A. Theory:: 1. The Budget Constraint - What The Consumer Can Afford

TUTORIAL 1: 10 PRINCIPLES OF ECONOMICS AND THINKING LIKE
AN ECONOMIST (CHAPTER 1&2)

TUTORIAL 2: THE MARKET FORCES – DEMAND AND SUPPLY
(CHAPTER 4)
TUTORIAL 3: ELASTICITY (CHAPTER 5)
TUTORIAL 4: CONSUMERS, PRODUCERS & MARKET EFFICIENCY
(CHAPTER 7)
TUTORIAL 5: GOVERNMENT INTERVENTION AND THE WELFARE
ECONOMICS (CHAPTER 6&8)
TUTORIAL 6: THE THEORY OF CONSUMER CHOICE (CHAPTER 21)

A. THEORY:
1. The budget constraint – What the consumer can afford
 Budget constraint: the limit on comsumption bundles that a consumer can afford
- People consume less than they desire because their spending is constraint, or
limited, by their income.
- The slope of budget constraint measures the rate at which the consumer can
trade one good for the other.
- Example of the decision facing pizza consumption and Pepsi consumption:
***Graph:
Quantity of Pepsi
500 B
250 C
A Quantity of Pizza
0 50 100
+ The red line is called budget constraint, shows the consumption bundles that the
consumer can afford.
+ The slope of the budget constraint measures the rate at which the consumer can
trade one good for the other.
The slope between 2 points is calculated as the change in vertical distance divided by
the change in horizontal distance
In the graph above, the vertical distance is 500 pints, the horizontal distance is 100
pizzas
 From point A to point B, the slope is 5 pints per pizza
(Actually, because the budget constraint slopes downward, the slope is negative
number. But for our purposes, we can ignore the minus sign).
*Notice that the slope of the budget constraint equals the relative price of the two
goods – the price of one good compared to the price of the other.
-> A pizza costs 5 times as much as a pint of Pepsi, so the opportunity cost of a
pizza is 5 pints of Pepsi. The budget constraint’s slope of 5 reflects the trade-off
the market is offering the consumer: 1 pizza for 5 pints of Pepsi.
2. Preferences: What the consumer wants

- The consumer’s choices depend not only on his budget constraint, but also on
his preferences regarding two goods
- Indifference curve: A curve that shows consumption bundles that give the
consumer the same level of satisfaction
- The slope at any point on an indifference curve equals the rate at which
consumer is willing to substitute one good for the other.
 This rate is called the Marginal Rate of Substitution (MRS)
 Ex: MRS measures the quantity of Pepsi the consumer must be given in
exchange for 1 pizza
+ Notice that because the indifference curve are not straight lines, the
marginal rate of substitution (MRS) is not the same at all points on a given
indifference curve.
- Because the consumer prefers more of a good, points on a higher indifference

curve (I2) are preferred to points on a lower indifference curve (I1).
 4 properties of Indifference Curves

 Property 1: Higher difference curves are preferred to lower ones
(Higher indifference curves represent larger quantities of goods than lower
indifference curves)
 Property 2: Indifference curves are downward slopping
If the quantity of one good is reduced, the quantity of other good must
increase for the consumer to be equally happy.
 For this reason, most indifference curves slope downward.
 Property 3: Indifference curves do not cross
 Property 4: Indifference curves are bowed inward.
3. Two extreme examples of indifference curves

 Perfect substitutes: two goods with straight-line indifference curves
 Perfect complements: two goods with strongly complementary, such as left shoes
and right shoes -> the indifference curves are right-angle
4. Optimization: What the consumer chooses

We have 2 pieces necessary for analyzing how consumer makes choices:
- The consumer’s budget constraint (how much he can afford to spend)
- The consumer’s preferences (what he wants to spend it on)
 Now we put these two pieces together and consider the consumer’s decision
about what to buy
 The consumer’s optimal choices
 The consumer chooses the point on his budget constraint that lies on
the highest indifference curve. At this point, called the optimum, the
marginal rate of subsstitution equals the relative price of the two
goods.
 At the optimum, the slope of the indifference curve equals the slope of
the budget constraints
B. EXERCISES:

A. Theory:: 1. The Budget Constraint - What The Consumer Can Afford

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TUTORIAL 1: 10 PRINCIPLES OF ECONOMICS AND THINKING LIKE

AN ECONOMIST (CHAPTER 1&2)

TUTORIAL 6: THE THEORY OF CONSUMER CHOICE (CHAPTER 21)

2. Preferences: What the consumer wants

- Because the consumer prefers more of a good, points on a higher indifference

 4 properties of Indifference Curves

3. Two extreme examples of indifference curves

4. Optimization: What the consumer chooses

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