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Economists assume that consumers choose the
best bundle of goods they can afford.
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Q: When is a consumption bundle (x1, , xn)
affordable at prices p1, , pn?
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Q: When is a consumption bundle (x1, , xn)
affordable at prices p1, , pn?
{ (x1,,xn) | x1 0, , xn and
p1x1 + + pnxn = m }.
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The consumers budget set is the set of all
affordable bundles;
B(p1, , pn, m) =
{ (x1, , xn) | x1 0, , xn 0 and
p1x1 + + pnxn m }
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x2
Budget constraint is
m /p2
p1x1 + p2x2 = m.
m /p1 x1
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x2
Budget constraint is
m /p2
p1x1 + p2x2 = m.
m /p1 x1
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x2
Budget constraint is
m /p2
p1x1 + p2x2 = m.
Just affordable
m /p1 x1
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x2
Budget constraint is
m /p2
p1x1 + p2x2 = m.
Not affordable
Just affordable
m /p1 x1
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x2
Budget constraint is
m /p2
p1x1 + p2x2 = m.
Not affordable
Just affordable
Affordable
m /p1 x1
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x2
Budget constraint (budget line) is
m /p2
p1x1 + p2x2 = m.
the collection
of all affordable bundles.
Budget
Set
m /p1 x1
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x2
p1x1 + p2x2 = m is
m /p2
x2 = -(p1/p2)x1 + m/p2
so slope is -p1/p2.
Budget
Set
m /p1 x1
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For n = 2 and x1 on the horizontal axis, the
constraints slope is -p1/p2. What does it
mean?
p1 m
x2 = x1
p2 p2
Note: For a linear line: y=mx+c, m is the
slope of the line, while c is the y-intercept.
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For n = 2 and x1 on the horizontal axis, the
constraints slope is -p1/p2. What does it
mean?
p1 m
x2 = x1
p2 p2
To hold income m constant, increasing x1 by
1 must reduce x2 by p1/p2 .
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x2
Slope is -p1/p2
-p1/p2
+1
x1
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x2
Opp. cost of an extra unit of
commodity 1 is p1/p2 units
foregone of commodity 2.
-p1/p2
+1
x1
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x2
The opp. cost of an extra
unit of commodity 2 is
p2/p1 units foregone
of commodity 1.
+1
-p2/p1
x1
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The budget constraint and budget set depend
upon prices and income. What happens as
prices or income change?
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x2
Original
budget set
x1
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x2 New affordable consumption
choices
Original and
new budget
constraints are
parallel (same
Original slope).
budget set
x1
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x2
Original
budget set
x1
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x2
Consumption bundles
that are no longer
affordable.
Old and new
New, smaller constraints
budget set are parallel.
x1
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Increases in 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.
The slope p1 / p2 does not change.
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When income increases, NO original choice is
lost and new choices are added, so higher
income cannot make a consumer worse off.
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What happens if just one price decreases?
Suppose p1 decreases.
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x2
m/p2
-p1/p2
Original
budget set
m/p1 m/p1 x1
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x2
m/p2
New affordable choices
-p1/p2
Original
budget set
m/p1 m/p1 x1
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x2
m/p2
New affordable choices
Budget constraint
-p1/p2 pivots; slope flattens
from -p1/p2 to
Original -p1/p2
-p /p
1 2
budget set
m/p1 m/p1 x1
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Reducing the price of one commodity pivots
the constraint outward. No old choice is lost
and new choices are added, so reducing one
price cannot make the consumer worse off.
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Quantity/per-unit tax: price increases from p to
p+t.
Quantity/per-unit subsidy: price decreases from
p to p-s.
Ad valorem/value tax: price increases from p to
(1+t)p
Ad valorem/value subsidy: price decreases from
p to (1-s)p
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A uniform sales tax levied at rate t on all goods
changes the constraint from
p1x1 + p2x2 = m
to
(1+t)p1x1 + (1+t)p2x2 = m
i.e.
p1x1 + p2x2 = m/(1+t).
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x2
m
Equivalent income loss
p2
is
m m t
m = m
(1 t ) p2 1 t 1 t
m m x1
(1 t ) p1 p1
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x2 A uniform ad valorem
sales tax levied at rate t
m
is equivalent to an income
p2 tax levied at rate t
m .
1 t
(1 t ) p2
m m x1
(1 t ) p1 p1
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Lump-sum tax: government tax a fixed sum of
money, T, regardless of individuals behavior.
This is equivalent to a decrease in income by T,
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Food stamps are coupons that can be legally
exchanged only for food.
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Suppose m = $100, pF = $1 and the price of
other goods is pG = $1.
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G
F + G = 100: before stamps.
100
100 F
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G
F + G = 100: before stamps.
100 Budget set after $40 food
stamps issued.
40 100 140 F
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G
F + G = 100: before stamps.
100 Budget set after $40 food
stamps issued.
The familys budget
set is enlarged.
40 100 140 F
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How does the unit of account affect the budget
constraints and budget set?
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If prices and income are measured in cents,
then p1=200, p2=300, m=1200 and the
constraint is
200x1 + 300x2 = 1200,
upon simplification, it is the same as
2x1 + 3x2 = 12.
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The constraint for p1=2, p2=3, m=12
2x1 + 3x2 = 12
is also 1x1 + (3/2)x2 = 6,
the constraint for p1=1, p2=3/2, m=6.
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But what if prices are not constants?
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Suppose p2 is constant at $1 but that p1=$2 for
0 x1 20 and p1=$1 for x1>20.
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Suppose p2 is constant at $1 but that p1=$2 for
0 x1 20 and p1=$1 for x1>20.
Then the constraints slope is
- 2, for 0 x1 20
{
-p1/p2 =
- 1, for x1 > 20
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x2 m = $100
100 Slope = - 2 / 1 = - 2
(p1=2, p2=1)
Slope = - 1/ 1 = - 1
(p1=1, p2=1)
20 50
80 x1
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x2 m = $100
100 Slope = - 2 / 1 = - 2
(p1=2, p2=1)
Slope = - 1/ 1 = - 1
(p1=1, p2=1)
20 50
80 x1
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x2 m = $100
100
Budget Constraint
Budget Set
20 50
80 x1
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x2
Budget
Constraint
Budget Set
x1
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The budget set describes what consumption
bundles are affordable to the consumers.
The budget constraint is typically described by
p1 x1 + p2 x2 = m, which is a straight line when
prices are constant.
When income increases, budget set shifts
outward, enlarging the budget set.
When prices increases, the slope of budget line
changes, and the it shrinks the budget set.
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The next chapter will introduce preference,
which describes the ordering of what a
consumer likes among the consumption
bundles.
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