ECN 104 Chapter Notes - Chapter 21: Budget Constraint, Indifference Curve, Demand Curve

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bronzepig36

23 Jul 2016

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In this chapter a theory is developed that describes how consumers make decisions about what to buy. The theory examines the tradeoffs that people face in their role as consumers. The budget constraint: what the consumers can afford. Study of consumer choice, and it starts by examining the link between income and spending. Budget constraint: the limit on the consumption bundles that a consumer can afford. The slope of budget constraint equals the relative price of the two goods: the price of one good in comparison to the other. Indifference curves: a curve that shows consumption bundles that gives the consumer the same level of satisfaction. Marginal rate of substitution: the rate at which a consumer is willing to trade one good for another. Higher indifference curves are preferred to lower ones. People usually prefer more of something to less of it. In most cases the consumer likes both goods.

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CLASS NOTES ARE LOCATED WHERE IT SAYS CLASS NOTES!

During the early 1700s, a sailing ship is wrecked on an uninhabited island in the Caribbean Sea. The passengers and crew survive but lose all their possessions. There is no source of fresh water on the island, but coconut palm trees are fairly abundant, and the survivors are able to drink milk harvested from coconuts. There are no mammals living on the island, but many birds roost there, and these become a source of meat. There are a number of mango trees that provide fruit. A long, tough form of sawgrass grows in a number of different places on the island. This grass can be woven into knee-length sleeveless shirts, which are the basic type of clothing for people of both genders. The people on this island have developed a simple system of direct market exchange. Currently, two mangos trade for five coconuts, six coconuts trade for a pound of meat, and three pounds of meat trade for four shirts.

1. Use a formula that was stated in class, and in my notes, to calculate the total number of distinct relative prices in the islandâs economy. Note that when this formula is used to count relative prices, any given pair of goods is considered to have only one relative price. For example, if we count the price of a pound of meat in mangos as one relative price, then we donât count the price of mangos in pounds of meat as a second relative price.

(Class Notes: In a barter economy with markets, each good should have a market price, per unit, in terms of each of the other goods: baskets of fish per bushel of apples, bags of coconuts per bushel of apples, etc. A price of this type â units of one good per unit of the other good â is called a relative price (alternatively, a barter price). If there are different goods traded in an economy, then there turn out to be relative prices for a merchant to keep track of, in each market he visits. Each of the n goods has unit prices: one for each of the other goods. We divide by two to avoid counting reciprocal duplicates: if it costs 2 bags of coconuts to buy a bushel of apples, then it costs 1/2 bushel of apples to buy a bag of coconuts, and so on. )

2. Use the price information you are given to calculate all the distinct relative prices. Remember that the prices we are interested in are unit prices. A unit price is the price of a single unit of one good in units of another good. For each pair of goods, use the order that produces the highest unit price. In the case of coconuts and shirts, for example, if the price of a shirt in coconuts is higher than the price of a coconut in shirts, then report the first price but not the second one. Note: In calculating unit prices, donât worry about issues of divisibility. Assume that any good can be divided in any way, so that fractions or decimals can be components of unit prices.

3. For each relative price you just calculated, calculate the relative price if the order of the two items is switched. (In the scenario above, for example, you would now calculate the price of a coconut in shirts.) What very simple formula can you use to do this? Explain briefly.

4. Now suppose the people on this island start using mangos as money. The relative prices on the island do not change, and the absolute prices are consistent with them. a. Use a formula stated in class, and in my notes, to calculate the total number of absolute prices in the islandâs economy. b. Report these absolute prices.

Class Notes: ( In a monetary economy, in contrast, each good has a single absolute price (alternatively, a money price), which is its unit price in terms of money: dollars per bushel of apples, etc. If we assume that one of the n goods is used as money, then a merchant only needs to keep track of absolute prices. As long as there are more than two different goods ( ), it turns out that , and the difference between these two numbers gets very big as n gets large. Even if there are only 10 different goods, then there are 45 relative prices and only 9 absolute prices. And if there are 100 different goods, which is a more realistic number, then there are 99 absolute prices but almost 5000 relative prices.)

5. Comment briefly on the potential advantages and disadvantages of using mangos as money, using our list of the desirable properties of money as a guide.

6. Suppose you are a merchant on this island, where mangos are used as money in the market (see Item 4 above). A competing merchant who dislikes using money in transactions is willing to trade coconuts for shirts (or vice-versa) directly, at a rate of five coconuts per shirt. Explain, carefully and completely, how you could use this merchantâs willingness to trade these two goods, at this rate, in order to make a profit of one unit of money for yourself by (1) using money to buy units of a good in the market, (2) trading those units of the good to this merchant, in exchange for units of another good, and (3) selling those units in the market for money. Identify the items traded and the quantities, and verify the amount of the profit. Finally, explain what you would need to do in order to make a larger profit (double, for example).

