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CHAPTER 2 CHAPTER 2

BUDGET CONSTRAI NT
Consumpt i on Choi c e Set s
A consumption choice set is the collection A consumption choice set is the collection
of all consumption choices available to the
consumer.
What constrains consumption choice?
Budgetary, time and other resource g y,
limitations.
The budget c onst r ai nt
The basic concept is really straightforward: The basic concept is really straightforward:
The consumer has a limited income (m) to The consumer has a limited income (m) to
purchase different goods
Each type of good has a defined price (p) per yp g p (p) p
unit
We assume that the consumer does not save
d d ll hi i and spends all his income
This possibility will be examined later
Budget Const r ai nt s
A consumption bundle containing x
1
units A consumption bundle containing x
1
units
of commodity 1, x
2
units of commodity 2
and so on up to x
n
units of commodity n is p
n
y
denoted by the vector (x
1
, x
2
, , x
n
).
Commodity prices are p
1
, p
2
, , p
n
. y p p
1
, p
2
, , p
n
The budget c onst r ai nt
The general budget constraint for n goods The general budget constraint for n goods
is:
n
I p x =

m
If we only look at 2 goods it can be
i i
i 1
I p x
=
=

m
If we only look at 2 goods, it can be
expressed as:
1 1 2 2
I p x p x = +
m
The budget c onst r ai nt
Imagine the following student Imagine the following student
entertainment budget
You have 50 PhP
The price of a meal is 10 PhP
The price of a cinema ticket is 5 PhP
Your budget constraint is:
50 5 tickets 10 meals = +
1 1 2 2
I p x p x = + m
The budget c onst r ai nt
Di i ti
Meals
max
max
I
x =
Maximum amount of
Diagram in consumption space
m
max
meal
x meal
meal
x
p
=
Maximum amount of
meals you can buy
Cinema
The budget c onst r ai nt
Meals
max

max
I
x =
Maximum amount of
i ti k t
max
meal
x
m
cin.
cin.
x
p
=
cinema tickets you
can buy

max
cin.
x
Cinema
The budget c onst r ai nt
Meals
max

max
meal
x
Budget constraint

max
cin.
x
Cinema
The budget c onst r ai nt
1 1 2 2
I p x p x = + The budget constraint is m
Meals
max
1 1 2 2
p p
p I
g
Dividing by p
1
and rearranging:
m

