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Chapter 21 Notes.docx

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Ryerson University
ECN 104
Frank Trimnell

Alyssa Soubliere October 24, 2013 Ryerson University ECN104 Chapter21 Notes Budget Constraint:  the limit on consumption bundles that a consumer can afford  “consumption bundle” – a particular combination of goods (40 fish & 300 mangos)  QF (quantity of fish) = Y (income) / PF (price of fish)  QF = 1200 / 4  Y = Pm * Qm + Pf * Qf  Slope (Y/Pm) / (Y/Pf) = Pf / Pm (Rise over Run) M = (Y/Pm) – (Pf / Pm) * QF  budget line Indifference Curves Indifference curve: shows consumption bundles that give the consumer the same level of satisfaction  Downward sloping Properties 1. If one quantity is reduced, one must be increased 2. Higher indifference curves are preferred to lower ones 3. Indifference curves cannot cross 4. Indifference curves are curved inward Marginal Rate of Substitution -the rate at which a consumer is willing to trade one good for another. **MRS falls as you move down along an indifference curve. ** Perfect Substitutes (EXTREME): two goods with straight-line indifference curves, constant MRS Alyssa Soubliere October 24, 2013 Ryerson University ECN104 Perfect Complements two goods with right-angle indifference curves Close Substitutes & Close Complements Close Substitutes- Indifference curves for close substitutes are not very bowed Close Complements - Indifference curves for close complements are very bowed Optimization Optimum- The optimum is the bundle Hurley most prefers out of all the bundles he can afford. At the optimum, slope of the indifference curve equals slope of the budget constraint e.g. MRS = PF/PM Increased Income Effects: An increase in income shifts the budget constraint outward. If both goods are “normal,” Hurley buys more of each. Inferior vs. Normal:  An increase in income increases the quantity demanded of normal goods and reduces the quantity demanded of inferior goods. Price Change Effects: Budget constraint rotates outward if price decreases Income & Substitution Effects  Income effect A fall iF P boosts the purchasing power of Hurley’s income, allows him to buy more mangos and more fish. Alyssa Soubliere October 24, 2013 Ryerson University ECN104  Substitution effect A fall inFP makes mangos more expensive relative to fish, causes Hurley to buy fewer mangos & more fish. ***The net effect on mangos is ambiguous.*** “Giffen” Goods:  If price of potatoes rises,  substitution effect: buy less potatoes  income effect: buy more potatoes In this case… if the income effect > substitution effect, then potatoes are a Giffen good, a good for which an increase in price raises the quantity demanded Example—Wages & Labour Supply Budget constraint  Shows a person’s tradeoff between consumption and leisure.  Depends on how much time she has to divide between leisure and working.  The relative price of an hour of leisure is the amount of consumption she could buy wit
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