Ch 2 consumer theory basics

# For example here are the annual nominal and real

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Unformatted text preview: ences and Budget Constraints (this version 2012-2013) University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. 9. The Budget Set We want to model consumer choice: understand, explain, and predict which bundle a consumer chooses to consume. In microeconomics, the standard model of consumer choice is the Utility Maximization Problem ( ) which says that consumers choose the optimal bundle(s) to maximize their utility from consuming that bundle subject to the constraints that the bundle is affordable and physically available for consumption (i.e. is in the consumption set ). For {( }) ) commodities the general UMP is (here we assume that ( ) ⏟ ⏟ In this section we discuss the set of affordable bundles. In our models of consumer choice, we assume that consumers are price takers in the sense that they pay the seller’s price (customers do not have any bargaining power). In economic models, when we say “price”, it is understood that we mean “real” and not “nominal” prices. A nominal price is literally the “sticker” price while a “real” price is an index which adjusts the nominal price for inflation. For example, here are the (annual) nominal and real prices of retail gasoline prices in the US (you can download the data for this chart and other energy prices from here.) Denote income by and the prices of the commodities by We always assume that all pecuniary parameters (anything measured in terms of money) are always strictly positive and exogenously given: For now we assume that all commodities have uniform prices (the same price for each item). The consumer’s budget constraint for commodities is: \$Expenditure ⏟ Here \$ is total expenditure on good 1 and \$Income ⏟ is total expenditure on good 2. __________________________________________________________________________________________________ Note: At first glance it looks as if this budget constraint: \$Expenditure ⏟ \$Income ⏟ doesn’t allow for the possibility that the consumer can “save” or “borrow”. But in fact, it does: simply define “expenditure” on a good as “dollars saved” or “dollars borrowed”. For example we could make: ⏟ 41 ECO 204 CHAPTER 2 Modeling Consumer Choice and Behavior: Preferences and Budget Constraints (this version 2012-2013) University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. If the consumer is literally saving then while if the consumer is literally borrowing then if the consumer is neither saving nor borrowing then The budget constraint becomes: ⏟ and ⏟ Or: ⏟ __________________________________________________________________________________________________ Assuming uniform prices, the budget set can be graphed in the consumption set: Budget Line Equation A B Slope The equation of the outer edge of the budget set (“budget line”) is: () Here: Maximum units of good 1 the consumer can buy with her income; consumer can buy with her income; Maximum units of good 2 the number of units of good 2 that the consumer must give up in exchange for another unit of good 1 in order to remain within her budget constraint. 42 ECO 204 CHAPTER 2 Modeling Consumer Choice and Behavior: Preferences and Budget Constraints (this version 2012-2013) University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. The set of affordable bundles (“budget set”) depends on the consumer’s income and commodity prices which we denote by: { } Notice that nothing happens to the budget set if all pecuniary parameters change by the same percentage. For example, suppose: { } ⏟ Now suppose there is 10% inflation so that new budget set is: { } ⏟ However, a change in a single pecuniary parameter will change the set of affordable choices (see below): ( ) ( Example ( ) ) ( Example ( ) ) ( ) Example 43 ECO 204 CHAPTER 2 Modeling Consumer Choice and Behavior: Preferences and Budget Constraints (this version 2012-2013)...
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