# Cost of Living Budget - PowerPoint

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"Cost of Living Budget - PowerPoint"

```					Cost of Living

1
cost of living
On the next several slides we want to explore the
economic concept called the cost of living. We typically
look at a price index to help us understand the cost of
living.
In order to do this let’s first think about some examples of
consumer optimum points.

Say that you have income of \$20, the price of x is \$3, the
price of y is \$4.
Now if you spent all of your income on x you could buy
6 2/3 x or if you spent all your money on y you could buy
5 y. Note that each time an additional unit of x is
purchased, 3/4 of a y must be given up.
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cost of living
y
From the previous screen I
the budget line and have
drawn in the budget line. Plus
(0, 5)                        I have added the fact that when
(4, 2)
the consumer faces this budget
(6 2/3, 0)
We know that when the consumer ends up at point (4, 2)
the are as happy as they can be at this time. In fact they are
at a point of tangency between the budget line and their
highest possible indifference curve.
3
cost of living
y
In this diagram you can see the
optimum point for the
consumer.

(0, 5)   (4, 2)

x
(6 2/3, 0)

4
cost of living
Now let’s say that there are
y                        some changes in the world. The
price of x becomes 4(it used to be
3), and the price of y becomes
2(used to be 4). Now the new
budget line would have:
(0, 5)                       1) if all income(no change in this
(4, 2)
example) is spent on y, 10 y
could be bought.
x 2) 5 x could be bought if all is
(6 2/3, 0) spent on x.
In this example the original optimum point could also be
purchased at the new prices: (4)(4) + (2)(2) = 20.

5
y                                cost of living
In this diagram I put just the new
new                 and the old budget lines. Note
that the same original basket can
be purchased under either set of
prices. With the new budget we
know the consumer will not end
up to the right of the original
old baskets on the new budget could
x
have been purchased by the consumer under the old set of
prices, but the consumer didn’t buy them. Therefore, they
could not have been preferred to the basket.
6
y                                 cost of living
When I put in the indifference
new                 curve tangent to the old budget
line you can see the individual
will not end up at the original
because it isn’t tangent there
now. You know the consumer
will not end up on the new
old
x
budget line way up in the upper left - also left of the
indifference curve. Those points are less preferred
because they have to be on a lower indifference curve.
7
cost ofthis
We conclude that in
living
y                   example the consumer will
actually end up on a higher
indifference curve at the later
prices compared to the earlier
prices. Thus, the consumer is
(0, 5)                   happier under the new prices
(4, 2)
than under the old prices.

x
Note this is a special
(6 2/3, 0)
example because the
prices.
8
cost of living
x = 4 and y = 2.
Under the original prices of Px = 3, Py = 4 the cost of
living at the original basket was (3)(4) + (4)(2) = 20.

The consumer price index looks at the cost or ‘price’ of a
basket of goods over time. If we look at the original
basket and original prices in this example we see the cost
of living is 20.

Now the new prices are Px = 4, Py = 2. The cost of the
original market basket is still 20 = (4)(4) + (2)(2).

9
cost of living
In this example the consumer price index would show no
change in consumer prices.
price went up and one went down, the original basket cost
stayed the same- no CPI change - BUT the level of
happiness for the consumer went up.
In this sense you could say that the CPI is a misleading
indicator of the cost of living. It measures the cost of a
basket of goods - not the cost of a level of happiness. Since
the consumer ends up happier in our example (at the same
cost), the cost of having the original happiness went down.
Thus, the CPI overstates the cost of maintaining a given
level of happiness.
10
steak and potatoes
potatoes
Note in this example
the order of preference
goods
(steak, potatoes)
(2, 2) is preferred to
(2, 1) is preferred to
(1, 2) is preferred to
steak (1, 1)

11
steak and potatoes
potatoes
Now say in some year
Ps = \$2 and Pp = \$1
and the consumer has
\$4 of income. The
budget line is drawn in
and the optimum for
the consumer is 1
steak, 2 potatoes.
steak

12
steak and potatoes
potatoes
In a later year let’s say
prices change such that
steak is lowered to \$1
and potatoes rise to \$2.
The new budget line is
the dashed line.

Note at the new prices
steak
more steak is bought when steak is at a lower price and
less potatoes are bought when potato prices went up.

13
steak and potatoes
Also note on the previous screen that after the price
change the consumer is better off.

Now let’s look at the original basket (as is done with the
consumer price index). At the old prices the basket cost
\$4. Under the new prices the basket costs \$5. We can see
from the consumer preferences that this old basket is less
The consumer price index would indicate a 25% increase
in prices and the consumer is still better off. Why?

14
steak and potatoes
The CPI follows the cost of fixed basket of goods over
time.
They tend to shift to goods that have prices lowered and
away from goods that have had price increases.
In this regard the CPI overstates the true impact of
inflation. It measures inflation of a fixed basket of
goods. What would really be good is to look at the cost
of buying a fixed level of happiness. This method can
not be devised. So we live with a measure that has
problems and recognize what those problems are.

15

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