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Budget Constraint: Helia Rabie Spring 2021

This document provides an overview of consumer theory and budget constraints. It discusses key concepts such as: 1) A consumer's budget constraint defines the set of goods they can afford based on prices and their income. 2) Changes to prices, income, taxes or subsidies can shift or change the slope of the budget constraint line. 3) The theory aims to describe consumer behavior, predict how behavior changes with economic factors, and use observations to estimate preferences.

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Helia Rabie
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86 views14 pages

Budget Constraint: Helia Rabie Spring 2021

This document provides an overview of consumer theory and budget constraints. It discusses key concepts such as: 1) A consumer's budget constraint defines the set of goods they can afford based on prices and their income. 2) Changes to prices, income, taxes or subsidies can shift or change the slope of the budget constraint line. 3) The theory aims to describe consumer behavior, predict how behavior changes with economic factors, and use observations to estimate preferences.

Uploaded by

Helia Rabie
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Budget Constraint

Helia Rabie
Spring 2021
Consumer theory
• A. consumers choose the best bundles of goods they can afford.
• B. Two parts to theory
• 1. “can afford” — budget constraint
• 2. “best” — according to consumers’ preferences
Consumer theory
• C. What do we want to do with the theory?
• 1. test it — see if it is adequate to describe consumer behavior
• 2. predict how behavior changes as economic environment changes
• 3. use observed behavior to estimate underlying values
• a) cost-benefit analysis
• b) predicting impact of some policy
D. Consumption bundle
• 1. (x1, x2) — how much of each good is consumed
• 2. (p1, p2) — prices of the two goods
• 3. m — money the consumer has to spend
• 4. budget constraint: p1x1 + p2x2 ≤ m
• 5. all (x1, x2) that satisfy this constraint make up the budget set of the
consumer.
• E. Two goods
• 1. theory works with more than two goods, but can’t draw pictures.
• 2. good 2 : composite good, representing money to spend on other goods.
• 3. budget constraint becomes p1x1 + x2 ≤ m.
• 4. money spent on good 1 (p1x1) plus the money spent on good 2 (x2) has
to be less than or equal to the amount available (m).
• F. Budget line
• 1. p1x1 + p2x2 = m
• 2. also written as x2 = m/p2 − (p1/p2)x1.
• 3. budget line has slope of −p1/p2 and vertical intercept of m/p2.
• 4. set x1 = 0 to find vertical intercept (m/p2); set x2 = 0 to find horizontal intercept
(m/p1).
• 5. slope of budget line measures opportunity cost of good 1 — how much of good 2
you must give up in order to consume more of good 1.
G. Changes in budget line
• 1. increasing m makes parallel shift out. See Figure 2.2.
• 2. increasing p1 makes budget line steeper. See Figure 2.3.
• 3. increasing p2 makes budget line flatter
• 4. just see how intercepts change
• 5. multiplying all prices by t is just like dividing income by t
• 6. multiplying all prices and income by t doesn’t change budget line
• a) “a perfectly balanced inflation doesn’t change consumption possibilities”
H. The numeraire
• 1. can arbitrarily assign one price a value of 1 and measure other price
relative to that
• 2. useful when measuring relative prices; e.g., English pounds per dollar,
1987
• dollars versus 1974 dollars, etc.
I. Taxes, subsidies, and rationing
• 1. quantity tax — tax levied on units bought: p1 + t
• 2. value tax — tax levied on dollars spent: p1 + τp1. Also known as ad valorem tax
• 3. subsidies — opposite of a tax
• a) p1 − s
• b) (1 − σ)p1
• 4. lump sum tax or subsidy — amount of tax or subsidy is independent of
• the consumer’s choices. Also called a head tax or a poll tax
• 5. rationing — can’t consume more than a certain amount of some good
J. Example — food stamps
• 1. before 1979 was an ad valorem subsidy on food
• a) paid a certain amount of money to get food stamps which were worth
• more than they cost
• b) some rationing component — could only buy a maximum amount of
• food stamps
• 2. after 1979 got a straight lump-sum grant of food coupons. Not the same
as a pure lump-sum grant since could only spend the coupons on food.

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