The Budget Contraint

The Budget Contraint - Economics 21: Intermediate...

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Economics 21: Intermediate Microeconomics Topic 2: Consumer Theory - The Budget Constraint 1 Economics 21: Intermediate Microeconomics Topic 2: Consumer Theory The Budget Constraint Reference: Varian, Chapter 2 Outline: I. Introduction II. The Theory of Consumer Choice III. The Budget Constraint IV. Moving the Budget Line V. Taxes, Subsidies and Rationing VI. Example: The US Food Stamp Program I. Introduction We have seen how to use demand curves to represent consumer behaviour. But we said very little about the nature of the demand curve - why it slopes down for example. This topic will investigate how buyers reconcile what they would like to do, as described by their tastes and preferences, and what the market will allow them to do, as described by their incomes and the prices of different goods. II. The Theory of Consumer Choice The theory of consumer choice is comprised of four elements: (i) Consumer’s income; (ii) Prices of goods; (iii) Consumer’s tastes; (iv) Rational maximisation 1 The first two elements yield the consumer budget constraint and so tell us what the consumer can afford in the market vis . what they are able to consume given the purchasing power of the resources available to them (i.e. their real income). The Third element tells us what they would prefer to consume. The final element explains how the consumer reconciles what they would like to consume with what they can assume. III. The Budget Constraint Apples and Bananas Together (i) and (ii) above define the consumer’s budget constraint which itself describes the different bundles that the consumer can afford vis . his ‘feasible set’. Feasibility depends upon two factors - consumer’s incomes and prices of different goods. Consider the following example: A student earns $50 per week and is interested in only two goods - apples and bananas. The price 1 To be sure, it is assumed that given constraints they face, consumers do the best they can for themselves by picking the affordable consumption bundle that maximises satisfaction.
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Economics 21: Intermediate Microeconomics Topic 2: Consumer Theory - The Budget Constraint 2 of apples (bananas) = $5 ($10). His affordable consumption bundles (i.e. combinations) of the two goods are set out in Table 1 below: Quantity of Apples Q A Expenditure on Apples $5*Q A Quantity of Bananas Q B Expenditure on Bananas $10*Q B Total Expenditure $ 0 0 5 50 50 2 10 4 40 50 4 20 3 30 50 6 30 2 20 50 8 40 1 10 50 10 50 0 0 50 Table 1: Affordable Consumption Bundles We can illustrate this budget constraint graphically in Figure 1 following: Figure 1: The Budget Constraint – Specific Case Consider the slope of the budget constraint: One apple costs $5. To obtain that $5, the consumer must give up 1/2 a banana - each banana costs $10, therefore by giving up 1/2 a banana the consumer is able to release 1/2($10) = $5 for spending on apples. The slope of the budget constraint in this example is thus ( ) ( ) ( ) $5 $10 1 2 A B p p ! = !
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The Budget Contraint - Economics 21: Intermediate...

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