max
meal
x
2
1 2
1 1
p I
x x
p p
=
intercept
m
i
p I
slope
m

cin.
meal cin.
meal meal
p I
x x
p p
=
m
max
cin.
x
Cinema
Budget Const r ai nt s
Q: When is a consumption bundle Q: When is a consumption bundle
(x
1
, , x
n
) affordable at given prices p
1
, ,
p
n
? p
n
Budget Const r ai nt s
Q: When is a bundle (x
1
, , x ) affordable Q: When is a bundle (x
1
, , x
n
) affordable
at prices p
1
, , p
n
?
A: When A: When
p
1
x
1
+ + p
n
x
n
s m
where m is the consumers (disposable) ( p )
income.
Budget Const r ai nt s
The bundles that are only just affordable The bundles that are only just affordable
form the consumers budget constraint.
This is the set This is the set
{ (x
1
,,x
n
) | x
1
> 0, , x
n
> 0 and { (
1
, ,
n
) |
1
, ,
n
p
1
x
1
+ + p
n
x
n
= m }.
Budget set
The consumers budget set is the set of all The consumer s budget set is the set of all
affordable bundles;
B(p
1
, , p
n
, m) = (p
1
, , p
n
, )
{ (x
1
, , x
n
) | x
1
> 0, , x
n
> 0 and
p
1
x
1
+ + p
n
x
n
s m }
The budget constraint is the upper
boundary of the budget set.
Budget Set and Const r ai nt f or
Two Commodi t i es Two Commodi t i es
x
2
B d t t i t i Budget constraint is
p
1
x
1
+ p
2
x
2
= m.
m /p
2
x
1
m /p
1
Budget Set and Const r ai nt f or
Two Commodi t i es Two Commodi t i es
x
2
B d t t i t i Budget constraint is
p
1
x
1
+ p
2
x
2
= m.
m /p
2
x
1
m /p
1
Budget Set and Const r ai nt f or
Two Commodi t i es Two Commodi t i es
x
2
B d t t i t i Budget constraint is
p
1
x
1
+ p
2
x
2
= m.
m /p
2
Just affordable
x
1
m /p
1
Budget Set and Const r ai nt f or
Two Commodi t i es Two Commodi t i es
x
2
B d t t i t i Budget constraint is
p
1
x
1
+ p
2
x
2
= m.
m /p
2
Just affordable
Not affordable
x
1
m /p
1
Budget Set and Const r ai nt f or
Two Commodi t i es Two Commodi t i es
x
2
B d t t i t i Budget constraint is
p
1
x
1
+ p
2
x
2
= m.
m /p
2
Just affordable
Not affordable
Affordable
x
1
m /p
1
Budget Set and Const r ai nt f or
Two Commodi t i es Two Commodi t i es
x
2
B d t t i t i Budget constraint is
p
1
x
1
+ p
2
x
2
= m.
m /p
2
the collection
f ll ff d bl b dl
Budget
S t
of all affordable bundles.
x
1
m /p
1
Set
Budget Set and Const r ai nt f or
Two Commodi t i es Two Commodi t i es
x
2
i p
1
x
1
+ p
2
x
2
= m is
x
2
= -(p
1
/p
2
)x
1
+ m/p
2
l i /
m /p
2
so slope is -p
1
/p
2
.
Budget
S t
x
1
m /p
1
Set
Budget Const r ai nt s
If n = 3 what do the budget constraint and If n 3 what do the budget constraint and
the budget set look like?
Budget Const r ai nt f or Thr ee
Commodi t i es Commodi t i es
x
2
x
2
m /p
2
p
1
x
1
+ p
2
x
2
+ p
3
x
3
= m
m /p
3
x
3
x
1
m /p
1
Budget Set f or Thr ee
Commodi t i es Commodi t i es
x
2
{ (x x x ) | x > 0 x > 0 x > 0 and
x
2
m /p
2
{ (x
1
,x
2
,x
3
) | x
1
> 0, x
2
> 0, x
3
> 0 and
p
1
x
1
+ p
2
x
2
+ p
3
x
3
s m}
m /p
3
x
3
x
1
m /p
1
Budget Const r ai nt s
For n = 2 and x
1
on the horizontal axis, For n 2 and x
1
on the horizontal axis,
the constraints slope is -p
1
/p
2
. What
does it mean?
2
1
2
1
2
p
m
x
p
p
x + =
Budget Const r ai nt s
For n = 2 and x
1
on the horizontal axis,
the constraints slope is -p
1
/p
2
. What
does it mean? does it mean?
1
1
2
p
m
x
p
p
x + =
Increasing x
1
by 1 must reduce x
2
by
2 2
p p
Increasing x
1
by 1 must reduce x
2
by
p
1
/p
2.
Budget Const r ai nt s
x
2
Slope is -p
1
/p
2
Slope is p
1
/p
2
-p
1
/p
2
+1
x
1
Budget Const r ai nt s
x
2
Opp. cost of an extra unit of
commodity 1 is p
1
/p
2
units
foregone of commodity 2.
-p
1
/p
2
+1
x
1
Budget Const r ai nt s
x
2
Opp. cost of an extra unit of
commodity 1 is p
1
/p
2
units
foregone of commodity 2. And
the opp cost of an extra the opp. cost of an extra
unit of commodity 2 is
p
2
/p
1
units foregone
+1
p
2
/p
1
units foregone
of commodity 1.
-p
2
/p
1
x
1
Budget Set s & Const r ai nt s;
I nc ome and Pr i c e Changes I nc ome and Pr i c e Changes
The budget constraint and budget set The budget constraint and budget set
depend upon prices and income. What
happens as prices or income change? pp p g
How do t he budget set and budget
c onst r ai nt change as i nc ome m
i ? i nc r eases?
x
2
Original
b d t t budget set
x
1
Hi gher i nc ome gi ves mor e
c hoi c e c hoi c e
New affordable consumption
x
2
choices
Original and
new budget new budget
constraints are
parallel (same
Original
b d t t
parallel (same
slope).
budget set
x
1
How do t he budget set and budget
c onst r ai nt change as i nc ome m
d ? dec r eases?
x
2
Original
b d t t budget set
x
1
How do t he budget set and budget
c onst r ai nt change as i nc ome m
dec r eases?
x
2
Consumption bundles
that are no longer
affordable.
Old and new
New, smaller
b d t t
Old and new
constraints
are parallel
x
1
budget set
are parallel.
Budget Const r ai nt s - I nc ome
Changes Changes
I i i hift th Increases in income m shift the
constraint outward in a parallel manner,
thereby enlarging the budget set and thereby enlarging the budget set and
improving choice.
Budget Const r ai nt s - I nc ome
Changes Changes
I i i hift th Increases in income m shift the
constraint outward in a parallel manner,
thereby enlarging the budget set and thereby enlarging the budget set and
improving choice.
Decreases in income m shift the Decreases in income m shift the
constraint inward in a parallel manner,
thereby shrinking the budget set and thereby shrinking the budget set and
reducing choice.
Budget Const r ai nt s - I nc ome
Changes Changes
No original choice is lost and new choices No original choice is lost and new choices
are added when income increases, so
higher income cannot make a consumer g
worse off.
An income decrease may (typically will) y ( yp y )
make the consumer worse off.
Budget Const r ai nt s - Pr i c e
Changes Changes
What happens if just one price decreases? What happens if just one price decreases?
Suppose p
1
decreases.
How do t he budget set and budget
c onst r ai nt change as p dec r eases c onst r ai nt change as p
1
dec r eases
f r om p
1
t o p
1
?
x
2
m/p
2
-p
1
/p
2
Original
b d t t budget set
x
1
m/p
1
m/p
1

