PAM 200 – Microeconomics  Week 2 Lecture Notes
I.
BUDGET CONSTRAINTS CONTINUED
At this point we have learned how to determine the equation for a budget constraint in two
dimensions i.e.
X
P
P
P
M
Y
Y
X
Y
−
=
.
To this point we have used very little economics, except to note that the opportunity cost of a
unit of X is
Y
X
P
P
.
We will now introduce two assumptions that will help our analysis going
forward:
1)
People prefer more to less.
This assumption assures that people select a bundle of
goods that is on the budget constraint.
2)
Tastes are stable (consistent, unchanging).
This assumption assures that people
don’t change their desired consumption bundle in random ways.
Typical economic analysis investigates the effects of changes in the budget constraint on the
consumptions bundle.
We will now consider various factors that can affect budget constraints.
For much of the analysis I will continue to use the example presented in class.
That is, assume
initially that M=$8, the price of a glass of wine is P
W
=$4/glass, and the price of beer is
P
B
=$2/glass.
The resulting budget constraint is
X
P
P
P
M
W
W
B
W
−
=
or
X
W
5
.
0
2
−
=
(
1
)
The chart of this budget constraint is
4
0.5
2
Beer
Wine
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The Effect of an Increase in Income
If the amount of money doubles from M=$8 to M=$16 and prices are constant then the new
budget constraint becomes
.
Notice that the Yaxis intercept doubles from 2 to 4,
but there is no effect on the slope: it remains 0.5.
Therefore there is no change in the
opportunity cost of wine relative to beer.
The new budget constraint is shown below.
Notice
that since income has doubled both intercepts double; it is now possible to purchase twice as
much wine, or twice as much beer.
Assume that the initial consumption bundle is A.
After
money doubled to $16, will the final consumption bundle fall into region B, C, or D?
It depends
on whether Beer or Wine are normal or inferior.
X
W
5
.
0
4
−
=
D
C
B
A
0.5
8
4
4
0.5
2
Wine
Beer
B.
The Effect of Equal Percentage Changes in Income and Prices
If the amount of money doubles from M=$8 to M=$16 and all prices also double to P
W
=$8 and
P
B
=$4 the budget constraint becomes 16=8W+4B. Rearranging the expression to solve for W
yields W=20.5B, which is identical to the initial budget constraint.
If the budget constraint
doesn’t shift then there is no reason to predict that the consumption bundle would change.
If
there is no impact in our simple model of inflation, then why is inflation so reviled?
C.
The Effect of Income and Prices Changes that Make it Possible to Consume the Initial
Consumption Bundle
The title is a bit of a mouthful, but what I mean is demonstrated in the following diagram.
Assume that initially M=$8, P
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 Spring '07
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