These slides are by courtesy of Prof. 李稻葵 and Prof. 郑捷.
Chapter Two
Budget Constraint
Where are We in the Course?
We are working on the 1st of the 3
components of microeconomics:
Consumer behavior, production
theory, and market.
There are three elements of
consumer behavior: budget
constraint, preference, and choices.
Consumption Choice Sets
A consumption choice set is the
collection of all consumption choices
available to the consumer.
What constrains consumption
choice?
– Money
– And something else?
Budget Constraints
Consumer plans to spend money on
n goods
Bundle: (x1, … , xn)
Q: When is a bundle (x1, … , xn)
affordable at prices p1, … , pn?
A: When
p1x1 + … + pnxn m
where m is the consumer’s income.
Budget Constraints
The consumer’s budget set is the set
of all affordable bundles;
B(p1, … , pn, m) =
{ (x1, … , xn) | x1 0, … , xn 0 and
p1x1 + … + pnxn m }
The budget line is the upper
boundary of the budget set.
Budget Set for Two Commodities
x2
Budget line is
m /p2
p1x1 + p2x2 = m.
Not affordable
Just affordable
Affordable with some
money left
m /p1 x1
Budget Set for Two Commodities
x2
p1x1 + p2x2 = m is
m /p2
x2 = -(p1/p2)x1 + m/p2
so slope is -p1/p2.
Budget
Set
m /p1 x1
Budget Constraints
If n = 3 what do the budget line and
the budget set look like?
Budget Set for Three
Commodities
x2 { (x1,x2,x3) | x1 0, x2 0, x3 0 and
m /p2 p1x1 + p2x2 + p3x3 m}
m /p3
x3
m /p1 Budget line becomes
x1 budget “plane”
Budget Constraints
For n = 2 and x1 on the horizontal
axis, the budget line’s slope is -p1/p2.
What does it mean?
p1 m
x2 = − x1 +
p2 p2
Increasing x1 by 1 must reduce x2 by
p1/p2.
– Opportunity cost / trade-off
Budget Constraints
On the budget line,
x2 getting an extra unit
of commodity 1
means forgoing
+1 p1/p2 units of
commodity 2
-p1/p2
x1
Notes on Units of Measure
Economists tend to be sloppy in
terms of units of measure.
It depends on specific applications:
– 15 kg of apples
– 1 hour of massage
–…
Income and Price Changes
What happens as prices or income
change?
Higher income gives more choice
x2 New affordable consumption
choices
Original and
new budget
lines are
parallel (same
Original slope).
budget set
x1
How do the budget set change as p1
decreases from p1 to p1’?
x2
New affordable choices
m/p2 Budget line rotates
around the vertical
intercept; slope is
-p1/p2 less negative (from
-p1/p2 to -p1’/p2.
Original
-p1’/p2
budget set
m/p1 m/p1’ x1
Uniform Ad Valorem Sales Taxes
in the US
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.
Uniform Ad Valorem Sales Taxes
A uniform sales tax levied at rate t
changes the constraint from
p1x1 + p2x2 ≤ m
to
(1+t)p1x1 + (1+t)p2x2 ≤ m
i.e.
p1x1 + p2x2 ≤ m/(1+t).
Uniform Ad Valorem Sales Taxes
x2
m
p2
m
( 1 + t ) p2
m m x1
( 1 + t ) p1 p1
The Food Stamp Program in the
US
Food stamps are coupons that can
be legally exchanged only for food.
How do food stamps change a
family’s budget set?
The Food Stamp Program
F + G = 100; without
G stamps.
Note: We may “normalize”
both prices to 1 by changing
100 the unit of the goods: Define
the amount of food that can be
bought with $1 as one
“basket”. Then price of food is
$1 per basket by definition.
100 F
The Food Stamp Program
G
F + G = 100: before stamps.
100 Budget set after
receiving 40 food
stamps. (Each food
stamp can be used as
$1 to buy food only.)
40 100 140 F
The Food Stamp Program
What if food stamps can be traded on
a black market at the price of $0.5?
The Food Stamp Program
G
F + G = 100: before stamps.
120
100 Budget line after 40
food stamps issued.
Black market trading
makes the budget
set larger again.
40 100 140 F
Relative Prices
Suppose prices and income are
measured in dollars. Say p1=$2,
p2=$3, m = $12. Then the constraint
is
2x1 + 3x2 ≤12.
Relative Prices
The constraint for p1=2, p2=3, m=12
2x1 + 3x2 ≤ 12
is also x1 + (3/2)x2 ≤ 6,
the constraint for p1=1, p2=3/2, m=6.
Setting p1=1 makes commodity 1 the
numeraire and defines all prices in
terms of commodity 1.
Numeraire
Any commodity can be chosen as
the numeraire without changing the
budget set.
– Dividing the budget constraint by
pk will make commodity k the
numeraire.
Shapes of Budget Set
But what if prices are not constants?
– E.g. bulk buying discounts
– or the opposite, price penalties for
buying “too much”.
Then lines will be curved.
Shapes of Budget Sets - Quantity
Discounts
Suppose p2 is constant at $1 but that
p1=$2 for 0 x1 20 and p1=$1 for
x1>20.
Then budget line’s slope is
- 2, for 0 x1 20
{
-p1/p2 =
- 1, for x1 > 20
Shapes of Budget Sets with a
Quantity Discount
x2 m = $100
100 Slope = - 2 (p1=2, p2=1)
60
Slope = - 1 (p1=1, p2=1)
20 50 80 x1
Shapes of Budget Sets with a
Quantity Discount
x2 m = $100
100 Slope = - 2 (p1=2, p2=1)
60
Slope = - 1 (p1=1, p2=1)
20 50 80 x1
Shapes of Budget Sets with a
Quantity Discount
x2 m = $100
100
Budget line
Budget Set
20 50 80 x1
Shapes of Budget Sets with a
Quantity Penalty
x2
Budget line
Budget Set
x1
Shapes of Budget Sets - One
Price Negative
Commodity 1 is stinky garbage. You
are paid $2 per unit to accept it; i.e.
p1 = - $2. p2 = $1. Income, other than
from accepting commodity 1, is m =
$10.
Then the constraint is
- 2x1 + x2 ≤ 10 or x2 ≤ 2x1 + 10.
Shapes of Budget Sets - One
Price Negative
x2
x2 = 2x1 + 10
10
x1
Shapes of Budget Sets - One
Price Negative
x2
Budget set is
all bundles for
which x1 0,
x2 0 and
x2 2x1 + 10.
10
x1
More General Choice Sets
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.
More General Choice Sets
Other Stuff
At least 10 units of food
must be eaten to survive
10 Food
More General Choice Sets
Other Stuff
At least 10 units of food
must be eaten to survive
Budget
10 Food
The set of feasible bundles is the intersection.
A Quick Summary
1. Basic concepts
1. Budget set
2. Numeraire and relative price
2. Basic skills
To work out a budget set
