1. budget constraint ab 0__ 1 2 3 4 5 6 p a = $12 p b = $2.40 income = $72 7 6 5 4 3 2 1 0 510...
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1. Budget Constraint
A B0 __1 __2 __3 __4 __5 __6 __
PA = $12 PB = $2.40 Income = $72
7
6
5
4
3
2
1
05 10 15 20 25 30 35 40 45 50
Choices are based on Comparisons of MU per $ spent on each
good
MUA
PA=
MUB
PB= . . . =
MUN
PN
Would a person maximize satisfaction
by buying a $15 product that adds
twice as much satisfaction as a $5
product?
Item Price Utility
Pants $60 125
Shirt $40 100
Wallet $20 50
Number
Bought
With Constraint
1
2
3
4
5
6
7
10
8
7
6
5
4
3
24
20
18
16
12
6
4
Domestic MU/$
____ ____
Domestic $1
MU
Marginal Utility per $Imported $2
MU
Without Income Constraint?
Imported MU/$
____ ____
____ ____
____ ____
____ ____
____ ____
____ ____
With $12?
2. Budget Increase
A B0 351 302 253 204 155 106 57 0
3. Price Change
A B0 241 202 163 124 85 46 0
At a lower price consumers can switch to
the cheaper good, substituting the cheaper for the more expensive.
Substitution Effect
Why the Demand Curve slopes downOne Reason:
A lower price of a good will increase purchasing power of the consumer. They can buy more than
before.
Income Effect
A Second Reason:
Why the Demand Curves slopes down
Diminishing Utility
Consumers get less satisfaction as they buy more of a good. For the
consumer to buy more the price must be reduced.
A Third Reason:
Why the Demand Curves slopes down
$2.50
$2.00
Price
Frozen pizzasper week
$3.00
$3.50
MB4 MB3 MB2 MB1<<<
MU4 MU3 MU2 MU1<<<because
d MB=
• The demand for frozen pizzas reflects the law of diminishing marginal utility.
• Because marginal utility (MU) falls with increased consumption, so does a consumer’s maximum willingness to pay -- marginal benefit (MB).• A consumer will purchase until
MB = Price . . . so at $2.50 they would purchase 3 frozen pizzas and receive a consumer surplus shown by the shaded area (above the price line and below the demand curve).
Price = $2.50
The Pizza Demand Curve
John’s demand curvefor frozen pizza
421 3
MB4
MB3
MB2
MB1
Jones Smith 2-Person market
1 3 2 3 3 62 4 5 76 8 1 4 5 76 8 21 4 5 7 8
Price Price Price
Weekly frozen pizza consumption
At $3.50 Jones demands 1 pizza …
and so on … At $3.50 Smith demands 2 pizzas …
and so on …
$3.50
$2.50
$3.50
$2.50
d
$3.50
$2.50D
d
• Consider Jones’s demand for frozen pizza. at $2.50 3 pizzas …• Consider Smith’s demand for frozen pizza. at $2.50 3 pizzas …
• The market demand curve is merely the horizontal sum of the individual demand curves (here Jones and Smith).• The market demand curve will slope downward to the right, just as the individual demand curves do.
Individual and Market Demand Curves
4. Labor-Leisure Budget Constraint
Work Income
0 0
10 100
20 200
30 300
40 400
50 500 (550?)
60 600 (700?)
70 700 (850?)
a. 70 hour week, $10 per hour wages b. $12 per hour wages
5. Present versus Future Consumptiona. 6% annual rate of return b. 9% annual rate of return.
5. Present versus Future Consumptiona. 6% annual rate of return b. 9% annual rate of return.
Present Present Future Consumption Future ConsumptionConsumption Savings (6% annual return) (9% annual return) $1,000,000 0 0 0 $900,000 $100,000 $574,000 $1,327,000
$800,000 $200,000 $1,148,000 $2,654,000
$700,000 $300,000 $1,722,000 $3,981,000
$600,000 $400,000 $2,296,000 $5,308,000
$400,000 $600,000 $3,444,000 $7,962,000
$200,000 $800,000 $4,592,000 $10,616,000
0 $1,000,000 $5,740,000 $13,270,000
PV
where i = 6 %
=
PV =Receipts 1 year from now
interest rate + 1
$ 94.34
Present ValueThe interest rate connects the value of dollars
today with the value of dollars in the future.The present value (PV) of a single ($100)
payment to be received one year from now is:
=$ 1001.06
$ 1001 + .06 =
PV
where i = 6 % and n = 3
=
PV =Receipts n years from now
(interest rate + 1) n
$ 83.96
Present Value n Years in the FutureThe present value (PV) of that single ($100)
payment to be received n years from now is:
=$ 100(1.06)3
$ 100(1 + .06)3 =
The present value of the future payment is inversely related to:the interest rate, and,how far in the future the payment will be
received.
PV =
where i = 6 % and n = 3 and R = $100
PV =R1
(1 + i)+
R2
(1 + i)2
R n
(1 + i) n+
R3
(1 + i)3 + +. . . . .
Present Value n Years in the FutureThe present value (PV) of a stream of
payments (each of nominal magnitude R) to be received each year for n years is:
$100
(1.06)+
(1.06)2
$100+
(1.06)3
$100=$ 267.30
PV = $94.34+
$89+
$83.96 =$ 267.30
Co
Cd
Age
Annual earningsor costs
22
$ 0
18 65
Earningsw/o college
Earningsw/ college
Investing in Human Capital
Consider a somewhat simplified example of a human- capital investment decision confronting Juanita, an 18-year old who just finished high-school. We have graphed Juanita’s expected earnings both with …
and without college. Should Juanita attend college or not?
