Consumption Choice Sets

 A consumption choice set is the collection

of all consumption choices available to the
consumer.
 What constrains consumption choice?
 Budgetary,
g y, time and other resource
limitations.

CHAPTER 2
BUDGET CONSTRAINT

The budget constraint Budget Constraints

 The basic concept is really straightforward:  A consumption bundle containing x1 units

of commodity 1, x2 units of commodity 2
 The consumer has a limited income (m) to and so on up
p to xn units of commodity y n is
purchase different goods denoted by the vector (x1, x2, … , xn).
 Each type
yp of g
good has a defined price
p (p) p
per  Commodity yp
prices are p1, p2, … , pn.
unit
 We assume that the consumer does not save
and
d spends
d all
ll his
hi income
i
 This possibility will be examined later

The budget constraint The budget constraint

 The general budget constraint for n goods  Imagine the following “student
student
is: entertainment budget”
n
I
m p
i 1
i xi 


You have 50 PhP
The price of a meal is 10 PhP
 The price of a cinema ticket is 5 PhP
 If we only look at 2 goods,
goods it can be
expressed as:
 Your budget constraint is:
I
mp1 x1  p 2 x 2
mI  p1 x1  p 2 x 2 50  5  tickets  10  meals
 The budget constraint The budget constraint

Di
Diagram iin ““consumption
ti space””
Meals Meals
mI
Maximum amount of
meal 
x max
max max
xmeal

p meal meals you can buy
xmeal


Maximum amount of Im
cinema
i ti
tickets
k t you
max
x cin. 
p cin.
can buy


max
Cinema x cin. Cinema

The budget constraint The budget constraint

The budget
g constraint is m
I  p1 x1  p 2 x 2
Dividing by p1 and rearranging:
Meals Meals
max max I
m p2
xmeal
 xmeal
 intercept x1   x2
p1 p1

Budget constraint slope

I
m p cin.
x meal   i
x cin.
p meal p meal
 
max max
x cin. Cinema x cin. Cinema

Budget Constraints Budget Constraints

 Q: When is a consumption bundle  Q: When is a bundle (x1, … , xn) affordable

(x1, … , xn) affordable at given prices p1, … , at prices p1, … , pn?
pn?  A: When
p1x1 + … + pnxn  m
where m is the consumer’s (disposable)
( p )
income.
 Budget Constraints Budget set

 The bundles that are only just affordable  The consumer

consumer’s s budget set is the set of all
form the consumer’s budget constraint. affordable bundles;
This is the set B(p
(p1, … , pn, m)) =
{ (x1, … , xn) | x1  0, … , xn 0 and
, n) | x1  0,, …,, xn  and
{ ((x1,,…,x p1x1 + … + pnxn  m }
p1x1 + … + pnxn  m }.  The budget constraint is the upper
boundary of the budget set.

Budget Set and Constraint for Budget Set and Constraint for
Two Commodities Two Commodities
x2 x2
Budget
B d t constraint
t i t is
i Budget
B d t constraint
t i t is
i
m /p2 m /p2
p1x1 + p2x2 = m. p1x1 + p2x2 = m.

m /p1 x1 m /p1 x1

Budget Set and Constraint for Budget Set and Constraint for
Two Commodities Two Commodities
x2 x2
Budget
B d t constraint
t i t is
i Budget
B d t constraint
t i t is
i
m /p2 m /p2
p1x1 + p2x2 = m. p1x1 + p2x2 = m.
Not affordable

Just affordable Just affordable

m /p1 x1 m /p1 x1
 Budget Set and Constraint for Budget Set and Constraint for
Two Commodities Two Commodities
x2 x2
Budget
B d t constraint
t i t is
i Budget
B d t constraint
t i t is
i
m /p2 m /p2
p1x1 + p2x2 = m. p1x1 + p2x2 = m.
Not affordable

Just affordable the collection

off allll affordable
ff d bl b bundles.
dl
Affordable
Budget
S t
Set
m /p1 x1 m /p1 x1

Budget Set and Constraint for

Budget Constraints
Two Commodities
x2
 If n = 3 what do the budget constraint and
p1x1 + p2x2 = m is i
m /p2 the budget set look like?
x2 = -(p1/p2)x1 + m/p2
so slope
l iis -p1/p
/ 2.

