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Intermediate Microeconomics

Intermediate Microeconomics. Budget Sets. Consumer Theory. First part of class we want to understand “demand”. We want to do so from “first principles”. Consumer Theory - a model to describe how individuals behave. How do individuals choose what to consume?

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Intermediate Microeconomics

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  1. Intermediate Microeconomics Budget Sets

  2. Consumer Theory • First part of class we want to understand “demand”. • We want to do so from “first principles”. • Consumer Theory - a model to describe how individuals behave. • How do individuals choose what to consume? • How do these decisions respond to changes in the environment? • How can we use this model to describe market demand for goods? • How should we start?

  3. Budget Set • How do you know what goods you can choose to consume at any one time?

  4. Budget Set • Suppose you are endowed with $10 and only goods you consume are peanuts and beer. • Peanuts cost $0.10/oz (i.e. pp = 0.10) • Beer costs $0.20/oz (i.e. pb = 0.20) • How can we fully describe what combinations of peanuts and beer you can consume? • Analytically? • Graphically?

  5. Budget Set • Consumption Bundle – A list of numbers indicating how much of each good an individual is consuming: {q1, q2, …., qn} • Budget Set – the set of consumption bundles of goods a person can afford to consume. • Generally can be expressed by equation of form: p1q1 + p2q2 + … + p3q3 ≤ m

  6. Budget Set • Ex: Suppose there are two goods, peanuts and beer. • {50, 20} is a consumption bundle containing 50 oz. of peanuts and 20 oz of beer, • {0,50} is a consumption bundle containing 0 oz. of peanuts and 50 oz of beer, • {10,50} is a consumption bundle containing 10 oz. of peanuts and 50 oz of beer. • If pp = 0.10, pb = 0.20, and m = 10, the budget set is 0.10qp + 0.20qb ≤ 10 • Is the bundle {50, 20} in your budget set? How about {0,50}? How about {10,50} ? • What does it mean when the budget equation holds with inequality as opposed to equality?

  7. Budget Set • Interpreting prices • As we will see, prices will play a big role in our analysis of consumer behavior. • In our previous example, what was the price of beer? • How do you interpret the slope of budget set? • What if you lived in London, were endowed with 5 pounds, and Peanuts cost 0.5 pence/oz and Beer costs 0.10 pence/oz . What would your budget set look like? Are prices the same in London or different?

  8. Graphing Budget Sets • So slope of budget constraint is rise/run or simply negative of price ratio (-p1/p2). • Interpretation of slope: relative cost of good 1 in terms of good 2. q2 m/p2 p1/p2 -1 q1 m/p1

  9. Graphing Budget Sets • What happens when relative prices change? • (original) m = 10, pp = 0.10 and pb = 0.20 • m = 10, pp = 0.20, and pb = 0.20 • m = 10, pp = 0.10 and pb = 0.10

  10. Graphing Budget Sets • What happens when endowment changes but relative prices don’t? • (original) m = 10, pp = 0.10 and pb = 0.20 • m = 20, pp = 0.10, and pb = 0.20 • m = 4, pp = 0.10 and pb = 0.20

  11. Budget Sets and Taxes • Suppose m = $10, pp = 0.10, and pb = 0.20 • How would budget set change if a 25% sales tax were imposed on beer? • How about if a 25% sales tax were imposed on all goods? • How about if a 25% tax were imposed on each person’s endowment?

  12. Is two-good framework sufficient? • With two goods, we could write a budget set as : p1q1 + p2q2≤ m • Suppose we are interested in analyzing good 1, but there are two other goods that a consumer can also spend money on. • Analyze good 1 compared to a composite good which is just the amount of money spent on all other goods (i.e. goods 2 and 3). • Denoting “dollars” of composite good as qc we can write budget set as: • qc + p1q1≤ m • p2q2 + p3q3≤ qc • If we are only interested in analyzing good 1, we can ignore equation 2, and we are back in two-good framework. • How would we draw this? What is slope?

  13. More Complicated Budget Constraints • Budget constraints seem pretty simple, why do we make them so complicated? • Consider more complicated pricing schemes. • Bulk Pricing • Hamburger is $2/lb for first 3lbs, but only $1/lb for each additional amount past 3lbs.

  14. More Complicated Budget Constraints • Government policy can also often make budget constraints more complicated • Food Stamps • pre-1979 – qualifying poor households could get “50% off coupons” for up to $200 worth of food per month. • post-1979 - qualifying poor households given $100 in food vouchers. • How do budget sets differ across two programs for a person earning $300/mo.?

  15. More Complicated Budget Constraints • Public housing • Suppose a person is given a take-it-or-leave-it offer of a free apartment • Further suppose this apartment would rent for $300/month in the marketplace. • If person had $500/mo. in income, what would budget constraint look like? • What if instead of this “in-kind” benefit, person was given $300 in cash. • What would budget constraint look like? • So why don’t we always give cash benefits?

  16. Budget Constraints more broadly • Suppose you work for Doctors without Borders. • Your funds are enough to have twenty “beds” in your clinic. • Each malaria patient you treat needs one week in your clinic for full treatment. • Each tuberculosis patient you treat needs two weeks in your clinic for full treatment. • What is monthly “budget constraint”? What is the “cost/price” of treating a tuberculosis patient?

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