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# 2.

## The consumers budget constraint

Varian, Chapter 2

Consumer theory
Consumers maximize their individual well-being, subject to their choices being feasible How do we describe what is best for a consumer?
We use the consumers own preferences

## How do we describe what is feasible?

The expenditure is no greater than the budget

Bundles of Goods
Suppose that there are two goods
x1 is the amount of good 1 x2 is the amount of good 2
x2

x1

## Money and prices

Suppose that the consumer has m units of money The prices of goods are expressed in terms of money
p1 is the price of good 1 (the number of units of money needed to buy one unit of good 1) p2 is the price of good 2

## Costs and Budgets

The bundle (x1,x2) costs p1x1 + p2x2

The consumer can afford any bundle that satisfies the budget constraint: p1x1 + p2x2 m

Budget set
x2 m/p2

p1x1 + p2x2 = m

Affordable

Not affordable

m/p1

x1

p1x1 + p2x2 m

Normalizing prices
A good is called the numeraire if prices and money are measured in term of units of that good Let good 2 be the numeraire The opportunity cost of good 1 is the amount of good 2 that must be given up to get another unit of good 1

## Determining normalized prices

Divide budget constraint by p2 and rearrange: (p1/p2)x1 + x2 = m/p2 px1 + x2 = m x2 = m -px1 where p = p1/p2, m = m/p2
x2 m

Slope = -p = -(p1/p2)

m/p

x1

Effect of inflation
Initial budget constraint: p1x1 + p2x2 = m Then, prices and income double: 2p1x1 + 2p2x2 = 2m Relative prices and real income are unchanged: p = 2p1/(2p2) = p1/p2 m = 2m/(2p2) = m/p2 the budget set is unchanged

Income change
x2 m=m2

m=m1

x1

## A single price changes

x2 m/p2

m/pold1

m/pnew1

x1

A tax on good 1
Original budget constraint: p1x1 + p2x2 = m Quantity tax on good 1, at the rate t per unit: (p1+ t)x1 + p2x2 = m Total tax paid = tx1

A tax on good 1
Ad valorem tax on good 1, at the rate of t per dollar spent:

p1(1+t)x1 + p2x2 = m
Total tax paid = t p1x1

A per-unit subsidy
Original budget constraint: p1x1 + p2x2 = m A per-unit subsidy for good 1, at the rate of s per unit: (p1-s)x1 + p2x2 = m Total subsidy = sx1

A lump-sum subsidy
A lump-sum subsidy equal to : p1x1 + p2x2 = m+ x2 = ((m+ )/p2) (p1/p2)x1 Total subsidy =

Two constraints
Jack has \$1000 to spend on bowling and golf
A round of golf costs \$100; an hour of bowling costs \$10
Hours spent bowling 100 80

Budget

Time

## Jack has 80 hours to bowl and play golf

A round of golf takes 4 hours
10 20 Rounds of golf

Food stamps
Eligible individuals receive an allotment of food stamps
e.g., \$200 per month for a family These stamps can only be used to buy food
Money spent on other goods

200

## Food stamps with resale

Suppose that stamps might be sold to other consumers or shopowners at less than face value
Money spent on other goods

200

## m+200 Money spent on food

SNAP
Typically, recipients must be within 130% of the poverty line (\$28,665 for a family of four in 2010) The debit-card payment system cut errors (overpayments, underpayments, and payments going to ineligible households) by a third

Vouchers
Eligible individuals receive a voucher for educational expenditures
e.g., \$400 per month for a family The voucher can only be used to pay for education
400 Money spent on other goods

## m+400 Money spent on education

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Rationing
Consumption of good 1 is restricted to be _ no more than x1 x p1x1+ p2x2 = m
2

m/p2

_
x1 m/p1 x1

## Rationing with resale

x2 m/p2

p1x1+ p2x2 = m

_
x1 m/p1 x1

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Luxury Tax
_ Tax consumption of good 1 above x1
x2 m/p2

p1x1+ p2x2 = m
_ p1x1+ t(x1-x1) + p2x2 = m

_
x1

x1 (m+tx1)/(p1+t)

Quantity discount
Price of good 1 is p1d for quantities above x1
x2 m/p2

_
x1

x1 + (m-p1x1)/(p1-d)

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