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.