How do t he budget set and budget


c onst r ai nt change as p dec r eases c onst r ai nt change as p
1
dec r eases
f r om p
1
t o p
1
?
x
2
m/p
2
New affordable choices
-p
1
/p
2
Original
b d t t budget set
x
1
m/p
1
m/p
1

How do t he budget set and budget


c onst r ai nt change as p dec r eases c onst r ai nt change as p
1
dec r eases
f r om p
1
t o p
1
?
x
2
m/p
2
New affordable choices
Budget constraint
pivots; slope flattens
f /
-p
1
/p
2
Original
b d t t
from -p
1
/p
2
to
-p
1
/p
2
-p
1
/p
2
budget set
x
1
m/p
1
m/p
1

p
1
p
2
Budget Const r ai nt s - Pr i c e
Changes Changes
Reducing the price of one commodity 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.
Budget Const r ai nt s - Pr i c e
Changes Changes
Similarly, increasing one price pivots the Similarly, increasing one price pivots the
constraint inwards, reduces choice and
may (typically will) make the consumer y ( yp y )
worse off.
Uni f or m Ad Val or em Sal es
TTax es
An ad valorem sales tax levied at a rate of An ad valorem sales tax levied at a rate of
5% increases all prices by 5%, from p to
(1+005)p = 105p. ( )p p
An ad valorem sales tax levied at a rate of t
increases all prices by t, from p to (1+t)p. p y , p ( )p
A uniform sales tax is applied uniformly to A uniform sales tax is applied uniformly to
all commodities.
Uni f or m Ad Val or em Sal es
Tax es Tax es
A uniform sales tax levied at rate t A uniform sales tax levied at rate t
changes the constraint from
p
1
x
1
+ p
2
x
2
= m p
1 1
p
2 2
to
(1+t)p
1
x
1
+ (1+t)p
2
x
2
= m
Uni f or m Ad Val or em Sal es
Tax es Tax es
A uniform sales tax levied at rate t A uniform sales tax levied at rate t
changes the constraint from
p
1
x
1
+ p
2
x
2
= m p
1 1
p
2 2
to
(1+t)p
1
x
1
+ (1+t)p
2
x
2
= m
i.e.
p
1
x
1
+ p
2
x
2
= m/(1+t).
Uni f or m Ad Val or em Sal es Tax es
x
2
m
p
2
p
1
x
1
+ p
2
x
2
= m
x
m
x
1
p
1
Uni f or m Ad Val or em Sal es Tax es
x
2
m
p
2
p
1
x
1
+ p
2
x
2
= m
/( ) p
1
x
1
+ p
2
x
2
= m/(1+t) m
t p ( ) 1
2
+
x
m m
x
1
p
1
t p ( ) 1
1
+
Uni f or m Ad Val or em Sal es Tax es
x
2
m
p
2
Equivalent income loss
is
m
t p ( ) 1
2
+
is
m
m
t
t
t
m
+
=
+ 1 1
x
m m
x
1
t p ( ) 1
1
+ p
1
Uni f or m Ad Val or em Sal es Tax es
x
2 A uniform ad valorem
sales tax levied at rate t
m
p
2
sales tax levied at rate t
is equivalent to an income
tax levied at rate
t
m
t p ( ) 1
2
+
tax levied at rate
t 1+
.
x
m m
x
1
t p ( ) 1
1
+ p
1
Rel at i ve Pr i c es
Numeraire means unit of account. Numeraire means unit of account .
Suppose prices and income are measured
in dollars. Say p
1
=$2, p
2
=$3, m = $12. Then in dollars. Say p
1
$2, p
2
$3, m $12. Then
the constraint is
2x
1
+ 3x
2
= 12.
1 2
Rel at i ve Pr i c es
If prices and income are measured in cents, If prices and income are measured in cents,
then p
1
=200, p
2
=300, m=1200 and the
constraint is
200x
1
+ 300x
2
= 1200,
the same as
2x
1
+ 3x
2
= 12.
Changing the numeraire changes neither the
budget constraint nor the budget set.
Rel at i ve Pr i c es
The constraint for p
1
=2, p
2
=3, m=12
2x
1
+ 3x
2
= 12
is also 1x
1
+ (3/2)x
2
= 6.
The constraint for p
1
=1, p
2
=3/2, m=6. Setting p
1
=1
k dit 1 th i d d fi ll makes commodity 1 the numeraire and defines all
prices relative to p
1
; e.g. 3/2 is the price of commodity
f 2 relative to the price of commodity 1.
Rel at i ve Pr i c es
