Background Ch2

Microeconomics
Academic Year 2020/21

Corso di Laurea in
Business and Economics (CLaBE)
Module Lecturer ‘consumer theory’
Matthew Wakefield
•1
Microeconomics
Matthew Wakefield
E-mail: matthew.wakefield (at) unibo.it
Office hour :
Given the current situation, office hours will
tend to be by appointment and online
using microsoft Teams.
•2
1
Microeconomics
 Lecture times :
Thu, 11 - 14 Fri, 11 – 14 Total of 7 lectures
 You should know about use of presente.unibo.it to book
attendance
 Teaching materials:
Virtuale:
Go to my institutional website (sito web docente,
https://www.unibo.it/sitoweb/matthew.wakefield/en), click on the
tab for “teaching”, then on hyperlink to
“teaching resources on virtuale” under relevant course; you will
need unibo credentials
(email: name.surname@studio.unibo.it, and password)
 Course Tutor: tbc

3
•3
Microeconomics
• Text book:
Hal R. Varian,
INTERMEDIATE MICROECONOMICS:
A Modern Approach
9th International Student Edition, 2014
W.W.Norton & Co., New York (& London),
ISBN: 978-0-393-92077-2
• Strongly recommended to have a copy

• Amazon; etc.
•4
2
Microeconomics
Course Outline (provisional)
May be subject to some modification
Topics to be covered; (#) indicates relevant chapter in Varian
Bold indicates greater certainty that the topic will be covered.
1st part: Consumer Theory
I. Introduction VII.Demand (6)

II. Budget Constraint VIII. Slutsky Equation (8)
(2)
IX. Buying and Selling (9)
III. Preferences (3) [includes labour supply]
IV. Utility (4)
V. Choice (5) … Equilibrium ???
•5
Microeconomics
Lecture Timetable (Provisional)
May be subject to some modification
Timetable is Provisional
See: http://corsi.unibo.it/1cycle/EconomicsFinance/Pages/course-timetable.aspx
Week 1: 25/9
Week 2: 1/10, 2/10
Week 3: 8/10, 9/10
Week 4: 15/10, 16/10
… Prof Dragone …
•Notifications: studio.unibo email, and presente
•6
3
Microeconomics
Module Aims
• Introduction to microeconomics, specifically consumer theory
• Preparatory for second module
• Preparatory for the exam (will see exam type exercises)
• Preparatory for other economics courses
• Provide an understanding of the principles and tools

of economic analysis
• Building and interpreting models
• Graphical and/or mathematical analysis where appropriate
• Analyse consequences of optimising behaviour
• Get you thinking as economists about everyday

phenomena – on which, another book:
Harford, Tim, (2006), The Undercover Economist,
London: Abacus, ISBN: 978-0-349-11985-4
7
•7
Microeconomics
Ground rules
• Follow CoVID protocols at all times!!!
• You will see material (theory) and exercises

• The responsibility for being on top of the material is
yours ...
• In lectures, I ask for quiet

• Don’t talk to your neighbours ...
• But you can interrupt with queries
• Following remotely: use the chat for queries

• Can potentially unmute and ask
•8
4
Microeconomics
Academic Year 2020/21

Corso di Laurea in
Business and Economics (CLaBE)
Module Lecturer ‘consumer theory’
Matthew Wakefield
•9
5
9/25/2020
Microeconomics
Part 1: Consumer Theory
True or false?
• When the price of a commodity falls, consumers will always
buy more of it.
• When prices fall, this makes a consumer better off.
• Taxes imposed on cigarettes and alcohol are proof that
Governments care about the health of citizens.
• The economics required to analyse labour-supply decisions is
very different from the economics required to analyse how
individuals make their spending decisions.
• Economists can help Governments design consumption taxes,
labour-income taxes, and benefit (transfer payment)
programs.
Consumer theory: much more detail on demand side than in

chapter 1 1
2 Budget Constraints
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Consumer theory in a nutshell

 Behind optimisation principle for consumer
 Consumer will choose the “best” bundle she
“can afford”
– Best? – ch 3 ff.
– Can afford? – this chapter
– Focus on financial constraints on what can
buy, there may be other constraints (e.g.
time).
Chapter 2
 Budget constraint, budget set
 Two goods are often enough
– Composite good $ (euro, £) spending on
 Drawing the budget line
 Interpretation: slope and opportunity cost
 Changes in the budget line
– And some conclusions about well-being
 Examples: Budget lines that are not straight
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Chapter 2
Budget Constraints: notation

