Chapter 2 BUDGET CONSTRAINT

2.1 The Budget Constraint

Consumers choose the BEST bundle of goods they can AFFORD.

Budget set: affordability Consumption bundle: (x1, x2)

2.1 The Budget Constraint

The budget constraint

p1x1+p2x2≤m

p1x1 : the amount of money the consumer is spending on good 1.

p2x2: the amount of money the consumer is spending on good 2.

m: the consumer’s income

2.2 Two Goods Are Often Enough

Composite goodgood 2 represents a composite good that stands for everything else that the consumer might want to consume other than good 1.

The budget constraint will take the form:

p1x1+x2≤m

2.3 Properties of the Budget Set

p1x1+ p2x2 = m

p1(x1+Δx1) + p2(x2+Δx2) = m

Subtracting the first equation from the second:

p1Δx1 + p2Δx2 = 0

Δx2/Δx1=-p1/p2

2.3 Properties of the Budget Set

Opportunity cost of consuming good 1 the slope of the

budget line. In order to consume

more of good 1 one has to give up some consumption of good 2.

2.4 How the Budget Line Changes

Changes in income:a parallel shift of the

budget line.

2.4 How the Budget Line Changes

Changes in prices: increasing price 1 while holding price 2 and income fixed.

2.4 How the Budget Line Changes

Change the price of good 1 and good 2 at the same time:

Multiplying both prices by t yields

tp1x1+tp2x2 = m

p1x1+p2x2 = m/t

2.5 The Numeraire

The budget line

p1x1+ p2x2 = m

is exactly the same budget line as

p1/p2x1+ x2 = m/p2

or

p1/mx1+ p2/mx2 = 1

2.6 Taxes, Subsidies, and Rationing

Quantity tax t dollars per unit of good 1,changes the price of good 1 from p1 to p1+t.

Quantity subsidys dollars per unit of good 1, the price of good 1 would be p1-s.

2.6 Taxes, Subsidies, and Rationing Value tax

a sales tax at rate t, the actual price is (1+t)p1.

Ad valorem subsidyan ad valorem subsidy at rate s, the actual price is (1-s)p1.

2.6 Taxes, Subsidies, and Rationing

Lump-sum taxthe budget line shifts inward.

Lump-sum subsidythe budget line will shift outward.

2.6 Taxes, Subsidies, and Rationing

RationingGood 1 rationed.

2.6 Taxes, Subsidies, and Rationing

Sometimes taxes, subsidies, and rationing are combined.