consumer cannot borrow or save.
Feasible bundle: Any combination of goods on or below the budget constraint that the
consumer has the income to purchase
Infeasible bundle: Any combination of goods above or to the right of the budget line that the
consumer cannot afford to purchase
The Slope of the Budget Constraint:
a) Figure 4.15a demonstrates what happens to our example budget constraint if the
price of lattes doubles to $10. The budget constraint rotates clockwise around the
vertical axis. Because doubles, doubles, and the budget constraint
becomes twice as steep. If Sarah spends all her money on lattes, then the doubling of
the price of lattes means she can buy only half as many lattes with the same income.
If, on the other hand, she spends all her money on burritos (point B), then the change
in the price of a latte doesn’t affect the bundle she can consume.
b) If instead the price of a burrito doubles to $20, but that of a latte remains stable at the
original $5 price (Figure 4.15b), the budget constraint’s movement is reversed: It
rotates counterclockwise around the horizontal axis, becoming half as steep.
c) Now suppose prices are stable but Sarah’s income falls by half (to $25). With only
half the income, Sarah can buy only half as many lattes and burritos as she could
before (Figure 4.15c). If she spends everything on lattes, she can now buy only 5. If
she buys only burritos, she can afford 2.5. But because relative prices haven’t
changed, the tradeoffs between the goods haven’t changed.
a. Thus, the slope of the budget constraint remains the same.
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,Important: Always remember that when the price rises, the budget constraint
rotates toward the origin. When the price falls, it rotates away from the origin.
Note that had both prices doubled while income stayed the same, the budget constraint
would be identical to the new one shown in Figure 4.15c.
Nonstandard Budget Constraints
Quantity Discounts
• With a quantity discount, the price the consumer pays per unit of the good depends
on the number of units purchased.
•
Quantity Limits
• Another way a budget constraint can be kinked is if there is a limit on how much of
one good can be consumed.
•
• When Alex is limited to 600 MBs of data per week, his budget constraint is horizontal
at that quantity. The triangle above the horizontal section of the budget constraint and
below the dashed line represents the set of data and pizzas that are now infeasible
for Alex to buy. Note that Alex can still afford these sets since his income and the
prices have not changed, but the restrictions on how much he can purchase dictate
that he cannot buy them.
Constrained optimization problem: There is something you want to maximize (utility, in this
case), and there is something that limits how much you can get (the budget constraint, in this
case).
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, • Figure 4.18 presents an example that shows a combination of indifference curves
and a budget constraint. Remember, the consumer wants to get as much utility as
possible from consuming the two goods, subject to the limits imposed by her budget
constraint.
• Why is A the utility-maximizing consumption bundle? Compare point A to another
feasible bundle, such as B. Point B is on the budget constraint, so the consumer
could afford it. However, because B is on a lower indifference
curve than A is , bundle B provides less utility than A. Bundles C and D,
too, are feasible but worse than A in terms of utility provided because they are on the
same indifference curve as B.
• The consumer would love to consume bundle E because it’s on an indifference
curve that corresponds to a higher utility level than . Unfortunately, she can’t
afford E.
This single tangency is not a coincidence. It is a requirement of utility maximization. To see
why, suppose an indifference curve and the budget constraint never touched. Then no point
on the indifference curve is feasible, and by definition, no bundle on that indifference curve
can be the way for a consumer to maximize her utility given her income.
This means that only at a point of tangency are there no other bundles that are both (1)
feasible and (2) offer a higher utility level.
• When the consumer spends all her income and maximizes her utility, her optimal
consumption bundle is the one at which the ratio of the goods’ marginal utilities
exactly equals the ratio of their prices.
• Although they have the same budget constraint, Jack and Meg have different relative
preferences and, therefore, different optimal consumption bundles. Because Jack
likes gum relative to iTunes downloads, his indifference curve (Uj) is flat and he
consumes much more gum than iTunes at his optimal consumption bundle at point J.
Meg’s indifference curve (Um) is much steeper and reflects her relative preference for
iTunes downloads over gum; her utility-maximizing bundle is shown at point M.
Although their consumption bundles are different, the MRS is the same at these
points.
• Again, both consumers end up with the same MRS in their utility-maximizing bundles
because each consumes a large amount of the good for which he or she has the
stronger preference. By behaving in this way, Jack and Meg drive down the relative
marginal utility of the good they prefer until their marginal utility ratio equals the price
ratio.
• Note that these two indifference curves cross. Although earlier we learned that
indifference curves can never cross, the “no crossing” rule applies only to the
indifference curves of one individual.
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