 Consumption bundle: set of all items consumed, may
include more than one of any good
 Describe a consumption bundle by quantities of each
good consumed:
 Bundle containing x1 units of good (or service) 1, x2
units of good 2 and so on up to xn units of good n is
described by the vector (x1, x2, … , xn).
 Goods’ prices are p1, p2, … , pn.
 Let us suppose that the consumer has disposable
income m to allocate between the different goods
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Budget Constraints
 Q: When is a consumption bundle
(x1, … , xn) affordable at prices p1, … , pn?
 A: When
p 1x 1 + … + pnx n  m
 Expenditure no greater than disposable

income
Budget Constraints
p 1x 1 + … + pnx n  m
 The consumer’s Budget Constraint

 Choices must satisfy this constraint (inequality)
 (Quantities consumed must (usually) be non-
negative)
 All bundles that satisfy this constraint form the
consumer’s Budget Set
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Chapter 2
Budget Constraints
 Convenient to have 2 goods because (as will see) can
represent constraint on a 2-D graph
(more goods, more dimensions!)
 With 2 goods:
p1x1 + p2x2  m
 For many purposes, two goods are “enough”:
 Can consider good of interest (e.g. “food”) and
 Second good as composite: “all other things consumed”
 If define 1 unit of other stuff as $1 of spending, then:
p1x1 + x2  m
 Where food is good 1
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10
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Chapter 2
11
11
Budget Constraints
 Generally with 2 goods, 1 and 2.
Budget Constraint
p1x1 + p2x2  m
 If we consider this as an equation, we can also define

the budget line (bundles just affordable):
p1x1 + p2x2  m
 Which can be rearranged to

x2 = -(p1/p2)x1 + m/p2
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12
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Budget Set and Constraint for

x2
Two Commodities
Budget line is
m /p2
p1x1 + p2x2 = m or
x2 = m/p2 - (p1/p2) x1
m /p1 x1
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Budget Constraints
 Generally with 2 goods, 1 and 2.
Budget Constraint
p1x1 + p2x2  m
 If we consider this as an equation, we can also define

the budget line (bundles just affordable):
p1x1 + p2x2  m
 Which can be rearranged to

x2 = -(p1/p2)x1 + m/p2
 Example: p1=2, p2=4, m = 20
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x2
Two Commodities
m /p2
m /p1 x1
15
15

x2
Two Commodities
m /p2
Not affordable
Just affordable
Affordable
m /p1 x1
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x2
Two Commodities
Budget line is upper limit
m /p2 of budget set: just affordable
the collection
of all affordable bundles
Budget (includes budget line)
Set
m /p1 x1
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Chapter 2
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Interpretation of the Budget Line
Budget line is:

p1x1 + p2x2 = m
or: x2 = -(p1/p2)x1 + m/p2
so slope (gradient) is -p1/p2.
(Nb. This is for x1 on horizontal axis.)
What does this mean?
In terms of calculus, ∂x2 / ∂x1 = -p1/p2
• m (spending on the 2 goods) is constant along budget line, so gradient
is rate at which purchases of good 2 must change, in response to a
change in purchases of good 1, to keep total spending fixed
More intuitively …
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19

