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CHAPTER -1
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BUDGET CONSTRAINT
Introduction
Economists assume that consumers act rationally this implies that consumers choose
the best bundle of goods they can afford. In this context, "Best" implies optimal
behaviour and "affordability" is concerned with the constraints within which the
consume would chose the bundle. A, consumer would like to reach the highest level of
satisfaction. His behavour is however constrained by
(a) His own money income

(b) Prices of the goods likely to be purchased.

For the purpose of keeping the analysis simple we assume

(a) The consumer is consuming only two goods good xi and good x2.
(b) The consumption bundle of the consumer is given by (X1,X) where

i) X represents the number of units of good x.

ii) X2 represents the number of units of good x2.
The money income of the consumer is m.
(c)
All money income is spent on the two goods and there are no savings.
(d)
The prices of the two good are pj and p2.
(e)
Amount of spending on two goods =
Amount of money income

PiXtP2X2 m
PiX the total expenditure on good x
p2X2 is the total expenditure
on good x2.
savings, LHS =
RHS
When there are no

m =Rs. 100
Suppose
Pi Rs. 5 p.u.

the budget 1line, drawn as AB, in figure-1, shall be of the form

In this case

+ 4x2
=
100
5x,

25
TAo,?:)

5N 41, -100

B(83P,
Figure-1

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Coordinate Ashall be (0, m/p2) or (0, 25)
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Coordinate B shall be (m/pi. 0) or (20, 0)
The =
slope of the budget line is p2X2 m-- p(x)
X2m/p2 -Pi/p2X
Comparing this withy y = mx +c

slope =p/p2= 5/4

Joining A and B we obtain the budget line. The budget line therefore shows all
possible combinations of good xj and good x2 that the consumer can purchase given
the prices of good Xj and xi and
money income, when there are no savings.
The slope of the budget line is the
(negative) ratio of product prices pi/P2 which can
also be interpreted as the market rate of exchange between good xi and good xz. It is
negative because the budget line is downward sloping as increase in consumption of
good X leads to reduction in consumption of good X2 in accordance with the
constraints of money income and prices.
I fp i = 5 and p = 4 therefore -p/p2 = - 5 / 4 1 . 2 5 . This implies 1 unit of good

X1.25 units of good xX2. The slope ofthe budget line shows the rate at which the
market is willing to exchange good xj for good x. This is mathematically explained
below.
Suppose the consumer decides to increase his consumption of good x by Ax. Given
the unchanged money income and the prices of the two goods, the consumer would be
forced to reduce the consumption of good x2, say by Axz.
The original budget constraint shall be
=
m
PX +P2X, (A)
and given the change in consumption of good xj and good x2 we obtain
=
m (B)
P(x +Ax,)+p,(X, +Ax,)
(B)-(A) equals
=
PAx, +p,Ax, 0

Ax P
Ax P2
We can therefore say that the slope of the budget line (-p, /p,) is equal to the rate at
which good xi can be substituted for good x,(Ax,/ Ax,)

We can further state that the slope of the budget line measures the opportunity cost of
consuming good x. This implies that the true economic cost of consuming an
additional unit of good x is the number of units of good x that must be foregone.

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AB represented the budget line. We now introduce the concept of budget set. The
budget set shows all possible bundles that the consumer can purchase irrespective of
whether the entire income is spent or not. The budget set has the following form
PX, +PX, S m

In the above figure-I area AOB represents the budget set. The budget set shows all
the affordable bundles that don't cost any more than m.
Now let goods x, represent expenditure on all other goods other than good x1. In such
a case good N2 is also called the composite good. Suppose the money income of
consumer is (m)
Rs. 100 and pi
= =
Rs.5
Even with the above data we can plot the budget line, FG as shown in figure-2
Let good x2expenditure all other goods other than X1
=
on

F has the following coordinates (o.m) or (o, Rs.100)

G has the fotlowing coordinates (m/pi, o) or (20, o).
where good x is in number of units
good x2 is in rupee terms.
The slope of FG is -p/1; wherein p2 = 1, and slope is -5.

