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Slide 1Copyright © 2004 McGraw-Hill Ryerson Limited Chapter 3 Rational Consumer Choice
Slide 2Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-1 Two Bundles of Goods A bundle is a specific combination of goods. Bundle A has 5 units of shelter and 7 units of food. Bundle B has 3 units of shelter and 8 units of food.
Slide 3Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-2 The Budget Constraint, or Opportunity Set Line B describes the set of all bundles the consumer can purchase if all of income is spent at the given prices. Its slope is the negative of the price of shelter divided by the price of food. This slope is the opportunity cost of an additional unit of shelterthe number of units of food that must be sacrificed in order to purchase one additional unit of shelter at market prices.
Slide 4Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-3 The Effect of a Rise in the Price of Shelter When shelter goes up in price, the vertical intercept of the budget constraint remains the same. The original budget constraint rotates inward about this intercept.
Slide 5Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-4 The Effect of Cutting Income by Half Both horizontal and vertical intercepts fall by half. The new budget constraint has the same slope as the old but is closer to the origin.
Slide 6Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-5 The Budget Constraint with the Composite Good The vertical axis measures the amount of money spent each month on all goods other than X.
Slide 7Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-6 A Quantity Discount Gives Rise to a Nonlinear Budget Constraint Once electric power consumption reaches 1000 kWh/mo, the opportunity cost of additional power falls from $.10/kWh to $.05/kWh.
Slide 8Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-7 Budget Constraints Following Theft of Gasoline, Loss of Cash A theft of $20 worth of gasoline has exactly the same effect on the budget constraint as the loss of $20 in cash. The bundle chosen should therefore be the same, irrespective of the source of the loss.
Slide 9Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-8 Generating Equally Preferred Bundles Z is preferred to A because it has more of each good than A has. For the same reason, A is preferred to W. It follows that on the line joining W and Z there must be a bundle B that is equally preferred to A. In similar fashion, we can find a bundle C that is equally preferred to B.
Slide 10Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-9 An Indifference Curve An indifference curve is a set of bundles that the consumer prefers equally. For two goods, any bundle, such as L, that lies above an indifference curve is preferred to any bundle on the indifference curve. Any bundle on the indifference curve, in turn, is preferred to any bundle, such as K, that lies below the indifference curve.
Slide 11Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-10 Part of an Indifference Map The entire set of a consumers indifference curves is called the consumers indifference map. Bundles of goods on any indifference curve are less preferred than bundles on a higher indifference curve, and more preferred than bundles on a lower indifference curve.
Slide 12Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-11 Why Two Indifference Curves Do Not Cross If indifference curves were to cross, they would have to violate at least one of the assumed properties of preference orderings.
Slide 13Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-12 The Marginal Rate of Substitution MRS at any point along an indifference curve is defined as the absolute value of the slope of the indifference curve at that point. It is the amount of food the consumer must be given to compensate for the loss of 1 unit of shelter.
Slide 14Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-13 Diminishing Marginal Rate of Substitution The more food the consumer has, the more she is willing to give up to obtain an additional unit of shelter. The marginal rates of substitution at bundles A, C, and D are 3, 1, and 1/4, respectively.
Slide 15Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-14 People with Different Tastes Relatively speaking, Pete is a potato lover; Rick, a rice lover. This difference shows up in the fact that at any given bundle Petes marginal rate of substitution of potatoes for rice is smaller than Ricks.
Slide 16Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-15 The Best Affordable Bundle The best the consumer can do is to choose the bundle on the budget constraint that lies on the highest attainable indifference curve. Here, that is bundle F, which lies at a tangency between the indifference curve and the budget constraint.
Slide 17Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-16 A Corner Solution When the MRS of food for shelter is always less than the slope of the budget constraint, the best the consumer can do is to spend all his income on food.
Slide 18Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-17 Equilibrium with Perfect Substitutes Here, the MRS of Coke for Jolt is 2 at every point. Whenever the price ratio P J /P C is less than 2, a corner solution results in which the consumer buys only Jolt. On the budget constraint B, the consumer does best to buy bundle A.
Slide 19Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-18 Housing Subsidy vs. Cash Grant For 3 families receiving subsidized housing at E, only Family 1 (with indifference curve I ) is equally well off with the subsidy or an equivalent cash grant. With a cash grant that raised the budget constraint to JK, Family 2 would choose bundle E 2 and Family 3 would choose bundle E 3. Both would be better off than at E. 1E1E
Slide 20Copyright © 2004 McGraw-Hill Ryerson Limited FIGURE 3-19 A Change in Tastes The black indifference curves I A and I B describe the consumers preferences in period t; the green indifference curves I A´ and I B´ describe her preferences in period t + 1. Her indifference curves reflect a shift towards a stronger preference for X in period t + 1.
Slide 21Copyright © 2004 McGraw-Hill Ryerson Limited PROBLEM 17
Slide 22Copyright © 2004 McGraw-Hill Ryerson Limited ANSWER 3-1
Slide 23Copyright © 2004 McGraw-Hill Ryerson Limited ANSWER 3-2
Slide 24Copyright © 2004 McGraw-Hill Ryerson Limited ANSWER 3-3
Slide 25Copyright © 2004 McGraw-Hill Ryerson Limited ANSWER 3-4
Slide 26Copyright © 2004 McGraw-Hill Ryerson Limited ANSWER 3-5
Slide 27Copyright © 2004 McGraw-Hill Ryerson Limited ANSWER 3-7
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