Any commodity can be chosen as the Any commodity can be chosen as the
numeraire without changing the budget set
or the budget constraint. g
Rel at i ve Pr i c es
p
1
=2, p
2
=3 and p
3
=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 Const r ai nt s
Q: What makes a budget constraint a Q: What makes a budget constraint a
straight line?
A: A straight line has a constant slope and A: A straight line has a constant slope and
the constraint is
p
1
x
1
+ + p
n
x
n
= m p
1 1
p
n n
so if prices are constants then a constraint
is a straight line.
Shapes of Budget Const r ai nt s
But what if prices are not constants? But what if prices are not constants?
E.g. bulk buying discounts, or price
penalties for buying too much. penalties for buying too much .
Then constraints will be curved.
Quant i t y Di sc ount s
Suppose p
2
is constant at $1 but that p
1
=$2 Suppose p
2
is constant at $1 but that p
1
$2
for 0 s x
1
s 20 and p
1
=$1 for x
1
>20.
Quant i t y Di sc ount s
Suppose p
2
is constant at $1 but that p
1
=$2 Suppose p
2
is constant at $1 but that p
1
$2
for 0 s x
1
s 20 and p
1
=$1 for x
1
>20. Then
the constraints slope is p
- 2, for 0 s x
1
s 20
-p
1
/p
2
=
{
- 1, for x
1
> 20
and the constraint is
{
Shapes of Budget Const r ai nt s
w i t h a Quant i t y Di sc ount w i t h a Quant i t y Di sc ount
m = $100
x
2
100
Slope = - 2 / 1 = - 2
(p
1
=2, p
2
=1)
Slope = - 1/ 1 = - 1 Slope 1/ 1 1
(p
1
=1, p
2
=1)
50 20
80
x
1
Shapes of Budget Const r ai nt s
w i t h a Quant i t y Di sc ount w i t h a Quant i t y Di sc ount
m = $100
x
2
100
Slope = - 2 / 1 = - 2
(p
1
=2, p
2
=1)
Slope = - 1/ 1 = - 1 Slope 1/ 1 1
(p
1
=1, p
2
=1)
50 20
80
x
1
Shapes of Budget Const r ai nt s
w i t h a Quant i t y Di sc ount w i t h a Quant i t y Di sc ount
m = $100
x
2
100
C Budget Constraint
Budget Set
50 20
80
x
1
Budget Set
Shapes of Budget Const r ai nt s
w i t h a Quant i t y Penal t y w i t h a Quant i t y Penal t y
x
2
Budget
Constraint Constraint
Budget Set
x
1
Budget Set
I n-cl ass exer c i se
You have an income of $40 to spend on two commodities. Commodity 1 costs $10
per unit and commodity 2 costs $5 per unit per unit, and commodity 2 costs $5 per unit.
(a) Write down your budget equation.
(b) If you spent all your income on commodity 1, how much could you
buy?
(c) If you spent all of your income on commodity 2, how much could you
buy?
Draw your budget line.
(d) Suppose that the price of commodity 1 falls to $5 while everything else (d) Suppose that the price of commodity 1 falls to $5 while everything else
stays the same. Write down your new budget equation. Draw your new
budget line.
(e) Suppose that the amount you are allowed to spend falls to $30, while
the prices of both commodities remain at $5 Write down your budget the prices of both commodities remain at $5. Write down your budget
equation. Draw this new budget line.
(f) On your diagram, use blue ink to shade in the area representing
commodity bundles that you can afford with the budget in Part (e) but
could not afford to buy with the budget in Part (a) Use black ink or could not afford to buy with the budget in Part (a). Use black ink or
pencil to shade in the area representing commodity bundles that you
could afford with the budget in Part (a) but cannot afford with the
budget in Part (e).
N t f Nex t pr ef er enc es