EQ: What is a Budget Constraint? EQ: What is Consumer Economics? EQ: What is a Budget Constraint? EQ: What is a Budget Constraint?

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1 EQ: What is Consumer Economics? From Wikipedia: Consumer economics is a branch of economics principally concerned with [the] microeconomic analysis [of the] behavior of consumers, families, or individuals (in contrast to traditional economics, which primarily government or business units). It sometimes also encompasses family financial planning. Consumer economics is primarily concerned with understanding how individuals and households make decisions about maximizing consumer satisfaction given their limited incomes (their budgets). Usually, this means choosing between things (shorts or pants, food or TV). We will first look at limited incomes (budget constraints) and then examine consumer satisfaction in Lesson -. A budget can be described in a couple ways: A limit on the amount of resources available. A plan on how to allocate limited resources. In most cases, the resource that is limited and allocated is money ($). Although every person does not have a plan on how to allocate their money, every person DOES have a limit on the amount of money they have. This limit on money available limits the amount of consumer satisfaction they can experience. In consumer economics, people should try to use their limited money to maximize their satisfaction. We refer to the limit on money resources as a budget constraint. In the Warm-Up, your budget constraint on your shopping trip to the mall was $00. It is the absolute maximum limit on the amount of financial resources available to a household/person. Sometimes, people can exceed their cash budget constraint by using credit cards and other loans. This is still a part of the budget constraint. For example, the $00 budget constraint in the Warm- Up could have been a $00 credit limit on a credit card. Since economics is concerned with making a decision about how to allocate resources, a budget constraint represents the combinations of goods and services that a consumer can purchase given current prices with his or her income. For example, with $00, you could buy: pants & no shirts (all of one thing and none of the other) shirts & no pants shirts & pants (some of one thing and some of the other) Usually, people will buy a combination of goods to maximize consumer satisfaction.

2 Graphically, a budget constraint looks like this: Pants $ You could buy 0 shirts and pants (0,) You could also buy any combination of shirts & pants inside the budget line. You would have some money left over. This line is called the Budget Constraint or Budget Line. You could buy shirts and pants (,) You could buy shirts and 0 pants (,0) 0 You have to divide your limited income between items. Shirts $0 A Budget Line is a curve of a graph of the maximum quantities that can be afforded of goods given: Income (the maximum money resources available) Price of Good X (first good that is on the X-Axis) Price of Good Y (second good that is on the Y-Axis) Given a budget line you can determine the prices or the income available. You can also draw or identify a budget line given these three pieces of information. EQ: How Do I Draw a Budget Line? A budget line can be drawn and identified by calculating the quantities by the prices: Pants $ Every point on this line represents $00 (the limit of money): pants x $ = $00 ( pants x $) + ( shirts x $0) = $00 shirts x $0 = $00 0 Shirts $0 EQ: How Do I Draw a Budget Line? You can draw your own budget line as follows: Pants $ () Divide the budget constraint ($00) by the price of Good Y ($). $00 / $ = of Good Y (pants) This gives you the maximum quantity of Good Y that you can afford. Place a dot at (0,) () Draw a straight line connecting the first point (,0) and the second point (0,). 0 () Divide the budget constraint ($00) by the price of Good X ($0). $00 / $0 = of Good X (shirts) This gives you the maximum quantity of Good X that you can afford. Place a dot at (,0) Shirts $0

3 EQ: How Do I Draw a Budget Line? Lets say we have the following: Income is $00 Price of Good X is $0 Price of Good Y is $ Draw a budget line: Good Y () Divide the budget constraint ($00) by the price of Good Y ($). $00 / $ = of Good Y () Draw a straight line connecting the first point (,0) and the second point (0,). This gives you the maximum quantity of Good Y that you can afford. Place a dot at (0,) () Divide the budget constraint ($00) by the price of Good X ($0). $00 / $0 = of Good X This gives you the maximum quantity of Good X that you can afford. Place a dot at (,0) 0 Good X EQ: How Do I Calculate Price & Income Given a Budget Line? Given a Budget Line and the Price of one good, you can calculate the Price of the other good and Income: Price of Good Y = $.0 What is Income? Multiply the maximum number of units of Y by price. Maximum QY = x.0 = $.0 Income = $.0 What is the price of Good X? Divide Income by the maximum number of X units. Maximum QX = $.0 / = $. Price of X = $. Good Y 0 Good X EQ: How Do I Calculate Price & Income Given a Budget Line? You do not need a graph of a budget line to calculate prices and income if you are given the maximum number of units of Good X & Good Y: Example: The Price of Good Y is $0 The maximum # of Good Y that can be bought is The maximum # of Good X that can be bought is. What is Income? Income = (Price of Y) x (# of Good Y) Income = $0 x = $0 What is the Price of Good X? Price of X = Income / (# of Good X) = $0 / = $.0 Previously, we have talked about consumer satisfaction being the final goal of all economic decision making. Utility is the technical term in economics that refers to the measure of satisfaction that consumers get out of the stuff they buy. But how do you measure utility? If we can measure utility, we can know how much satisfaction people are getting and whether satisfaction is growing over time.

4 Unfortunately, you can t measure the amount of utility that products provide. Why? Utility is subjective. Different individuals get different amounts of satisfaction from the same products. Example: Some people like to go to fancy restaurants and eat gourmet food. I prefer fast food and casual dining. Others get more utility from fancy dining than I do. Measuring Utility Unfortunately, you can t measure the amount of utility that products provide. Why? Utility is inconsistent Each individual gets different amounts of satisfaction from a product at different times. Example: I like fast food when I go on trips. On long trips, I get sick of fast food after a couple days. The satisfaction I receive from eating fast food changes over two or three days. The best measure of utility is the amount of money you are willing to pay to get something: The more utility you get from something, the more you are willing to pay for it. Things providing little or no utility, you would pay less money for (or just not buy). A major concept in economics is the idea that the cheaper something is, the more people are willing and able to buy it (the basis for the demand curve). This is because some people may be willing to pay more for it because they would get more utility from it. Others would pay less for it because they would get less utility from it. So how do we know whether the satisfaction people are getting is increasing or not? Well, since one of the best measures of utility is how much people are willing to pay for stuff, the best estimate we have for the growth of utility (i.e., satisfaction) in the economy is the growth of money spent for Consumption in Gross Domestic Product, but that is a topic for Macroeconomics.

5 EQ: What is Marginal Utility? Remember that Marginal means one more of something. Marginal Utility is the amount of added utility that a person receives from consuming one more unit of a product. For example: Eating one Dorito might give you utility. So, the marginal utility of the first Dorito is. Eating two Doritos might give you utility. So, the marginal utility of the second Dorito is. Utility and Consumer Decisions The Utility concept is most useful for understanding how and why households and individuals decide to buy some things instead of other things. In Lesson -, we will look at a concept that is related to the Production Possibilities Frontier. Remember that with the PPF, a business has to decide what combination of Goods A and B to produce. The outward curve of the PPF indicates that it is better for the firm to produce some of each product. Similarly, we will see that consumers will get the most utility if they choose to purchase and consume a combination of two goods rather than spending all their money on one thing. This is related to the Law of Diminishing Returns.