1) Choice and Constraints on Choice

Budget set Feasible

Consumption Choice Sets
Collection of all consumption choices available to the consumer
Constraints consumption choice
o Budgetary, time and other resource limitations
Budget Constraints
Consumption bundle:
o x1 units of commodity 1
o x2 units of commodity 2
o xn units of commodity n

denoted by vector (x1, ... , xn)

commodity prices p1,p2 pn
when is a consumption bundle (x1, ... , xn) affordable at prices p1,,pn?
o when dont cost any more than m
p1x1 + + pnxn < m
m consumers disposable income
budget constraint: (budget line)

the bundles that are just affordable budget

constraint
o bundles ON the constraint

consumers budget set is set of all affordable bundles

o budget constraint is upper boundary of the budget set

composite good: everything else consumer might want to consume other than
good 1

Budget Set and Constraint for Two Goods

budget line slope = -p1/p2

 change in x2/change in x1 = -p1/p2

budget line measure opportunity cost of consuming good 1
Budget Constraints

Budget Constraint for Three Commodities

Three Commodities

Budget Sets & constraints; Income and Price Changes

budget constraint and set depends on prices and income
when one changes
Budget set change: Income m increases
gives more choice

Budget Set for

Budget
decreases

set

change: Income m

Budget Constraints - Income Changes

Increases in income m
o shift constraint outward in parallel enlarging budget set improving
choice
o original choice isnt lost, new choices added
o cant make consumer worse off
decreases in income m
o shift constraint inward in parallel shrinking budget set reducing choice
o may make consumer worse
off
Budget Constraints Price Changes
if just one price decreases? From P1 to

reducing price of one commodity pivots the constraint outward

o cant make consumer worse off
increasing one also pivots inward make consumers worse off

Uniform Ad Valorem Sales Taxes

Ad valorem sales tax levied at a rate of 5% p (1 + 0.05)p = 1.05p
Levied at a rate of t increases all prices by tp from p (1 + t)p

P1

Uniform sales tax: applied uniformly to all commodities

o Levied at rate t changes constraint

Subsidy
quantity subsidy govt gives an amount to consumer that depends on that
amount of good purchased
o if consumption of milk subsidized govt pay some amount to each milk
consumer depending on amount purchased (p1 s)
o budget line = flatter
ad valorem subsidy price of good one with ad valorem subsidy = v
o (1 v) p1
Lump Sum
lump sum tax govt takes away some fixed amount of money
budget line = shift inward (income reduced)
lump sum subsidy budget line = shift outward
Rationing
level of consumption is fixed to be no larger than some amount
The

Food Stamp Program

taxes, subsidies and rationing combined
coupons that can be legally exchanged only for food
how does it alter a familys budget constraint?

o
o
o
o

M = $100
Pf = $1
Price of other goods Pg = $1
Budget constraint F + G = 100

What if food stamps can be traded on black market for $.50 each?

Budget Constraint Relative Price

Numeraire = unit of account
Rearrange budget line :

o
OR
o first case p2 =1
m =1
doesnt change budget set at all
o when we set one of the prices to 1 numeraire price
price relative to which we are measuring other price and income
prices and income measured in dollars
o p1 = $2, p2 = $3, m = $12
o constraint 2x1 + 3x2 = 12
prices and incomes measured in cents
o p1 = 200, p2 = 300, m = 1200
o constraint 200x1 + 300x2 = 1200 (same as $)
changing numeraire changes nothing
constraint 2x1 + 3x2 = 12
o 1*x1 + (3/2)x2 = 6
o constraint for p1 = 1, p2 = 3/2, m = 6
o p1 = 1 makes Commodity 1 the numeraire and defines all prices relative to
p1;
3/2 is price of commodity 2 relative to price of commodity 1
any commodity can be chosen as numeraire without changing the budget
set/constraint

p1 =
o
o
o

2, p2 = 3 & p3 = 6
price of commodity 2 relative to 1 is 3/2
price of commodity 3 relative to 1 is 3
relative prices are the rates of exchange of commodities 2 and 3 for units
of commodity 1

Shapes of Budget Constraints

what makes a budget constraint a straight line?
o A straight line constant slope and constraint:

o If prices are constant constraint is a STRAIGHT line

If prices not constants?
o (bulk buying discounts, price penalities)
o constraint CURVED

Quantity Discounts
p2 constant at $1
p1 = $2 for 0 < x1 < 20
p1 = $1 for x1 > 20
constraints slope is
o
o constraint

Quantity
Penalty

Application
x1 is consumption ($) NOW, x2 is consumption in FUTURE
consumer has income $m1 NOW, $m2 in FUTURE
can lend at interest rate rL but must pay rH (>rL) to borrow
intertemporal (over time) budget
One price Negative
commodity 1= stinky garbage paid $2 per unit to accept it

income outside of collecting garbage is m = $10

o constraint
o -2x1 + x2 = 10
10

OR

More General Choice Sets

choices constrained by more than a budget
o time constraints and other resource constraint
bundle only available if it meets every constraint

choice set is the intersection of all the constraint sets

x2 = 2x1 +