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Markets

Chapter 1: Alternatives and Budget

Ahmet Ozkardas

Ozkardas 1 / 23

Introduction

afford.

what we mean by “best” and

what we mean by “can afford.”

Ozkardas 2 / 23

The Budget Constraint

numbers that tells us how much the consumer is choosing to

consume of good 1 and good 2, x1 , x2 , respectively

The prices of the two goods: (p1 , p2 ), and the amount of money

the consumer has to spend: m.

p1 x1 + p2 x2 ≤ m (1)

Ozkardas 3 / 23

The Budget Constraint

andp2 x2 is the amount of money the consumer is spending on good

2.

cost any more than m.

income m : the budget set of the consumer.

Ozkardas 4 / 23

Two Goods Are Often Enough

else the consumer might want to consume.

2 as being the dollars that the consumer can use to spend on other

goods. Thus the budget constraint will take the form

p1 x1 + x2 ≤ m (2)

Ozkardas 5 / 23

Properties of the Budget Set

p1 x1 + p2 x2 = m (3)

These are the bundles of goods that just exhaust the consumer’s

income.

m p1

x2 = − x1 (4)

p2 p2

This is the formula for a straight line with a vertical intercept of

m/p2 and a slope of −p1 /p2 .

Ozkardas 6 / 23

line—the bundles that cost exactly m—and the bundles below this line are

Properties of less

those that cost strictly thethanBudget

m. Set

x2

Vertical

intercept

= m/p 2 Budget line;

slope = – p1 /p2

Budget set

ure The budget set. The budget set consists of all bundles that

are aﬀordable at the given prices and income.

Ozkardas

We can rearrange the budget line in equation (2.3) to give us the formula 7 / 23

Properties of the Budget Set

the rate at which the market is willing to “substitute” good 1 for

good 2.

p1 x1 + p2 x2 = m

p1 ∆x1 + p2 ∆x2 = 0

This says that the total value of the change in her consumption

must be zero.

∆x2

∆x2 = − pp21

Ozkardas 8 / 23

Properties of the Budget Set

measures the opportunity cost of consuming good 1.

consumption of good 2.

cost of more good 1 consumption; and that cost is measured by the

slope of the budget line.

Ozkardas 9 / 23

How the Budget Line Changes

intercept and not affect the slope of the line.

the budget line, similarly, a decrease in income will cause a parallel

shift inward.

Ozkardas 10 / 23

allel shift outward of the budget line as in Figure 2.2. Similarly, a decrease

How the

in income Budget

will cause Line

a parallel shift Changes

inward.

x2

m’/p2

Budget lines

m/p2

Slope = –p1/p 2

m/p1 m’/p1 x1

shift outward of the budget line.

Ozkardas 11 / 23

How the Budget Line Changes

intercept, but it will make the budget line steeper since p1 /p2 will

become larger.

Ozkardas 12 / 23

consumption of good 1 must decrease. Thus the horizontal intercept of

How the

the budget Budget

line must Line

shift inward, Changes

resulting in the tilt depicted in Fig-

ure 2.3.

x2

m/p2

Budget lines

m/p'1 m/p1 x1

budget line becomes steeper. 2.3

What happens to the budget line when we change the prices of good 1

and good

Ozkardas 2 at the same time? Suppose for example that we double the 13 / 23

How the Budget Line Changes

good 1 and good 2 at the same time?

p1 x1 + p2 x2 = m

tp1 x1 + tp2 x2 = m

m

p 1 x1 + p 2 x2 = t

income by t: the budget line won’t change at all.

Ozkardas 14 / 23

How the Budget Line Changes

m/p1 and m/p2 must both decrease: the budget line will shift

inward

absolute value): the budget line will be flatter.

If price 2 increases less than price 1, the budget line will be steeper.

Ozkardas 15 / 23

Taxes, Subsidies, and Rationing

We could peg one of the prices, or the income, to some fixed value,

and adjust the other variables so as to describe exactly the same

budget set.

p1 x1 + p2 x2 = m

p1 m p1 p2

p 2 x1 + x2 = p2 or m x1 + m x2 =1

the numeraire price. The numeraire price is the price relative to

which we are measuring the other price and income.

Ozkardas 16 / 23

Taxes, Subsidies, and Rationing

a certain amount to the government for each unit of the good he

purchases.

price of good 1 from p1 to p1 + t: the budget line must get steeper.

Ozkardas 17 / 23

Taxes, Subsidies, and Rationing

good, rather than the quantity purchased of a good, usually

expressed in percentage terms.

then the actual price facing the consumer is (1 + τ )p1 .

Ozkardas 18 / 23

Taxes, Subsidies, and Rationing

the government gives an amount to the consumer that depends on

the amount of the good purchased.

from the viewpoint of the consumer, the price of good 1 would be

p1 − s. This would therefore make the budget line flatter.

Ozkardas 19 / 23

Taxes, Subsidies, and Rationing

be no larger than some amount.

Suppose, for example, that good 1 were rationed so that no more

than x1 could be consumed by a given consumer.

are affordable but have x1 > x¯1 .

Ozkardas 20 / 23

consumption bundles that are aﬀordable but have x1 > x1 .

Taxes, Subsidies, and Rationing

x2

Budget line

Budget

set

x1 x1

of the budget set beyond the rationed quantity will be lopped

oﬀ.

Ozkardas 21 / 23

Taxes, Subsidies, and Rationing

consume good 1 at a price of p1 up to some level x¯1 , and then had

to pay a tax t on all consumption in excess of x¯1 .

Here the budget line has a slope of −p1 /p2 to the left of x¯1 , and a

slope of −(p1 + t)/p2 to the right of x¯1 .

Ozkardas 22 / 23

Taxes, Subsidies, and Rationing

TAXES, SUBSIDIES, AND RATIONING 29

x2

Budget line

Slope = – p1/p 2

Budget set

x1 x1

Taxing consumption greater than x1 . In this budget set Figure

the consumer must pay a tax only on the consumption of good 2.5

1 that is in excess of x1 , so the budget line becomes steeper to

the right of x1 .

EXAMPLE:

Ozkardas The Food Stamp Program 23 / 23

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