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2 Budget Constraint

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16 views21 pages

2 Budget Constraint

a

Uploaded by

cenkaykusmez6
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CHAPTER 2

Budget Constraint
Consumer’s choice
Economics is the study of exchange.
• ... develop a set of models
• … who will exchange with whom for what and at what price?

Build the model in pieces, then put the whole thing together.
• ... Budget constraint
• ... Preferences
• ... Decision making (choice: how to choose from a set of options?)

Stated together: Classical economic theory assumes "that consumers choose the best bundle of
goods they can afford." (Varian p. 20)
Consumption choice sets and consumption bundle
A consumption choice set is the collection of all consumption choices available to the
consumer.
What constrains consumption choice?
• Budgetary, time, and other resource limitations.

A consumption bundle containing x1 units of commodity 1, x2 units of commodity 2, ..., xn units


of commodity n is denoted by the vector (x1, x2, . . . , xn).
• For two goods, the consumption bundle is (x1, x2).
Commodity prices are denoted by the vector (p1, p2, . . . , pn).
• For two goods, the price vector is (p1, p2).
Budget constraints
A bundle (x1, . . . , xn) i s affordable at prices (p1, . . . , pn) if
where m is the income.

The bundles that are only just affordable form the consumer’s budget constraint. This is the
set and

The consumer’s budget set is the set of all affordable bundles;


and

The budget constraint is the upper boundary of the budget set.


Budget constraint for two commodities
Budget set and constraint for two commodities

x2
Budget constraint is
m/p2 p1x1 + p2x2 = m (slope is -p1 /p2).

The collection of
all affordable bundles

m/p1 x1
Interpreting the slope
For n = 2 and x1 on the horizontal axis, the constraint’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.


• The opportunity cost of an extra unit of commodity 1 is p1/p2 units foregone of commodity 2.
Interpreting the slope
The slope describes how many units of good 2 you can get in exchange for an additional unit of
good 1.
Suppose we increase consumption of good 1 by ∆x1.
Given that we face a budget constraint, this will mean that we need to reduce consumption of
good 2 by some amount, call it ∆x2.
p1∆x1+ p2∆x2=0
The rate of substitution between the two goods is the slope of
the budget line.
∆𝑿𝟐 𝒑𝟏
 Marginal rate of substitution (MRS) =
∆𝑿𝟏 𝒑𝟐

 Opportunity cost
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
Budget set: Income changes consumer worse off.

What happens as income changes?


• Increases in income m shift the constraint outward in a parallel manner, thereby enlarging
the budget set and improving choice.

• Decreases in income m shift the constraint inward in a parallel manner, thereby shrinking
the budget set and reducing choice.

Higher Income Gives More Choice Lower Income Shrinks the Budget Set
Budget set: Price changes
What happens if just one price decreases?

• 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 inward, reduces
choice and may (typically will) make
the consumer worse off.
Uniform sales taxes
A uniform sales tax levied at rate t changes the constraint from
to

Or equivalently,

• A uniform sales tax is applied uniformly


to all commodities.
• A uniform (ad valorem) sales tax levied
at a rate of 5% increases all prices by
5%, from p to (1 + 0.05)p = 1.05p.
Three types of taxes
A uniform sales tax of t%:
An income tax at the rate of s%:
A lump sum income tax of T:

Note that all are equal if



Budget set: Relative prices
• “Numeraire” means “unit of account.”
• Suppose prices and income are measured in TL: ,
 Then the constraint is:

• If prices and income are measured in kuruş, then


and the constraint is the same as

• Changing the numeraire changes neither the budget constraint nor the budget set.
• i.e., all that matters are relative prices and the budget.
Budget set: Relative prices
The constraint for p1 = 2, p2 = 3, m = 12

is also

The constraint for p1 = 1, p2 = 3/2, m = 6.


Setting p1 = 1 makes commodity 1 the numeraire and defines all prices relative to p1. E.g.,
3/2 is the price of commodity 2 relative to the price of commodity 1 (relative prices)

Any commodity can be chosen as the numeraire without changing the budget set or the
budget constraint.
Shapes of budget constraints
What makes a budget constraint a straight line?
 A straight line has a constant slope and the constraint is

So, if prices are constants then a constraint is a straight line.

But what if prices are not constants?


 For example, bulk buying discounts, or price penalties for buying “too much.”
 Then constraints will be curved.
Shape of budget constraint with quantity discounts
Suppose p2 =1 but p1 = 2 for 0  x1  20 and p1 = 1 for x1 > 20.
Then the constraint’s slope is: for and for
Shape of budget constraint with a quantity penalty
Shape of budget constraint with one price negative
Commodity 1 is garbage. You are paid 2 per unit to accept it; i.e.,

p1 = -2, p2 = 1, m = 10.

Then the constraint is or


Shape of budget constraint with rationing

Governments also sometimes


impose rationing constraints. This
means that the level of
consumption of some good is fixed
to be no larger than some amount.
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.
Choice set constraints combined
Other Stuff

Food
10

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