CHAPTER 1: BUDGET

CONSTRAINT

LECTURER: PHD. TRAN AN QUAN

MAIN CONTENT

1/ Budget constraint
2/ Budget constraint line
3/ Changes of budget constraint line
4/ Numeraire
5/ Consumer preferences
6/ Assumption about preferences
MAIN CONTENT

7/ Indifference curve
8/ Cases of indifference curve
9/ Marginal rate of substitution
 BUDGET CONSTRAINT

• We will indicate the consumer’s consumption bundle by (x1, x2).

This simplifies a basket that tells us how much the consumer is
choosing to consume of good 1, x1, and how much the consumer is
choosing to consume of good 2, x2.
 BUDGET CONSTRAINT
We suppose that we can observe the prices of the two goods, (p 1, p2), and the
amount of money the consumer has to spend, m. Then the budget constraint of
the consumer can be written:
p1x1 + p2x2 ≤ m.
• p1x1 is the amount of money the consumer is spending on good 1
• p2x2 is the amount of money the consumer is spending on good 2.
The budget constraint of the consumer requires that the amount of money spent
on the two goods no more than the total amount the consumer has to spend.
 BUDGET CONSTRAINT LINE
• The budget line is the set of
bundles that cost exactly m
• In Figure1, The heavy line
called the budget line. It
includes the bundles that
cost exactly m and the
bundles below this line are
those that cost less than m
 BUDGET CONSTRAINT LINE

• We can rearrange the budget line equation:

• This is the formula for a straight line with a vertical intercept of m/p 2 and a
slope of −p1/p2. The formula tells us how many units of good 2 the consumer
needs to consume in order to just satisfy the budget constraint if he is
consuming x1 units of good 1
 BUDGET CONTRAINT LINE

• The slope of the budget line measure the rate at which the market is willing
to “substitute” good 1 for good 2.
• Solving for Δx2 /Δx1, the rate at which good 2 can be substituted for good 1
while still satisfying the budget constraint, gives Δx2 /Δx1 = −p1/p2 .
• This is just the slope of the budget line. The negative sign is there since Δx2
and Δx1 must always have opposite signs. If you consume more of good 1,
you have to consume less of good 2 and vice versa
 BUDGET CONTRAINT LINE

• The slope of the budget line also measures the opportunity cost of
consuming good 1. In order to consume more of good 1 you have
to give up some consumption of good 2.
 CHANGES OF BUDGET CONTRAINT LINE

• An increase in income will result

in a parallel shift outward of the
budget line. Similarly, a decrease
in income will cause a parallel
shift inward
• An increase in income will
increase the vertical intercept and
not affect the slope of the line
CHANGES OF BUDGET CONTRAINT LINE

• Increasing p1 will not change the

vertical intercept, but it will make
the budget line steeper since
p1/p2 will become larger
• If good 1 becomes more
expensive, the budget line
becomes steeper and vice versa
 THE NUMERAIRE
• The budget line is defined by two prices and one income, but one of these
variables is redundant. We could peg one of the prices, or the income, to
some fixed value, and adjust the other variables so as to describe exactly the
same budget set
p1x1 + p2x2 = m
• We can transform the budget equation into other type
or
 THE NUMERAIRE

• In the first case, we have pegged p2 = 1, and in the second case m = 1.

Pegging the price of one of the goods or income to 1 and adjusting the
other price and income appropriately doesn’t change the budget set.
• When we set one of the prices to 1, we refer to that price as the
numeraire price. The numeraire price is the price relative to which we
are measuring the other price and income.
 CONSUMER PREFERENCES
• We will suppose that given any two consumption bundles, (x1, x2) and (y1, y2),
the consumer can rank them as to their desirability. That is, the consumer can
determine that one of the consumption bundles is strictly better than the other,
or decide that she is indifferent between the two bundles
• We will use the symbol to mean that one bundle is strictly preferred to
another, so that (x1, x2) (y1, y2) should be interpreted as saying that the
consumer strictly prefers (x1, x2) to (y1, y2), in the sense that he definitely
wants the x-bundle rather than the y-bundle.
 CONSUMER PREFERENCES

• If the consumer is indifferent between two bundles of goods, we use the

symbol ∼ and write (x1, x2) ∼ (y1, y2). Indifference means that the consumer
would be just as satisfied, according to her own preferences, consuming the
bundle (x1, x2) as he would be consuming the other bundle, (y1, y2)
• If the consumer prefers or is indifferent between the two bundles we say that
he weakly prefers (x1, x2) to (y1, y2) and write (x1, x2) (y1, y2)
 ASSUMPTIONS ABOUT PREFERENCES
Three axioms about consumer preference:
• Complete: We assume that any two bundles can be compared. That is, given
any x-bundle and any y-bundle, we assume that (x 1, x2) (y1, y2), or (y1, y2) (x1,
x2), or both, in which case the consumer is indifferent between the two bundles.
• Reflexive: We assume that any bundle is at least as good as itself: (x 1, x2) (x1,
x2).
• Transitive: If (x1, x2)(y1, y2) and (y1, y2) (z1, z2), then we assume that (x1, x2)
(z1, z2). In other words, if the consumer thinks that X is at least as good as Y
and that Y is at least as good as Z, then the consumer thinks that X is at least
as good as Z
 INDIFFERENCE CURVE
• Indifference curve: Curve representing all combinations of market baskets
that provide a consumer with the same level of satisfaction.
• Indifference map: Graph containing a set of indifference curves showing the
market baskets among which a consumer is indifferent.
• Pick a certain consumption bundle (x1, x2) and shade in all of the
consumption bundles that are weakly preferred to (x1, x2). This is called the
weakly preferred set.
 INDIFFERENCE CURVE

• The shaded area consists of

all bundles that are at least as
good as the bundle (x1, x2).
 INDIFFERENCE CURVE

• Indifference curves cannot cross.

