ECO3013:

INTERMEDIATE MICROECONOMICS

Chapter 2: Budget Constraint

In this lecture we will

- use the consumption theory to understand consumer

behaviour

- assume that consumers select the best bundle of goods

they can afford.

-examine how to describe what a consumer can afford

-determine the best consumption bundle

 Consumer Theory
 is a model that describes how individuals
behave.

How do individuals choose what to

consume?
How do these decisions respond to
changes in the environment?
How can we use this model to describe
market demand for goods?
 Consumption Choice Sets

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.
 Budget Constraints

A consumption bundle containing x1

units of commodity 1, x2 units of
commodity 2 and so on up to xn units of
commodity n is denoted by the vector
(x1, x2, … , xn).

 Commodity prices are p1, p2, … , pn.

 Budget Constraints

 Q:When is a bundle (x1, … , xn) affordable

at prices p1, … , pn?

 A: When
p1x1 + … + pnxn  m

where m is the consumer’s (disposable)

income.
 Budget Constraints

 The bundles that are only just affordable

form the consumer’s budget constraint. This
is the set

{ (x1,…,xn) | x1  0, …, xn  and

p1x1 + … + pnxn  m }.
 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 constraint is the upper boundary

of the budget set.
 Budget Set and Constraint for
x2 Two Commodities
Budget constraint is
m /p2
p1x1 + p2x2 = m.
Not affordable
Just affordable
Affordable

m /p1 x1
Budget Set and Constraint for Two
Commodities
x2
Budget constraint is
m /p2
p1x1 + p2x2 = m.

the collection
of all affordable bundles.
Budget
Set
m /p1 x1
 Budget Set and Constraint for
x2 Two Commodities
p1x1 + p2x2 = m is
m /p2
x2 = -(p1/p2)x1 + m/p2
so slope is -p1/p2.

Budget
Set
m /p1 x1
 Budget Constraints

 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

A: Increasing x1 by 1 must reduce x2 by p1/p2.

 Summary
x2
Slope is -p1/p2

-p1/p2
+1

x1
the Opp. cost of an extra unit of commodity 1 is p1/p2
units foregone of commodity 2.
 Budget Constraints
x2 Opp. cost of an extra unit of
commodity 1 is p1/p2 units
foregone of commodity 2.
And
the opp. cost of an extra
+1 unit of commodity 2 is
p2/p1 units foregone
-p2/p1 of commodity 1.

x1
Budget Sets & Constraints; Income and
Price Changes

 Thebudget constraint and budget set

depend upon prices and income.

What happens as prices or income

change?
 How do the budget set and budget
constraint change as income m
x2 increases?

Original
budget set
x1
Higher income gives more choice
x2 New affordable consumption
choices
Original and
new budget
constraints are
parallel (same
Original slope).
budget set
x1
 How do the budget set and budget
constraint change as income m decreases?
x2
Consumption
bundles
that are no longer
affordable.
Old and new
New, smaller constraints
budget set are parallel.
x1
Budget Constraints - Income Changes

 Increasesin income m shift the

constraint outward in a parallel
manner, thereby enlarging the budget
set and improving choice.
Budget Constraints - Income Changes

 Increasesin 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.
Budget Constraints - Income Changes

 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 consumer worse off.
Budget Constraints - Price Changes
 What happens if just one price
decreases?
 Suppose p1 decreases.
 Effect on budget set and budget constraint
if p1 decreases from p1’ to p1”

x2
m/p2
New affordable choices
Budget constraint pivots; slope
flattens from -p1’/p2 to -p1”/p2
-p1’/p2

Original
-p1”/p2
budget set
m/p1’ m/p1” x1
Budget Constraints - Price Changes
 Reducing the price of one commodity
pivots the constraint outward.

