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ECN104 Chapter 21.doc

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ECN 104
Tsogbadral Galaabaatar

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ECN104 – Chapter 21 Notes Chapter 21 Notes • Questions o How does the budget constraint represent the choices a consumer can afford? o How do indifference curves represent the consumer’s preferences? o What determines how a consumer divides her resources between two goods? o How does the theory of consumer choice explain decisions such as how much a consumer saves, or how much labour she supplies? • Introduction o Recall one of the Ten Principles from Chapter 1: People face tradeoffs.  Buying more of one good leaves less income to buy other goods  Working more hours means more income and more consumption, but less leisure time  Reducing saving allows more consumption today but reduces future consumption o This chapter explores how consumers make choices like these. • The Budget Constraint: What the Consumer Can Afford o E.g., Hurley divides his income between two goods: fish and mangos. o A “consumption bundle” is a particular combination of the goods, e.g., 40 fish and 300 mangos o Budget constraint: the limit on the consumption bundles that a consumer can afford • The Slope of Budget Constraint o “rise” = -200 mangos o “run” = +50 fish o Slope = -4  Hurley must give up 4 mangos to get one fish o The slope of the budget constraint equals  The rate at which Hurley can trade mangos for fish  The opportunity cost of fish in terms of mangos  The relative price of fish: • Price of fish / price of mangos • The Income and Substitution Effects o A fall in the price of fish has two effects on Hurley’s optimal consumption of both goods.  Income Effect: A fall in Pf boosts the purchasing power of Hurley’s income, allows him to buy more mangos and more fish.  Substitution Effect: A fall in Pf makes mangos more expensive
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