 Suppose we define ∆x2 as the change in the quantity of good 2
that will just keep us on a given budget line after the quantity of
good 1 is increased by ∆x1.
- Note that ∆x2 will be negative
 What can we say about relationship between ∆x1 and ∆x2?
 If the budget line is for income (expenditure) level m, then:
p1x1 + p2x2 = m
and p1(x1 + ∆x1)+ p2(x2 + ∆x2) = m
 Subtracting these two equations from each other gives
p1∆x1 + p2∆x2 = 0
 Or rearranging: ∆x2 / ∆x1 = - p1 / p2
 So minus the ratio of the two prices is the rate at which the
commodities can be exchanged (on the market) without a
change in budget
 Graphically: 20
20
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9/25/2020
Budget Constraints
x2 Equal but opposite change in
spending on each good:
p1∆x1 = - p2∆x2
Hence slope is
∆x1 ∆x2/ ∆x1 = -p1/p2
(x1 , x2)
∆x2
(x1+ ∆x1, x2+∆x2)
x1
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∆x2 / ∆x1 = - p1 / p2
 Consider case where the change in the quantity of good 1 is 1:
 Then: ∆x2 = - p1 / p2
 Says if one extra unit of good one is bought, then (p1 / p2) fewer
units of good 2 must be bought if spending is to be held constant
- (Note that if quantity of good one had been reduced by 1,
then (p1 / p2) more units of good 2 could have been afforded).
 - p1 / p2 is the OPPORTUNITY COST of an extra unit of good 1, in
terms of units of good 2 that must be foregone
 Example: p1=2, p2=4
 Buying 1 extra unit of good 1 costs 2 euro
 From a given budget, this can be funded by giving up 0.5 (= 2/4)
units of good 2
 General case can be represented graphically:
22
22
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9/25/2020
Budget Constraints
x2
Slope is -p1/p2
+1
-p1/p2
x1
23
23
Budget Constraints
x2
Slope is -p1/p2
Opportunity cost of an
+1 extra unit of commodity 1 is
p1/p2 units foregone of
commodity 2. “Give up”
p1/p2 units of good 2 to
-p1/p2 “buy” extra unit of good 1.
x1
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∆x2 / ∆x1 = - p1 / p2
 To get opportunity cost of good 2, need to set change in quantity of
good 2 to 1, then rearrange to get an expression for ∆x1
 This gives: ∆x1 = - p2 / p1
 Says if one extra unit of good 2 is bought, then (p2 / p1) fewer units
of good 1 must be bought if spending is to be held constant
 Example: p1=2, p2=4
 Buying 1 extra unit of good 2 costs 4 euro
 From a given budget, this can be funded by giving up 2 (= 4/2)
units of good 2
 Graphically:
25
25
Budget Constraints
x2
Opportunity cost of an extra
unit of commodity 2 is
p2/p1 units foregone
+1 of commodity 1.
-p2/p1
x1
26
26
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Chapter 2
27
27
Budget Sets & Constraints;

Income and Price Changes
 The budget constraint and budget set depend upon
prices and income. What happens as prices or
income change?
Key questions to answer

 What happens to intercepts? ((m/p1) and (m/p2))
 What happens to the slope? (- p1 / p2 )
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28
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9/25/2020

 First suppose that m increases, but prices remain
constant.
 Intercepts (m/p1) and (m/p2) both increase

 But prices and the price ratio (slope) are unchanged
 So …
29
29
Higher income …
x2
Original
budget set
x1
30
30
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9/25/2020
Higher income …
x2
… results in a parallel
outward shift in budget
constraint
Original
budget set
x1
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31

 First suppose that m increases, but prices remain
constant.
 Intercepts (m/p1) and (m/p2) both increase

 But prices and the price ratio (slope) are unchanged
 So …
 Example: p1=2, p2=4, m = 20, m’ = 28
 What about an income decrease?
32
32
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9/25/2020

 Now suppose that 1 price falls, but income and the
other price are unchanged.
- Let p1 be the price that falls
 Intercept (m/p1) changes, other intercept does not

 Price ratio (p1/p2) gets smaller: slope less negative
 So …
33
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A reduction in price of good 1 …

x2
m/p2
-p1’/p2
Original
budget set
m/p1’ m/p1” x1
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34
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A reduction in price of good 1 …

x2
m/p2 … causes budget line
to pivot outwards
-p1’/p2
Original
budget set
m/p1’ m/p1” x1
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35

 Now suppose that 1 price falls, but income and the
other price are unchanged.
- Let p1 be the price that falls
 Intercept (m/p1) changes, other intercept does not

 Price ratio (p1/p2) gets smaller: slope less negative
 So …
 Example: p1=2, p2=4, m = 20, p1’ = 1
 What about decrease in price of good 2? Price

increases?
36
36
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Chapter 2
37
37
Some conclusions about well being

 Increase in income, or fall in at least one price (all else
unchanged):
 Leave all original bundles affordable
 And make some extra bundles affordable
 Thus agent is not forced to change choice
 Optimising agent will only change if this makes her better off
 So these changes CANNOT reduce welfare but can (usually
will) improve welfare
 (When price(s) fall, this makes a consumer better off
 Income falls and price rises reduce consumption possibilities
so can (generally will) reduce welfare
38
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Chapter 2
39
39
Uniform Ad Valorem Sales Taxes

 An ad valorem sales tax levied at a rate of 5%
increases all prices by 5%, from p to
(1+005)p = 105p.
 An ad valorem sales tax levied at a rate of t
increases all prices by tp from p to (1+t)p.
 A uniform sales tax is applied uniformly to all
commodities.
40
40
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9/25/2020

 A uniform sales tax levied at rate t changes
the constraint from
p 1x 1 + p 2x 2 = m
to
(1+t)p1x1 + (1+t)p2x2 = m
41
41