Budget
S t
Set
m /p1 x1

Budget Constraint for Three Budget Set for Three

Commodities Commodities

x3) | x1  0,
0 x2  0,
0 x3  0 and
x2 x2
{ (x1,x
x2,x
m /p2 p1x1 + p2x2 + p3x3 = m m /p2
p1x1 + p2x2 + p3x3  m}

m /p3 m /p3
x3 x3

m /p1 m /p1
x1 x1
 Budget Constraints Budget Constraints

 For n = 2 and x1 on the horizontal axis,

 For n = 2 and x1 on the horizontal axis,
the constraint’s slope is -p1/p2. What
the constraint’s slope is -p1/p2. What
does it mean?
does it mean?
p1 m
x2   x1  p1 m
p2 p2 x2   x1 
p2 p2

 Increasing x1 by 1 must reduce x2 by

p1/p2.

Budget Constraints Budget Constraints

x2 x2
Slope is -p
p1/p2 Opp. cost of an extra unit of
commodity 1 is p1/p2 units
foregone of commodity 2.
-p1/p2 -p1/p2
+1 +1

x1 x1

Budget Sets & Constraints;

Budget Constraints
Income and Price Changes
x2 Opp. cost of an extra unit of
 The budget constraint and budget set
commodity 1 is p1/p2 units
depend upon prices and income. What
foregone of commodity 2. And
happens
pp as prices
p or income change?
g
the opp.
opp cost of an extra
+1 unit of commodity 2 is
p2/p1 units foregone
-p2/p1 of commodity 1.

x1
How do the budget set and budget
constraint change as income m Higher income gives more
i
increases?
? choice
x2 x2 New affordable consumption
choices
Original and
new budget
constraints are
parallel (same
Original Original slope).
b d t sett
budget b d t sett
budget
x1 x1

How do the budget set and budget How do the budget set and budget
constraint change as income m constraint change as income m
d
decreases?? decreases?
x2 x2
Consumption bundles
that are no longer
affordable.
Old and new
Original New, smaller constraints
b d t sett
budget b d t sett
budget are parallel
parallel.
x1 x1

Budget Constraints - Income Budget Constraints - Income

Changes Changes

 IIncreases in
i income
i m shift
hift the
th  IIncreases in
i income
i m shift
hift the
th
constraint outward in a parallel manner, constraint outward in a parallel manner,
thereby enlarging the budget set and thereby enlarging the budget set and
improving choice. improving choice.
 Decreases in income m shift the
constraint inward in a parallel manner,
thereby shrinking the budget set and
reducing choice.
 Budget Constraints - Income Budget Constraints - Price
Changes Changes
 No original choice is lost and new choices  What happens if just one price decreases?
are added when income increases, so  Suppose p1 decreases.
higher
g income cannot make a consumer
worse off.
 An income decrease may y ((typically
yp y will))
make the consumer worse off.

How do the budget set and budget How do the budget set and budget
constraint change as p1 decreases constraint change as p1 decreases
x2 from p1’ to p1”? x2 from p1’ to p1”?

m/p2 m/p2
New affordable choices

-p1’/p2 -p1’/p2

Original Original
b d t sett
budget b d t sett
budget
m/p1’ m/p1” x1 m/p1’ m/p1” x1

How do the budget set and budget Budget Constraints - Price

constraint change as p1 decreases Changes
x2 from p1’ to p1”?
 Reducing the price of one commodity
m/p2 pivots the constraint outward. No old
New affordable choices
choice is lost and new choices are added,,
Budget constraint so reducing one price cannot make the
-p1’/p2 pivots; slope flattens consumer worse off.
f
from -p1’/p
’/ 2 to
Original -p 1”/p2
-p
p ”/p
1 p2
b d t sett
budget
m/p1’ m/p1” x1
 Budget Constraints - Price Uniform Ad Valorem Sales
Changes Taxes
 Similarly, increasing one price pivots the  An ad valorem sales tax levied at a rate of
constraint inwards, reduces choice and 5% increases all prices by 5%, from p to
mayy ((typically
yp y will)) make the consumer ((1+0×05)p
)p = 1×05p.
p
worse off.  An ad valorem sales tax levied at a rate of t
increases all p
prices by
y t,, from p to (1+t)p.
( )p

 A uniform sales tax is applied uniformly to

all commodities.

Uniform Ad Valorem Sales Uniform Ad Valorem Sales

Taxes Taxes

 A uniform sales tax levied at rate t  A uniform sales tax levied at rate t
changes the constraint from changes the constraint from
p1x1 + p2x2 = m p1x1 + p2x2 = m
to to
(1+t)p1x1 + (1+t)p2x2 = m (1+t)p1x1 + (1+t)p2x2 = m
i.e.
p1x1 + p2x2 = m/(1+t).

