The Budget
What is a budget line?
A budget line is a line that shows the
combinations of goods that can be
purchased at specified prices
assuming all income is spent on
those goods.
The budget constraint helps us
understand how consumers income
and prices that must be paid for
various goods limit choices.
Let us consider a consumer whose
weekly or monthly income is
K60,000. He is faced with the choice
of consuming two goods ; apples
and oranges
The price of apples is K12,000 per
unit while the price of oranges is
K6,000 per unit.
Task
What will the budget line for this
consumer be?
Apples = 60,000/12,000 = 5
Oranges = 60,000/6,000 = 10
Oranges
10
Apples
5
The budget constraint
The way in which consumer income
and prices that must be paid for
limit choices.
Shifts in budget lines
The budget line can shift due to
the following reasons:
(a)Income
If income increases the budget line
will shift to the right and it will shift
to the left if income decreases
Oranges
Apples
(b) Prices
If the prices increases, they will have
the effect of shifting the budget line
to the left while a reduction in the
prices will shift the budget line to the
right.
If however the price of one of the
product either increase or reduces
while the price of the other remains
the same the budget line will either
tilt to the right or to the left.
Oranges
Apples
Indifference curve analysis
What is an indifference curve?
An indifference curve is a locus of all
combinations of two goods which
yield the same level of satisfaction
(utility) to the consumer.
Since any combination of the two
goods on an indifference curve give
equal level of satisfaction, the
consumer is indifferent to any
combination he consumes.
Consumers differ very much in their
preferences e.g. some like liver,
others do not.
How are these consumer choices
made? This is explained by
indifference curve theory.
Assumptions
(i) Preferences are complete – they
are complete in the sense that
consumers can rank all baskets in
order of preferences.
Thus, a consumer would say he
prefers Coca Cola to Pepsi or Pepsi
to Coca Cola or that he is indifferent
between the two.
Being indifferent simply means that
both alternatives are equally
satisfactory.
(ii) We also assume that preferences
are transitive – transitivity
means that if a consumer
prefers good A to good B and B
to C, then this consumer prefers
A to C.
If a consumer prefers Coca Cola
to Pepsi and Pepsi to Fanta, then
the consumer prefers Coca Cola
to Fanta. Transitivity ensures
consistency in preferences.
(iii) The consumer prefers more of
any good to less – this condition
is referred to as nonsatiation –
more is preferred to less
Note that there are instances when
these assumptions do not hold
The observation that more is
preferred to less may not hold
especially if we have to consume
economic bads – e.g. pollution.
Characteristics of indifference
curves
(i) Indifference curve must slope
downwards because consumers
prefer more to less.
Oranges
Apples
(ii) Indifference curves on the right
offers higher total utility than
those on the left, which
inevitable offer low, total utility.
Oranges I1
I2
I2
I1
Apples
(iii) Indifference curves cannot
intersect
Oranges
I
U
A
.C
. B
U
I
Apples
This is because point A offers the
same total utility as point B. But
point A offers the same total utility
as point C, which lies on UU.
B however, is a superior point to
point C because it offers more
Oranges and Apples than point C
Optimization
Consumers will choose a point on
the indifference curve which satisfies
the budget constraint as all points
above the line are not affordable
while all points below are affordable
but offers lower total utility.
Oranges
I1 I
I2
A
B
C
Apples
Points A, B and C are affordable,
but the consumer will pick point B
because it provides higher total
utility.
The Marginal Rate of Substitution
(MRS) between Oranges and Apples
is the maximum amount of oranges
the consumer is willing to give up to
obtain an additional apple.
UTILITY THEORY
Utility is the satisfaction derived
from consuming a good
Despite price changes satisfaction
may decline or improve because of
the following:
(a)Changes
in taste
(b)Changes in income/wealth
Marginal Utility Theory
Total utility is the total satisfaction
that a consumer gets from the
consumption of all units of a good
consumed within a given time.
Marginal utility is the extra
satisfaction that a consumer gets
from consuming one extra unit of a
good within a given time period.
A consumer would purchase units of
a commodity until his moneys worth
of utility obtained from a unit was
equal to the price he paid for that
good.
𝑴𝒖𝒂 𝑴𝑼𝒃
𝑴𝑼𝒏
=
……….
𝑷𝒂
𝑷𝒃
𝑷𝒏
MUa = Marginal utility of good a
Pa = Price of good a