 A uniform sales tax levied at rate t changes
the constraint from
p 1x 1 + p 2x 2 = m
to
(1+t)p1x1 + (1+t)p2x2 = m
i.e.
p1x1 + p2x2 = m/(1+t).
 So just like scaling income by a factor of
1/(1+t)
42
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9/25/2020

x2
m p1x1 + p2x2 = m
p2
m x1
p1
43
43

x2
m p1x1 + p2x2 = m
p2
m p1x1 + p2x2 = m/(1+t)
(1  t ) p2
m m x1
(1  t ) p1 p1
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44
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Shapes of Budget Constraints

 Q: What makes a budget constraint a straight
line?
 A: constant slope (i.e. a straight line) when
prices are constants
 But what if prices are not constants?
 E.g. bulk buying discounts, (or price penalties
for buying “too much”).
 Then constraints will be kinked.
45
45
Shapes of Budget Constraints -

Quantity Discounts
 Suppose p2 is constant at $1 but that p1=$2
for 0  x1  20 and p1=$1 for x1>20.
 Then the constraint’s slope is
- 2, for 0  x1  20
{
-p1/p2 =
- 1, for x1 > 20
and the constraint (with m = $100) is
46
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9/25/2020

with a Quantity Discount
x2 m = $100
100 Slope = - 2 / 1 = - 2
(p1=2, p2=1)
Slope = - 1/ 1 = - 1
(p1=1, p2=1)
20 50 80 x1
47
47

x2 m = $100
100 Slope = - 2 / 1 = - 2
(p1=2, p2=1)
Slope = - 1/ 1 = - 1
(p1=1, p2=1)
20 50 80 x1
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x2 m = $100
100
Budget Constraint
Budget Set
20 50 80 x1
49
49

with a Quantity Penalty
x2
Budget
Constraint
Budget Set
x1
50
50
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9/25/2020
The Food Stamp Program

 “Food stamps” are a real (US) welfare
program for low-income families
 Since 2008 “SNAP”: Supplemental Nutrition
Assistance Program
 Food stamps are coupons that can be legally
exchanged only for food.
 How does a commodity-specific gift such as a
food stamp alter a family’s budget constraint?
 See “exercises part 1”, slides 14 ff.

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Chapter 2: Summary
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9/25/2020
2 Budget Constraints
53
27

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Microeconomics

Academic Year 2020/21

E-mail: matthew.wakefield (at) unibo.it

 Course Tutor: tbc

• Strongly recommended to have a copy

I. Introduction VII.Demand (6)

•Notifications: studio.unibo email, and presente

• Provide an understanding of the principles and tools

• Get you thinking as economists about everyday

• You will see material (theory) and exercises

• In lectures, I ask for quiet

• Following remotely: use the chat for queries

Academic Year 2020/21

Consumer theory: much more detail on demand side than in

Consumer theory in a nutshell

Budget Constraints: notation

 Expenditure no greater than disposable

 The consumer’s Budget Constraint

 If we consider this as an equation, we can also define

 Which can be rearranged to

Budget Set and Constraint for

 If we consider this as an equation, we can also define

 Which can be rearranged to

Budget Set and Constraint for

Budget Set and Constraint for

Budget Set and Constraint for

Interpretation of the Budget Line

Budget line is:

Interpretation of the Budget Line

Interpretation of the Budget Line

Interpretation of the Budget Line

Budget Sets & Constraints;

Key questions to answer

Budget Sets & Constraints;

 Intercepts (m/p1) and (m/p2) both increase

Budget Sets & Constraints;

 Intercepts (m/p1) and (m/p2) both increase

 What about an income decrease?

Budget Sets & Constraints;

 Intercept (m/p1) changes, other intercept does not

A reduction in price of good 1 …

A reduction in price of good 1 …

Budget Sets & Constraints;

 Intercept (m/p1) changes, other intercept does not

 What about decrease in price of good 2? Price

Some conclusions about well being

Uniform Ad Valorem Sales Taxes

Uniform Ad Valorem Sales Taxes

Uniform Ad Valorem Sales Taxes

Uniform Ad Valorem Sales Taxes

Uniform Ad Valorem Sales Taxes

Shapes of Budget Constraints

Shapes of Budget Constraints -

and the constraint (with m = $100) is

Shapes of Budget Constraints

Shapes of Budget Constraints

Shapes of Budget Constraints

Shapes of Budget Constraints

The Food Stamp Program

 See “exercises part 1”, slides 14 ff.

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