If Juanita chooses to attend college, she will incur both the direct cost of a college education (tuition, books, etc) Cd …
and the opportunity cost of earnings forgone while in college Co .
B
Cd
Co
Age
Annual earningsor costs
22
$ 0
18 65
Earningsw/o college
Earningsw/ college
Investing in Human Capital
With a college education, though, Juanita can expect higher future earnings (B) during her career (even though they may begin lower, they end higher).
If the discounted present value of the additional future earnings exceeds the discounted value of the direct and indirect costs of a college education, then the college degree will be a profitable investment for Juanita.
Less than9th grade
HighSchool
Some college
Bachelor’sdegree
Master’sdegree
Doctoraldegree
The earnings of both men and women increase with education.
Note, though, that women’s earnings were only about 2/3 those of similarly educated men.
Level of Education and Earnings (and Discrimination)
24,595
35,121
42,946
62,543
75,411
107,988
23,498
29,500
49,635
69,085
40,263
18,578 Women
Men
Mean earnings ($) ofyear-round-full-time workers (2000)
56% of men’s
Less thanhigh school
Highschool
Some college
Bachelor’sdegree
Master’sdegree
Doctoraldegree
Both still increase with education.
Updated in 2001
Women’s earnings still about 2/3 those of similarly
educated men.
Level of Education and Earnings
27,190
37,362
45,271
70,253
87,022
118,853
26,660
32,511
57,770
71,608
45,290
22,361 Women
Men
Mean earnings ($) ofyear-round-full-time workers (2001)
10% above 2000
14% above 200066% of men’s
Less thanhigh school
Highschool
Some college
Bachelor’sdegree
Master’sdegree
Doctoraldegree
Level of Education and Earnings
28,415
40,112
49,537
75,130
95,794
136,567
28,657
35,521
59,569
92,650
49,326
20,508 Women
Men
Mean earnings ($) ofyear-round-full-time workers (2005)
Both still increase with education.
Updated in 2005
Women’s earnings still about 2/3 those of similarly
educated men.
14.9% from 200114.9% from 200147% of men’s
Less thanhigh school
Highschool
Some college
Bachelor’sdegree
Master’sdegree
Doctoraldegree
The earnings of both men & women increase with education.
Updated in 2007
Women’s earnings still only about 2/3 those of similarly educated men.
Level of Education and Earnings
30,602
42,042
50,103
77,536
94,763
132,706
30,657
38,396
63,156
85,190
52,857
21,906 Women
Men
2000
2005
2007
Bachelor’s Degree
Comparison over time
77,536
52,857
Women
Men62,543
40,263
2001 70,253
45,290
75,130
49,326
If Mr. Smith thinks the last dollar spent on shirts yields less satisfaction than the last dollar spent on cola, and Smith is a utility-maximizing consumer, he should
a.decrease his spending on cola.b. decrease his spending on cola and increase his
spending on shirts.c.increase his spending on shirts.d. increase his spending on cola and decrease his
spending on shirts.Which of the following would be the best example of consumer surplus?
a.Jane does not get cell-phone service because she feels that it is worth less than the $30 a month fee.
b. Sam pays $8 for a haircut that is worth $10 to him.c.Ralph buys a house for $104,000, the maximum amount
that he would be willing to pay for it.d. Sue purchases a book for $20 and uses a credit card to
pay for it.
“I like ice cream, but after eating homemade ice cream last night, I want to have something else for dessert today.” This statement most clearly reflects
a.the budget constraint.b.consumer irrationality.c. the second law of demand: Price elasticity increases with time.d.the law of diminishing marginal utility.
If Sarah’s income rises by 20 percent, and, as a result, she purchases 40 percent more designer clothing, her income elasticity for designer clothing is
a.0.5.b.1.0.c. 2.0.d.seriously distorted.
Suppose the state of New York imposes a one dollar per pack tax on cigarettes, which increases their price by 30 percent, and as a result, the quantity sold declines by 20 percent. The price elasticity of demand for cigarettes is equal to
a.–0.20.b.–0.67.c. –1.50.d.–3.00.
Studies indicate that the demand for fresh tomatoes is much more elastic than the demand for salt. These findings reflect that
a.tomatoes are a necessity while salt is a luxury.b.it takes longer for consumers to adjust to a change in the price
of salt than to a change in the price of tomatoes.c. salt will not spoil as easily as fresh tomatoes.d.more good substitutes exist for fresh tomatoes than for salt.
If a Krispy Kreme doughnut shop near campus increases its prices by 5 %, but revenues from its sales are unchanged, the price elasticity of demand for the services offered by the doughnut shop must be
a.elastic.b.of unitary elasticity.c. inelastic.d.equal to 0.5.
If the price of gasoline goes up, and Dan now buys fewer candy bars because he has to spend more on gas, this would best be explained by
a.the substitution effect.b.the income effect.c. the highly elastic demand for gasoline.d.weight watchers effect.
Which of the following is true for this demand curve?
a.An increase in price from $2 to $3 will reduce total expenditures on the product.
b.In the $2 to $3 range, the price elasticity of the demand curve is approximately unitary.
c. At a price of $2, the price elasticity of the demand curve equals approximately –2.5.
d.In the $2 to $3 range, the demand curve is inelastic.
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