Uniform Ad Valorem Sales Taxes Uniform Ad Valorem Sales Taxes

x2 x2
m p1x1 + p2x2 = m m p1x1 + p2x2 = m
p2 p2
m p1x1 + p2x2 = m/(1+t)
/( )
(1  t ) p2

m x1 m m x1
p1 (1  t ) p1 p1
Uniform Ad Valorem Sales Taxes Uniform Ad Valorem Sales Taxes
x2 x2 A uniform ad valorem
sales tax levied at rate t
m m
Equivalent income loss is equivalent to an income
p2 p2 t
is tax levied at rate
m m t m .
m  m 1 t
(1  t ) p2 1 t 1 t (1  t ) p2

m m x1 m m x1
(1  t ) p1 p1 (1  t ) p1 p1

Relative Prices Relative Prices

 “Numeraire”
Numeraire means “unit unit of account
account”..  If prices and income are measured in cents,
 Suppose prices and income are measured then p1=200, p2=300, m=1200 and the
in dollars. Say p1=$2,
$2, p2=$3,
$3, m = $12. Then constraint is
the constraint is 200x1 + 300x2 = 1200,
2x1 + 3x2 = 12. the same as
2x1 + 3x2 = 12.

Changing the numeraire changes neither the

budget constraint nor the budget set.

Relative Prices Relative Prices

 Any commodity can be chosen as the

 The constraint for p1=2, p2=3, m=12 numeraire without changing the budget set
or the budget
g constraint.
2x1 + 3x2 = 12

is also 1x1 + (3/2)x2 = 6.

The constraint for p1=1, p2=3/2, m=6. Setting p1=1

makes
k commodity
dit 1 the
th numeraire
i and
d defines
d fi all
ll
prices relative to p1; e.g. 3/2 is the price of commodity
2 relative to the price off commodity 1.
 Relative Prices Shapes of Budget Constraints

 p1=2, p2=3 and p3=6   Q: What makes a budget constraint a

 price of commodity 2 relative to straight line?
commodity 1 is 3/2,  A: A straight line has a constant slope and
 price of commodity 3 relative to the constraint is
commodity 1 is 3. p1x1 + … + pnxn = m
 Relative prices are the rates of exchange so if prices are constants then a constraint
of commodities 2 and 3 for units of is a straight line.
commodity 1.

Shapes of Budget Constraints Quantity Discounts

 But what if prices are not constants?  Suppose p2 is constant at $1 but that p1=$2
$2
 E.g. bulk buying discounts, or price for 0  x1  20 and p1=$1 for x1>20.
penalties for buying “too
too much
much”..
 Then constraints will be curved.

Shapes of Budget Constraints

Quantity Discounts
with a Quantity Discount
x2 m = $100
 Suppose p2 is constant at $1 but that p1=$2
$2
for 0  x1  20 and p1=$1 for x1>20. Then
100 Slope = - 2 / 1 = - 2
the constraint’s slopep is (p1=2, p2=1)
- 2, for 0  x1  20
{
-p1/p2 =
- 1, for x1 > 20
Slope = - 1/ 1 = - 1
(p1=1, p2=1)
and the constraint is

20 50
80 x1
Shapes of Budget Constraints Shapes of Budget Constraints
with a Quantity Discount with a Quantity Discount
x2 m = $100 x2 m = $100
100 Slope = - 2 / 1 = - 2 100

(p1=2, p2=1)
Budget Constraint
C
Slope = - 1/ 1 = - 1
(p1=1, p2=1)
Budget Set
20 50
80 x1 20 50
80 x1

Shapes of Budget Constraints

In-class exercise
with a Quantity Penalty
x2 You have an income of $40 to spend on two commodities. Commodity 1 costs $10
per unit,
unit and commodity 2 costs $5 per unit
unit.
(a) Write down your budget equation.
Budget (b) If you spent all your income on commodity 1, how much could you
buy?
Constraint (c) If you spent all of your income on commodity 2, how much could you
buy?
Draw your budget line.
(d) Suppose that the price of commodity 1 falls to $5 while everything else
stays the same. Write down your new budget equation. Draw your new
budget line.
(e) Suppose that the amount you are allowed to spend falls to $30, while
Budget Set the prices of both commodities remain at $5
equation. Draw this new budget line.
$5. Write down your budget

(f) On your diagram, use blue ink to shade in the area representing
x1 commodity bundles that you can afford with the budget in Part (e) but
could not afford to buy with the budget in Part (a).
(a) Use black ink or
pencil to shade in the area representing commodity bundles that you
could afford with the budget in Part (a) but cannot afford with the
budget in Part (e).

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