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Econ 102 Budget Constraints

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1

Lecture 2 - Theory of the

Consumer; Budget Constraint

The budget constraint

Definition

Notations and assumptions

Properties of the budget set/constraint

Effects of changes in income and prices

Representing alternative policies in budget lines

Some observations

8/3/2009

2

Some notations:

spend can consumer money of amount

2 good of price

1 good of price

2 good of n consumptio

1 good of n consumptio

2

1

2

1

=

=

=

=

=

m

p

p

x

x

Consumption Bundle – List of n numbers

that indicate how much the consumer is

choosing to consume of n goods. In the case

of two goods, list of two numbers that

indicate how much the consumer is

choosing to consume of good 1 and good 2.

Denoted by:

X x x or ) , (

2 1

8/3/2009

3

Budget line or budget constraint: the set of

bundles that cost exactly m:

i.e.,

{ (x

1

,…,x

n

) | x

1

> 0, …, x

n

> 0 and

p

1

x

1

+ … + p

n

x

n

= m }.

The consumer’s budget set is the set of all

affordable bundles;

B(p

1

, … , p

n

, m) =

{ (x

1

, … , x

n

) | x

1

> 0, … , x

n

> 0 and

p

1

x

1

+ … + p

n

x

n

s m}

The budget line or budget constraint is the

upper boundary of the budget set.

8/3/2009

4

In the case of two goods, the budget constraint is

therefore:

spending on good 1:

spending on good 2:

Budget constraint requires that the total amount of

money spent on the two goods be no more than the

total amount of money the consumer has to spend

Budget set – set of affordable consumption bundles

at price

m x p x p s +

2 2 1 1

1 1

x p

2 2

x p

) , (

2 1

p p

Two good assumption

General enough if we interpret one good as a

composite good

We can think of good 2 as the amount of money that is

being spent on other goods. The price if good 2 is

assumed to be one since the price of one peso is one

peso.

Thus:

This representation is just a special case where the

price of good 2 is equal to 1. We can say about the

budget constraint will hold under the composite good

interpretation

m x x p s +

2 1 1

8/3/2009

5

x

2

x

1

Budget constraint is

p

1

x

1

+ p

2

x

2

= m.

m /p

1

m /p

2

x

2

x

1

Budget constraint is

p

1

x

1

+ p

2

x

2

= m.

m /p

2

m /p

1

8/3/2009

6

x

2

x

1

Budget constraint is

p

1

x

1

+ p

2

x

2

= m.

m /p

1

Just affordable

m /p

2

x

2

x

1

Budget constraint is

p

1

x

1

+ p

2

x

2

= m.

m /p

1

Just affordable

Not affordable

m /p

2

8/3/2009

7

x

2

x

1

Budget constraint is

p

1

x

1

+ p

2

x

2

= m.

m /p

1

Affordable

Just affordable

Not affordable

m /p

2

x

2

x

1

Budget constraint is

p

1

x

1

+ p

2

x

2

= m.

m /p

1

Budget

Set

the collection

of all affordable bundles.

m /p

2

8/3/2009

8

x

2

x

1

p

1

x

1

+ p

2

x

2

= m is

x

2

= -(p

1

/p

2

)x

1

+ m/p

2

so slope is -p

1

/p

2

.

m /p

1

Budget

Set

m /p

2

If n = 3 what do the budget constraint and

the budget set look like?

8/3/2009

9

x

2

x

1

x

3

m /p

2

m /p

1

m /p

3

p

1

x

1

+ p

2

x

2

+ p

3

x

3

= m

x

2

x

1

x

3

m /p

2

m /p

1

m /p

3

{ (x

1

,x

2

,x

3

) | x

1

> 0, x

2

> 0, x

3

> 0 and

p

1

x

1

+ p

2

x

2

+ p

3

x

3

s m}

8/3/2009

10

We can rearrange the equation of the budget line to yield:

Equation of a straight line that gives the consumption of good 2

that would just satisfy the budget constraint for units of good 1

consumed. Slide 8

Vertical intercept:

Slope:

1

2

1

2

2

x

p

p

p

m

x ÷ =

2

p

m

2

1

p

p

÷

Intercepts:

Interpretation: measures how much of each good can

be obtained if only that good is consumed

To derive the vertical intercept, just set equal to

zero and solve for

To derive the horizontal intercept, just set equal to

zero and solve for

To derive the budget line, just connect these two

intercepts.

1

x

2

x

2

x

1

x

8/3/2009

11

Slope of the budget line:

Slope of budget line measures the rate at which

the market is willing to substitute good 1 for

good 2. If you consume more of good 1, you have

to give up some good 2 in order to satisfy your

budget constraint.

Suppose that the consumer is going to increase

consumption of good 1:

2 good of n cons' in change

1 good of n cons' in change

2

1

= A

= A

x

x

Budget line should be fulfilled before and

after changes in consumption:

this just indicates that the change in the total

value of consumption should be zero.