 Noold choice is lost and new choices

are added, so reducing one price
cannot make the consumer worse off.
Budget Constraints - Price Changes

 Similarly,increasing one price pivots

the constraint inwards, reduces
choice and may (typically will) make
the consumer worse off.
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.
 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
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 p1x1 + p2x2 = m
p2

m x1
p1
Uniform Ad Valorem Sales Taxes
x2
m p1x1 + p2x2 = m
p2
m p1x1 + p2x2 = m/(1+t)
( 1  t ) p2

m m x1
( 1  t ) p1 p1
Uniform Ad Valorem Sales Taxes
x2
m
p2 Equivalent income loss
is
m m t
m  m
( 1  t ) p2 1 t 1 t

m m x1
( 1  t ) p1 p1
Uniform Ad Valorem Sales Taxes
x2 A uniform ad valorem
sales tax levied at rate t
m
is equivalent to an income
p2 t
tax levied at rate
m .
1 t
( 1  t ) p2

m m x1
( 1  t ) p1 p1
 The Food Stamp Program

 Food stamps are coupons that can be

legally exchanged only for food.

 Howdoes a commodity-specific gift

such as a food stamp alter a family’s
budget constraint?
 The Food Stamp Program

 Suppose m = $100, pF = $1 and the

price of “other goods” is pG = $1.

 The budget constraint is then

F + G =100.
 The Food Stamp Program
G
F + G = 100; before stamps.
100

100 F
 The Food Stamp Program
G
F + G = 100: before stamps.
100

100 F
 The Food Stamp Program
G
F + G = 100: before stamps.
100 Budget set after 40 food
stamps issued.
The family’s budget
set is enlarged.

40 100 140 F
 The Food Stamp Program

 What if food stamps can be traded

on a black market for $0.50 each?
 The Food Stamp Program
G
F + G = 100: before stamps.
120
100 Budget constraint after 40
food stamps issued.
Budget constraint with
black market trading.

40 100 140 F
 The Food Stamp Program
G
F + G = 100: before stamps.
120
100 Budget constraint after 40
food stamps issued.
Black market trading
makes the budget
set larger again.

40 100 140 F
Budget Constraints - Relative Prices
 “Numeraire” means “unit of account”.

 Suppose prices and income are

measured in dollars. Say p1=$2, p2=$3,
m = $12. Then the constraint is]

2x1 + 3x2 = 12.

Budget Constraints - Relative Prices
 Ifprices and income are measured in
cents, then p1=200, p2=300, m=1200
and the constraint is
200x1 + 300x2 = 1200,
the same as
2x1 + 3x2 = 12.

 Changing the numeraire changes neither

the budget constraint nor the budget set.
 Budget Constraints - Relative Prices
 The constraint for p1=2, p2=3, m=12
2x1 + 3x2 = 12
is also 1.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 relative to
p1;
e.g. 3/2 is the price of commodity 2 relative to the price of
commodity 1.
Budget Constraints - Relative Prices

 Any commodity can be chosen as

the numeraire without changing the
budget set or the budget constraint.
Budget Constraints - Relative Prices
p
1 =2, p2=3 and p3=6 
 price of commodity 2 relative to
commodity 1 is 3/2,
 price of commodity 3 relative to
commodity 1 is 3.
 Relative prices are the rates of
exchange of commodities 2 and 3 for
units of commodity 1.
 Shapes of Budget Constraints

 Q:What makes a budget constraint a straight

line?

 A:
A straight line has a constant slope and the
constraint is
p1x1 + … + pnxn = m

so if prices are constants then a constraint is a

straight line.
 Shapes of Budget Constraints

 But what if prices are not constants?

 E.g.
bulk buying discounts, or price
penalties for buying “too much”.

 Then constraints will be curved.

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.
 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 is
Shapes of Budget Constraints 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
 Shapes of Budget Constraints
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
Shapes of Budget Constraints with a
Quantity Discount
x2 m = $100
100

Budget Constraint

Budget Set
20 50 80 x1
Shapes of Budget Constraints with a
Quantity Penalty
x2

Budget
Constraint

Budget Set
x1