Ch. 2
Budget constraint describes what a consumer can afford
The Budget Constraint
Recall
How is the budget constraint
written?
Then the budget constraint of the
consumer is: p1 x1 + p2 x2 ≤ m
What is the budget set?
This set of affordable consumption
at prices (p1 , p2 ) and income m
the budget set of the consumer
Notes
Consumption bundle: (x1 , x2 ). This is
a list of two numbers that tells 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 .
We suppose that the the prices of the
two goods, (p1 , p2 ), and the amount
of money the consumer has to spend,
m.
The consumer's affordable
consumption bundles are those that
don't cost anymore than m
📌
SUMMARY: The budget set consists of all bundles of goods that the
consumer can afford at given prices and income.
Two Goods Are Often Enough
Recall
What is the budget constraint with
this idea?
Ch. 2
Notes
The two-good assumption
encompasses a lot because one of the
1
With this idea the budget
constraint looks like this: p1 x1 +
goods can represent everything else
the consumer might want
x2 ≤ m
Example: in studying a consumer's
demand for milk, we might let x1
What does good 2 represent when
written like this?
When written like this good 2
represents a composite good: that
stands for everything else that the
consumer might want to consume
other than good 1.
measure his or her consumption of
milk in quarts per month. And let
x2
stand for everything else the
consumer might want to consume —
when we adopt this interpretation it is
convenient to
Under this interpretation the price
of good 2 will automatically be 1,
since the price of one dollar is one
dollar
📌
SUMMARYWe will typically assume that there are only two goods, but
this assumption is more general than it seems - good 1 is something and
good 2 is everything else
Properties of the Budget Set
Recall
Notes
What is the budget line?
The budget line is the set of
bundles that cost exactly
m:
budget line: p1 x1 + p2 x2 =
Ch. 2
m
The budget line can be rearranged to
give the formula to this line:
x2 = (m/p2 ) − (p1 /p2 )x1
y (vertical) intercept: m/p2
What do the intercepts tell you?
x (horizontal) intercept: m/p1
The horizontal and vertical
intercepts measure how much the
consumer could get if she spent all
slope: −p1 /p2
2
of her money on goods 1 and 2,
respectively
What does the slope tell you?
The slope of the budget line has a
nice economic interpretation: it
measures the rate at which the
market is willing to "substitute"
The formula tells how many units of
good 3 the consumer needs to
consume in order to just satisfy the
budget constraint if they are
consuming x1 units of good 1
good 1 for good 2
What do economists call the
slope?
Economists say that the slope of
the budget line measures the
opportunity cost of consuming
good 1. ie in order to consume
more of good 1 you have to give
up some consumption of good 2
📌
SUMMARY The budget line is written as m
= p1 x1 + p2 x2
How the Budget Line Changes
Recall
An increase in income will
result in a parallel shift outward of
the budget line
Notes
When prices and incomes change, the
set of goods that a consumer can
afford changes as well.
A decrease in income will
result in a parallel shift inward of
the budget line
Ch. 2
3
If income changes the vertical and
horizontal intercepts both increase
because income increase or vice
versa
If one price change the intercepts
will...
The intercepts change depending
on which good changes price
If both prices change the
intercepts will...
If prices of both goods 1 and 2
move in proportion then it causes
a parallel shift of the budget line
📌
SUMMARY Increasing income shifts the budget line outward. Increasing
price of good 1 makes the budget line steeper. Increasing the price of
good 2 makes the budget line flatter
Taxes, Subsidies, and Rationing
Recall
Notes
Quantity Tax:
Economic policy often uses tools that
the consumer has to pay a certain
affect a consumer's budget constraint
such as taxes
amount to the government for
each unit of the good they
purchase
A tax increases the price to the
budget line is tilted based on
which good is taxed
Governments also sometimes impose
Value Tax:
consumer, and a subsidy decreases it
rationing constraints: so that the level
of consumption of some good is fixed
a tax on the value —the price— of
a good, rather than the quantity
Ch. 2
4
purchased of a good (also known
as ad valorem taxes)
budget line is tilted based on
which good is taxed
ie a sales tax
Subsidy:
the opposite of a tax
Quantity Subsidy:
the government gives an amount
to the consumer that depends on
the amount of the good purchased
budget line flatter bc the price of
the good would be (price subsidy)
Ad Valorem Subsidy:
a subsidy based on the price of
the good being—
of subsidy) p1
1-rate
Lump-sum tax:
the government takes away some
fixed amount of money, regardless
of the individual's behavior
budget line shifts inward
Lump-sum subsidy:
the governments gives some fixed
amount of money, regardless of
the individual's behavior
budget line shifts outward
Ch. 2
5
📌
Ch. 2
SUMMARY Taxes, subsidies, and rationing change the slope and
position of the budget line by changing the prices paid by the consumer
6