0

: yields second the from first the g subtractin

) ( ) (

2 2 1 1

2 2 2 1 1 1

2 2 1 1

= A + A

= + A + + A

= +

x p x p

m x x p x x p

m x p x p

8/3/2009

12

Solving for , the rate at which good 2 can

be substituted for good 1 while still satisfying the

budget constraint gives:

this is just the slope of the budget line

this is negative because and should

have opposite signs.

2

1

1

2

p

p

x

x

÷ =

A

A

1 2

x x A A

2

x A

1

x A

Slope of the budget line is also interpreted as the

opportunity cost of consuming good 1. In order to

consume more of good 1, you have to give up some

consumption of good 2.

The true cost of economic cost of more good 1 is the

opportunity to consume more of good 2, and it is the

slope of the budget line.

8/3/2009

13

For n = 2 and x

1

on the horizontal axis,

the constraint’s slope is -p

1

/p

2

. What

does it mean?

Increasing x

1

by 1 must reduce x

2

by

p

1

/p

2.

2

1

2

1

2

p

m

x

p

p

x + ÷ =

x

2

x

1

Slope is -p

1

/p

2

+1

-p

1

/p

2

8/3/2009

14

x

2

x

1

+1

-p

1

/p

2

Opp. cost of an extra unit of

commodity 1 is p

1

/p

2

units

foregone of commodity 2.

x

2

x

1

Opp. cost of an extra unit of

commodity 1 is p

1

/p

2

units

foregone of commodity 2. And

the opp. cost of an extra

unit of commodity 2 is

p

2

/p

1

units foregone

of commodity 1.

-p

2

/p

1

+1

8/3/2009

15

Income changes

An increase in income will change m and

not the slope.

An increase in income - parallel shift

outward of the budget line, thereby

increasing the budget set

A decrease in income - parallel inward shift

of the budget line, thereby decreasing the

budget set

To draw the new curve, just derive the new

intercepts and then connect the lines again.

Original

budget set

x

2

x

1

8/3/2009

16

Original

budget set

New affordable consumption

choices

x

2

x

1

Original and

new budget

constraints are

parallel (same

slope).

Original

budget set

x

2

x

1

8/3/2009

17

x

2

x

1

New, smaller

budget set

Consumption bundles

that are no longer

affordable.

Old and new

constraints

are parallel.

No original choice is lost and new choices

are added when income increases, so higher

income cannot make a consumer worse off.

An income decrease may (typically will)

make the consumer worse off.

8/3/2009

18

Price changes

Changes in prices will result in changes in the

slope of the budget line

Case 1: Price of one good decreases, price of

good 2 and income are constant.

Change in p

1

will shift the horizontal intercept

outward because for the same income, we can

purchase more of good 1

vertical intercept is unchanged since you can buy the

same amount of good 2 as before if good 1

consumption is zero.

Therefore budget line is flatter.

Original

budget set

x

2

x

1

m/p

2

m/p

1

’

m/p

1

”

-p

1

’/p

2

8/3/2009

19

Original

budget set

x

2

x

1

m/p

2

m/p

1

’

m/p

1

”

New affordable choices

-p

1

’/p

2

Original

budget set

x

2

x

1

m/p

2

m/p

1

’

m/p

1

”

New affordable choices

Budget constraint

pivots; slope flattens

from -p

1

’/p

2

to

-p

1

”/p

2

-p

1

’/p

2

-p

1

”/p

2

8/3/2009

20

Reducing the price of one commodity pivots

the constraint outward. No old choice is lost

and new choices are added, so reducing one

price cannot make the consumer worse off.

Similarly, increasing one price pivots the

constraint inwards, reduces choice and may

(typically will) make the consumer worse

off.

8/3/2009

21

Case 2: Price of both goods increase by the

same factor

E.g., prices of good 1 and good 2 double

horizontal and vertical intercepts shift inward by ½.

The budget curve shifts inward and it is like dividing income

by one half.

0 for ,

2

0 for ,

2

2 2

1

2

2

2

1

1

2 2 1 1

= =

= =

= +

x

p

m

x

x

p

m

x

m x p x p

Multiplying both prices by a constant factor

is just like dividing income by the same

constant factor

t

m

x p x p

m x tp x tp

m x p x p

= +

= +

= +

2 2 1 1

2 2 1 1

2 2 1 1

8/3/2009

22

Multiplying prices and income by the same factor

will not change the budget line at all:

1

2

1

2

2

2

1 1

2

2

1 1 2 2

2

2 2 1 1

,

,

, for solving

x

p

p

p

m

x

tp

x tp

tp

tm

x

x tp tm x tp

x

tm x tp x tp

÷ =

÷ =

÷ =

= +

Case 3: Price and income changes together

Suppose m decreases and p

1

and p

2

increase

Intercepts must decrease and the budget line

shifts inward.

Changes in the slope depends on the amount of

the change in p

1

and p

2

If p

2

increases by more than p

1

, - p

1

/ p

2

decreases,

the budget line becomes flatter

If p

1

increases by more than p

2

, budget line is

steeper

8/3/2009

23

Numeraire

The same budget set can be represented by setting

one of the prices or income to some fixed value and

adjusting the other variables accordingly.

