Microeconomics_4__Besanko

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.
c04consumerchoice.qxd 6/18/10 5:31 PM Page 107
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).
c04consumerchoice.qxd 6/18/10 5:31 PM Page 109
110 CHAPTER 4 CONSUMER CHOICE
We have learned that the consumer can choose any basket on or inside the budget
line. But which basket will he choose? We are now ready to answer this question.
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
decreases his purchasing power.
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
consumer\u2019s purchasing power. 
Similar Problems: 4.1, 4.2.
4.2
OPTIMAL
CHOICE
If we assume that a consumer makes purchasing decisions rationally and we know 
the consumer\u2019s preferences and budget constraint, we can determine the consumer\u2019s 
optimal choice\u2014that is, the optimal amount