# Microeconomics_4__Besanko

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\ufffdPy \ufffd \ufffd1\ufffd2).
Thus, an increase in income shifts the budget line outward in a parallel fashion.
It expands the set of possible baskets from which the consumer may choose.
Conversely, a decrease in income would shift the budget line inward, reducing the set
of choices available to the consumer.
HOW DOES A CHANGE IN PRICE
AFFECT THE BUDGET LINE?
How does Eric\u2019s budget line change if the price of food rises from to
per unit, while income and the price of clothing are unchanged? As shown inPx2 \ufffd $25 Px1 \ufffd$20
Px x \ufffd Py y \ufffd I
1To see why this is so, first solve equation (4.1) for y, which gives y \ufffd (I \ufffdPy) \ufffd (Px \ufffdPy)x. Then, recall from
algebra that the general equation for a straight line is y \ufffd mx \ufffd b, where m is the slope of the graph and
b is the intercept on the y axis. This matches up with the budget line equation solved for y: the y intercept
is I\ufffdPy, and the slope is \ufffdPx \ufffdPy.
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108 CHAPTER 4 CONSUMER CHOICE
Figure 4.3, the vertical intercept of the budget line remains unchanged since I and
Py do not change. However, the horizontal intercept decreases from
40 units to units. The higher price of food means that if Eric
spends all $800 on food, he can purchase only 32 units of food instead of 40. The slope of the budget line changes from to The new budget line BL2 has a steeper slope than BL1, which means that Eric must give up more units of clothing than before to purchase one more unit of food. When the price of food was$20, Eric needed to give up only 1/2 unit of
clothing; at the higher price of food ($25), he must give up 5/8 of a unit of clothing. Thus, an increase in the price of one good moves the intercept on that good\u2019s axis toward the origin. Conversely, a decrease in the price of one good would move the in- tercept on that good\u2019s axis away from the origin. In either case, the slope of the budget line would change, reflecting the new trade-off between the two goods. When the budget line rotates in, the consumer\u2019s purchasing power declines be- cause the set of baskets from which he can choose is reduced. When the budget line rotates out, the consumer is able to buy more baskets than before, and we say that the consumer\u2019s purchasing power has increased. As we have seen, an increase in income or a decrease in price increases purchasing power, whereas an increase in price or a decrease in income decreases purchasing power. \ufffd(25/40) \ufffd \ufffd5/8. \ufffd(Px2 /Py) \ufffd\ufffd(Px1/Py) \ufffd \ufffd(20/40) \ufffd \ufffd1/2 I/Px2 \ufffd 800/25 \ufffd 32 I/Px1 \ufffd 800/20 \ufffd FIGURE 4.2 Effect of a Change in Income on the Budget Line The price of food is Px \ufffd$20 per unit, and the price of clothing is Py \ufffd $40 per unit. If the con- sumer has an income of I1 \ufffd$800 per month, the budget line is BL1, with a vertical intercept of
y \ufffd 20, a horizontal intercept of x \ufffd 40, and a slope of \ufffd1/2. If income grows to I2 \ufffd $1,000 per month, the budget line is BL2, with a vertical intercept of y \ufffd 25, a horizontal intercept of x \ufffd 50, and the same slope of \ufffd1/2. The consumer cannot buy basket G with an income of$800, but he can afford it if income rises to $1,000. A B C G Px Py\u394x \u394y 1 2 BL1 BL2 D E F 100 5 10 15 20 20 30 Slope of BL2 = = \u2013 = \u2013 40 50 x, units of food y, u n its o f c lo th in g 25 I1 Px = 40 I2 Px = 50 I1 Py = 20 = 25 I2 Py c04consumerchoice.qxd 6/18/10 5:31 PM Page 108 4.1 THE BUDGET CONSTRAINT 109 FIGURE 4.3 Effect of a Price Increase on the Budget Line When the price of food rises from$20 to $25 per unit, the budget line rotates in toward the origin, from BL1 to BL2, and the horizontal intercept shifts from 40 to 32 units. The vertical intercept does not change because income and the price of clothing are unchanged. The new budget line BL2 has a steeper slope than BL1. 20 0 32 40 Px1 Py 1 2 20 = 40800I Px1 = 25 = 32800I Px2 = BL2 BL1 Slope of BL1 = \u2013 = \u2013 Px2 Py 5 8 Slope of BL2 = \u2013 = \u2013 x, units of food y, u n its o f c lo th in g 40 = 20800I Py = increased dramatically in Summer 2008. From the end of January to the end of June, prices rose from about$2.95 per gallon to $4.03 per gallon\u2014the first time that gasoline prices in the United States had topped$4.00.
The average retail price for a gallon of gasoline in the
United States has varied greatly in recent years. As
the table shows, the retail price of regular gasoline
A P P L I C A T I O N 4.1
The Rising Price of Gasoline
March April MayFebruaryJanuaryDate June July
Price
(per $gallon)$2.95 $3.12$3.26 $3.57$3.91 $4.03$3.90
Average Retail Price of Regular Gasoline in the United States in 2008
How would an increase in the price of gasoline
affect a consumer\u2019s budget line? To keep matters
simple, suppose the consumer buys only two goods,
gasoline and clothing, and suppose further that the
consumer\u2019s income and the price of clothing do not
change. We could draw budget lines on a graph like
that in Figure 4.3, with a horizontal axis measuring
gallons of gasoline (instead of units of food). An in-
crease in the price of gasoline would rotate the
budget line in toward the origin from BL1 to BL2.
Consumers responded to the rise in gasoline
prices in 2008 in several ways. As prices rose from
Source: U.S. Energy Information Administration, http://tonto.eia.doe.gov/oog/info/gdu/gasdiesel.asp (accessed September 25,
2009).
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110 CHAPTER 4 CONSUMER CHOICE
We have learned that the consumer can choose any basket on or inside the budget
January through June, total highway miles driven
declined every month. The U.S. Department of
Transportation estimated a total decline of 20 billion
miles traveled during the first half of 2008. At the same
time, commuter rail usage increased. Gasoline prices also
affected car sales. Purchases of gas-guzzling vehicles
such as SUVs (Sport Utility Vehicles) and pickup trucks
fell approximately 40 percent in May, and again in
June. Relative sales of smaller cars rose. In addition,
sales of diesel cars increased (the price of diesel gaso-
line did not rise as sharply).
In the next section we will combine budget lines
with the utility theory from Chapter 3. After studying
that section, you will be able to explain why con-
sumers changed their spending habits in response to
the rise in gasoline prices as described here.
Suppose that a consumer\u2019s income (I )
doubles and that the prices (Px and Py) of both goods in
his basket also double. He views the doubling of income
as good news because it increases his purchasing power.
However, the doubling of prices is bad news because it
Problem What is the net effect of the good and bad
news?
Solution The location of the budget line is deter-
mined by the x and y intercepts. Before the doubling
Good News/Bad News and the Budget Line
E
S
D
L E A R N I N G - B Y- D O I N G E X E R C I S E 4 . 1
of income and prices, the y intercept was I\ufffdPy; after-
ward, the y intercept is 2I\ufffd2Py \ufffd I\ufffdPy, so the y intercept
is unchanged. Similarly, the x intercept is unchanged.
Thus, the location of the budget line is unchanged,
as is its slope, since \ufffd(2Px \ufffd2Py) \ufffd \ufffd(Px \ufffdPy). The doubling
of income and prices has no net effect on the budget
line, on the trade-off between the two goods, or on the
optimal choice\u2014that is, the optimal amount