You are on page 1of 37

8/3/2009

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.