Setting the variables in terms of the price of one

good, suppose p

2,

the budget line is therefore:

Setting the variables in terms of income, we just

divide everything by m

2

2 1

2

1

p

m

x x

p

p

= +

1

2

2

1

1

= + x

m

p

x

m

p

Numeraire

In the first case, the price of p

2

is pegged at 1,

and in the second case m is pegged at 1.

Numeraire refers to the price that is set to one.

The numeraire price is the price relative to

which we are measuring other prices and

income.

8/3/2009

24

Government imposes policies that affect the

consumer’s budget constraint.

Some of these policies include:

Taxes – both quantity and value

Subsidies – both quantity and value

Lump-sum taxes or subsidies

Rationing constraints

Taxes

quantity taxes

paid for each unit of the good that is purchased

increases the price that is paid for the good

Quantity tax: t

value taxes

tax on the price of the good, expressed as a percentage

of the price

most common example are sales taxes

Value tax :

t p +

p ) 1 ( t +

t

8/3/2009

25

Subsidies

Subsidies decrease the effective price paid for

the good.

Quantity subsidies

given based on the amount that is purchased

Quantity subsidy: s

Value subsidies

given based on the price of the good being subsidized

Value subsidy:

s p ÷

o

p ) 1 ( o ÷

Lump sum tax or subsidy: A fixed amount

of money that is given (in the case of

subsidies) or taken away (in the case of

taxes) regardless of the consumer’s

behavior.

taxes – shift the budget line inward

subsidies – shift the budget line

outward

8/3/2009

26

Rationing constraints: level of consumption

is fixed to be less than some amount Figure 2.4

Rationing constraint combined with taxes

and subsidies

has the effect of changing the prices faced by

the consumer for certain goods beyond a

certain amount consumed Figure 2.5 conc

slide 29

8/3/2009

27

slide 29

Q: What makes a budget constraint a

straight line?

A: A straight line has a constant slope and

the constraint is

p

1

x

1

+ … + p

n

x

n

= m

so if prices are constants then a constraint

is a straight line.

8/3/2009

28

But what if prices are not constants?

E.g. bulk buying discounts, or price penalties

for buying “too much”.

Then constraints will be curved.

Suppose p

2

is constant at P1 but that p

1

=P2

for 0 s x

1

s 20 and p

1

=P1 for x

1

>20.

8/3/2009

29

Suppose p

2

is constant at P1 but that p

1

=P2

for 0 s x

1

s 20 and p

1

=P1 for x

1

>20. Then

the constraint’s slope is

- 2, for 0 s x

1

s 20

-p

1

/p

2

=

- 1, for x

1

> 20

and the constraint is

{

m =

P100

50

100

20

Slope = - 2 / 1 = - 2

(p

1

=2, p

2

=1)

Slope = - 1/ 1 = - 1

(p

1

=1, p

2

=1)

80

x

2

x

1

8/3/2009

30

m =

P100

50

100

20

Slope = - 2 / 1 = - 2

(p

1

=2, p

2

=1)

Slope = - 1/ 1 = - 1

(p

1

=1, p

2

=1)

80

x

2

x

1

m =

P100

50

100

20

80

x

2

x

1

Budget Set

Budget Constraint

8/3/2009

31

x

2

x

1

Budget Set

Budget

Constraint

Commodity 1 is stinky garbage. You are

paid P2 per unit to accept it; i.e. p

1

= - P2.

p

2

= P1. Income, other than from

accepting commodity 1, is m= P10.

Then the constraint is

- 2x

1

+ x

2

= 10 or x

2

= 2x

1

+ 10.

8/3/2009

32

10

Budget constraint’s slope is

-p

1

/p

2

= -(-2)/1 = +2

x

2

x

1

x

2

= 2x

1

+ 10

10

x

2

x

1

Budget set is

all bundles for

which x

1

> 0,

x

2

> 0 and

x

2

s 2x

1

+ 10.

8/3/2009

33

Choices are usually constrained by more

than a budget; e.g. time constraints and

other resources constraints.

A bundle is available only if it meets every

constraint.

Food

Other Stuff

10

At least 10 units of food

must be eaten to survive

8/3/2009

34

Food

Other Stuff

10

Budget Set

Choice is also budget

constrained.

Food

Other Stuff

10

Choice is further restricted by a

time constraint.

8/3/2009

35

So what is the choice set?

Food

Other Stuff

10

8/3/2009

36

Food

Other Stuff

10

Food

Other Stuff

10

The choice set is the

intersection of all of

the constraint sets.

8/3/2009

37

Perfectly balanced inflation, one in which all prices and incomes

rise at the same rate doesn’t change anybody’s budget set and

thus cannot change anybody’s optimal choice: e.g. income

indexation or wage increases are a way of assuring that the

optimal choices do not change, no adjustments in consumption

are necessary

Income increases with prices remaining the same leaves the

consumer at least as well off as before

If one price declines and all others remain the same, then the

consumer must be at least as well-off.

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