If they did, X, Y , and Z would all
have to be indifferent to each
other and thus could not lie on
distinct indifference curves
 CASES OF INDIFFERENCE CURVE
• Two goods are perfect substitutes if the consumer is willing to substitute one
good for the other at a constant rate. The simplest case of perfect substitutes
occurs when the consumer is willing to substitute the goods on a one-to-one
basis.
• For example, that we are considering a choice between red pencils and blue
pencils, and the consumer involved likes pencils, but doesn’t care about
color at all. Pick a consumption bundle, say (10, 10). Then for this
consumer, any other consumption bundle that has total 20 pencils is just as
good as (10, 10).
 CASES OF INDIFFERENCE CURVE

• Perfect substitutes: The

consumer only cares about the
total number of goods, not
about their features. Thus the
indifference curves are straight
lines with a slope of −1
 CASES OF INDIFFERENCE CURVE

• Perfect complements are goods that are always consumed together in fixed
proportions. In some sense, the goods “complement” each other. A nice
example is that of right shoes and left shoes. The consumer likes shoes, but
always wears right and left shoes together. Having only one out of a pair of
shoes doesn’t do the consumer a bit of good
 CASES OF INDIFFERENCE CURVE

• Perfect complements: The

consumer always wants to
consume the goods in fixed
proportions to each other. Thus
the indifference curves are L-
shaped
 CASES OF INDIFFERENCE CURVE

• A bad is a commodity that the consumer

doesn’t like. For example, suppose that
the commodities in question are now
pepperoni and anchovies— and the
consumer loves pepperoni but dislikes
anchovies. Here anchovies are a “bad,”
and pepperoni is a “good” for this
consumer. Thus the indifference curves
have a positive slope
 CASES OF INDIFFERENCE CURVE

• A good is a neutral good if the

consumer doesn’t care about it
one way or the other.
• For example, the consumer likes
pepperoni but is neutral about
anchovies, so the indifference
curves are vertical lines.
 CASES OF INDIFFERENCE CURVE

• Consider a situation involving satiation, where there is some overall best

bundle for the consumer, and the “closer” he is to that best bundle, the better
off he is in terms of his own preferences
• For example, suppose that the consumer has some most preferred bundle of
goods (x1, x2), and the farther away he is from that bundle, the worse off he
is. In this case we say that (x1, x2) is a satiation point, or a bliss point.
 CASES OF INDIFFERENCE CURVE

• The bundle (x1, x2) is the

satiation point or bliss point, and
the indifference curves surround
this point
 CASES OF INDIFFERENCE CURVE

• A discrete good: Panel A, good 1 is

only available in integer amounts.
The dashed lines connect together
the bundles that are indifferent
• Panel B, the vertical lines represent
bundles that are at least as good as
the indicated bundle
 CASES OF INDIFFERENCE CURVE

• We assume that more is better, if (x1, x2) is a bundle of goods and

(y1, y2) is a bundle of goods with at least as much of both goods
and more of one, then (y1, y2) ≻ (x1, x2). This assumption is
sometimes called monotonicity of preferences.
 CASES OF INDIFFERENCE CURVE

• Monotonic preferences: More of

both goods is a better bundle for
this consumer; less of both goods
represents a worse bundle
CASES OF INDIFFERENCE CURVE

Convexity of indifference curve

 MARGINAL RATE OF SUBSTITUTION
• The slope of an indifference curve is known as the marginal rate of substitution (MRS).
MRS measures the rate at which the consumer is just willing to substitute one good for
the other.
• We take a little of good 1, Δx1, away from the consumer. Then we give him Δx2, an
amount that is just sufficient to put him back on his indifference curve, so that he is just
as well off after this substitution of x2 for x1 as he was before. Δx2/Δx1: the rate at which
the consumer is willing to substitute good 2 for good 1.
• Δx1 as being a very small change, then the rate Δx2/Δx1 measures the marginal rate of
substitution of good 2 for good 1. As Δx1 gets smaller, Δx2/Δx1 approaches the slope of
the indifference curve.
 MARGINAL RATE OF SUBSTITUTION

• The marginal rate of

substitution measures the slope
of the indifference curve
 MARGINAL RATE OF SUBSTITUTION

Exchange rate:
• Exchange good 1 for 2, or good 2 for 1,
in any amount at a “rate of exchange” of
E. That is, if the consumer gives up Δx1
units of good 1, he can get E Δx1 units
of good 2 in exchange. Or, conversely, if
he gives up Δx2 units of good 2, he can
get Δx2/E units of good 1.
 MARGINAL RATE OF SUBSTITUTION

• Geometrically, consumer has opportunity to move to any point along a line

with slope “−E” that passes through (x1, x2)
• At any other rate of exchange, the exchange line would cut the indifference
curve and thus allow the consumer to move to a more preferred point
• At any rate of exchange other than the MRS, the consumer would want to
trade one good for the other.