Quantity of pita wraps	Total utility	Quantity of Bubble teas	Total Utility
1	60	1	40
2	102	2	70
3	132	3	91
4	144	4	106
5	144	5	112
6	138	6	115
7	128	7	115

Keegan has $30 to spend on Pita Wraps and Bubble Tea. The price of a Pita Wrap is $6 and the price of a glass of Bubble Tea is $3. The table above shows his total utility from different quantities of the two items.

a) What is Keegan's optimal consumption bundle?

b) What is Keegan's marginal utility per dollar spent on the third pita wrap?

c) If Keegan can drink all the bubble tea he wants for free, how many glasses will he consume?

2. Suppose Joe is maximizing total utility within his budget constraint. If the price of the last pair of jeans purchased is $25 and it yields 100 units of extra satisfaction and the price of the last shirt purchased is $20, then, using the rule of equal marginal utility per dollar spent, how much extra satisfaction must Joe receive from the last shirt?

3. Popular rock band U2 regularly sells out its concerts, charging $80 for its tickets. They could raise ticket prices to $120 and still sell out their concerts, but choose not to do so. What is the best economic explanation for this decision?

II. Mr. I.M Farmer has been producing 500 acres of irrigated cotton in the Texas High Plains. He is very concerned about increasing fuel costs because he uses a lot of fuel to pump irrigation water. He is also concerned because he believes that the price of cotton could drop to 58 cents per pound. He is not sure that he can profitably produce cotton if the price falls to 58 cents or less.

Assume you have been asked to analyze this problem. With the help of an extension agent, you developed the following cost schedule for irrigated cotton at various levels of production. All costs were figured on a per-acre basis. Fixed costs are $110 per acre. Total variable costs per acre are listed in the chart below.

Mr. Farmer has asked you to compute the profit-maximizing level of production and the amount of profit he can expect at various cotton prices. He particularly wants advice about whether or not he should produce any cotton at all if the price drops to 58 cents per pound. (Assume I. M. Farmer has no alternative to cotton; that is he either produces cotton or nothing.)

1. What is the most profitable cotton yield if the price is 80 cents per pound? What is the profit or loss per acre?

Yield_________________________________

Profit/Loss_________ _______________

2. a) If the price does fall to 58 cents per pound, should Mr. Farmer produce any cotton?

( ) Yes ( ) No

If yes, profit maximizing yield per acre___________________

Profit/loss per acre______ ______

b) How much would Mr. Farmer lose if he did not produce any cotton some year?

Loss per acre_____________________

3. If the expected price is only 40 cents per pound, should Mr. Farmer try to produce anything?

( ) Yes ( ) No

If he does produce, how much? ______ ___________lbs per acre.

What would Profit/Loss be if he produces? __ ________(per acre)

4. What is the lowest price that Mr. Farmer can receive and just cover all his costs? At what yield?

Price_________ _________________

Yield_________ ___________________

Profit/Loss_____ ____________(per acre)

5. At what price will Mr. Farmer stop producing? ____ ___________

Total Product (lbs./acre)	Total variable cost	Total fixed cost	Total cost	Average Cost Per Lb.			Marginal cost	Marginal Revenue
Total Product (lbs./acre)	Total variable cost	Total fixed cost	Total cost	Fixed	Variable	Total	Marginal Cost	Marginal Revenue
200	65.80	110	175.8	.55	.33	.88	.224	.58
250	77.00	110	187	.44	.31	.75	.073	.58
300	80.68	110	190.68	.36	.27	.63	.14	.58
350	87.59	110	197.59	.314	.25	.56	.15	.58
400	94.94	110	204.94	.28	.24	.52	.18	.58
450	103.80	110	213.8	.24	.23	.47	.23	.58
500	115.30	110	225.30	.22	.23	.45	.02	.58
550	133.30	110	243.30	.20	.24	.44	.36	.58
600	155.55	110	265.55	.18	.26	.44	.45	.58
650	182.80	110	292.80	.17	.28	.45	.56	.58
700	215.55	110	325.55	.16	.31	.47	.66	.58
750	254.30	110	364.30	.15	.34	.49	.78	.58
800	295.80	110	405.8	.14	.37	.51	.83	.58

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ECN 104 Chapter Notes - Chapter 21: Budget Constraint, Indifference Curve, Demand Curve

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