2.

The consumers budget constraint

Varian, Chapter 2

Consumer theory
Consumers maximize their individual well-being, subject to their choices being feasible How do we describe what is best for a consumer?
We use the consumers own preferences

How do we describe what is feasible?

The expenditure is no greater than the budget

Bundles of Goods
Suppose that there are two goods
x1 is the amount of good 1 x2 is the amount of good 2
x2

X = (x1,x2) is the bundle of goods consumed by the individual

x1

Money and prices

Suppose that the consumer has m units of money The prices of goods are expressed in terms of money
p1 is the price of good 1 (the number of units of money needed to buy one unit of good 1) p2 is the price of good 2

Costs and Budgets

The bundle (x1,x2) costs p1x1 + p2x2

The consumer can afford any bundle that satisfies the budget constraint: p1x1 + p2x2 m

Budget set
x2 m/p2

p1x1 + p2x2 = m

Affordable

Not affordable

m/p1

x1

p1x1 + p2x2 m

Normalizing prices
A good is called the numeraire if prices and money are measured in term of units of that good Let good 2 be the numeraire The opportunity cost of good 1 is the amount of good 2 that must be given up to get another unit of good 1

Determining normalized prices

Divide budget constraint by p2 and rearrange: (p1/p2)x1 + x2 = m/p2 px1 + x2 = m x2 = m -px1 where p = p1/p2, m = m/p2
x2 m

Slope = -p = -(p1/p2)

m/p

x1

Effect of inflation
Initial budget constraint: p1x1 + p2x2 = m Then, prices and income double: 2p1x1 + 2p2x2 = 2m Relative prices and real income are unchanged: p = 2p1/(2p2) = p1/p2 m = 2m/(2p2) = m/p2 the budget set is unchanged

Income change
x2 m=m2

m=m1

x1

A single price changes

x2 m/p2

m/pold1

m/pnew1

x1

A tax on good 1
Original budget constraint: p1x1 + p2x2 = m Quantity tax on good 1, at the rate t per unit: (p1+ t)x1 + p2x2 = m Total tax paid = tx1

A tax on good 1
Ad valorem tax on good 1, at the rate of t per dollar spent:

p1(1+t)x1 + p2x2 = m
Total tax paid = t p1x1

A per-unit subsidy
Original budget constraint: p1x1 + p2x2 = m A per-unit subsidy for good 1, at the rate of s per unit: (p1-s)x1 + p2x2 = m Total subsidy = sx1

A lump-sum subsidy
A lump-sum subsidy equal to : p1x1 + p2x2 = m+ x2 = ((m+ )/p2) (p1/p2)x1 Total subsidy =

Two constraints
Jack has $1000 to spend on bowling and golf
A round of golf costs $100; an hour of bowling costs $10
Hours spent bowling 100 80

Budget

Time

Jack has 80 hours to bowl and play golf

A round of golf takes 4 hours
10 20 Rounds of golf

Food stamps
Eligible individuals receive an allotment of food stamps
e.g., $200 per month for a family These stamps can only be used to buy food
Money spent on other goods

Budget line without food stamps

Budget line with food stamps

200

m+200 Money spent on food

Food stamps with resale

Suppose that stamps might be sold to other consumers or shopowners at less than face value
Money spent on other goods

Budget line with food stamps

200

m+200 Money spent on food

SNAP
Typically, recipients must be within 130% of the poverty line ($28,665 for a family of four in 2010) The debit-card payment system cut errors (overpayments, underpayments, and payments going to ineligible households) by a third

Vouchers
Eligible individuals receive a voucher for educational expenditures
e.g., $400 per month for a family The voucher can only be used to pay for education
400 Money spent on other goods

Budget line without voucher

Budget line with voucher

m+400 Money spent on education

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Rationing
Consumption of good 1 is restricted to be _ no more than x1 x p1x1+ p2x2 = m
2

m/p2

_
x1 m/p1 x1

Rationing with resale

x2 m/p2

p1x1+ p2x2 = m

_
x1 m/p1 x1

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Luxury Tax
_ Tax consumption of good 1 above x1
x2 m/p2

p1x1+ p2x2 = m
_ p1x1+ t(x1-x1) + p2x2 = m

_
x1

x1 (m+tx1)/(p1+t)

Quantity discount
Price of good 1 is p1d for quantities above x1
x2 m/p2

_
x1

x1 + (m-p1x1)/(p1-d)

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