Equation for FG is

PX,+X, =m
Sx, +X, = 100

Rs. 100(0,m)

R s 40t .
I(12, Rs 4")N

12

Figure-2
Now suppose the consumer purchased 12 units of good X1. In this case the consumer
would have spent (12 x 5) = Rs. 60 to purchase 12 units of x and would have Rs. 40

still left with him. The consumer would be at point J on the budget line FG. In
algebraic terms. to purchase OH units of good xi the consumer would have spent
Rs. FK on good x and would have an income of Rs. OK still remaining with him.

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Pivots and Shifts of the Budget Line
Case-1.
When price of one of the the of the other
goods is changed keeping price good
unchanged and money income constant, it would result in pivoting of the budget line.
It would cause the slope of the budget line to
change.
Consider the following example:
The original-budget line is defined by
PRs.5p.u.
P2 Rs. 4 p.u.
m= Rs. 100
This budget line s represented by the equation 5x +4X2 100 and graphically shown
as AB in the following figure-3. The slope of the AB is -p/p2--5/4.
Suppose the price of good x fails from p = Rs.5 to p = Rs.4 ceteris paribus.

This causes the budget line to pivot around point. A and pivot rightwards from AB to
AC. AC is represented by the following equation 4x + 4x2 100. AC has slope of
-P/p =-4/4 = -1/

(U.25)

i i r , 100

(20,0 (25.0

Figure-3
The student must remember that when, falls pi, falls, the slope changes from to
4

The negative sign shows that the line is downward sloping and moving from a

steepnesso f t o h e slope is becoming more flatter. When judging the steepness

4
or flatness of a curve/line, always consider i is absolute terms.

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Negative sign will show that the curve/line is downward sloping.
Positive sign will show that the curve/line is upward sloping.
Case-2.
Now consider a case when the price of both the goods changes consider
simultaneously.
Suppose the price of good xi and price of good x doubles simultancously. In such a
case the slope ofthe budget line shall remains the same. as -p, /p, = -2p, /2p,.
[Original budget line px, +p,x, = m with a slope of -P, /p,

New budget line is 2p,x, +2p,x, = m with slope of -2p,/2p, = -P, /p,]

800d x
p,p:)

Slope p, P:
(o,/2p E
P PX; i/2
Slope= 2p, /2,-Pi

(1/2P,)
B/p,0)

Figure-4
new
leftwards from the original budget line AB
The budget line FG shall shift parallel
as shown in figure-4.
This is because doubling of prices of both goods is identical to

dividing income by 2.
2p,X,+2p,X, =m
= m/2
P,X, +p,X,
are increased times, then it is identical to
We can generalize and say that if both prices
dividing income by the constant.

Case-3.
wherein both and even income change
number of cases prices
There can be a

simultaneously.
income must
an change, the student
In order to
analyse any price change coupled with shall
and x-intercept from the data provided. This calculation
calculate the y-intercept
the budget line on a graph.
help the student to correctly plot

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For eg. -

If both the prices go up and income

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goes down then the original budget line
AB shall shift leftwards to FG as the
income falls but it will not be
parallel as the
prices have also changed. Now if p2 increases more than
pi. then |p, / p, falls and FG
will became flatter. If
pi inereases more than p2. then p, / p,rises and FG will
became steeper as shown in the
figure below.

P P2r, =1
Slope=. P/7

P: 1/2
Sloe - p, / '

Figure-5

,'

'

Figure-66
Numeraire Price
When we set one of the pricein the budget constraint equal to one, and adjust the other
variables to descrive the same budget set, then the price that was set equal to one is
called the numeraire price.

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Mathematically the original budget line is given by
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PX, +P,X, =
m .

Wee set pi=1, by dividingthe above equation throughout by pi

P P
The objective of using a numeraire price is to simplify the analysis as there is "one
less price to worry about",
It is very much possible to peg any one of the prices or the income to a fixed value
(such as the one) and then adjust all the other variables so as to describe the same
budget set.

Impact of taxes, subsidies and rationing on the budget line.

We now consider specific cases of taxes, subsidies and rationing that change the slope
and position of the budget line
A. Quantity Tax
A quantity tax is a tax on the quantity purchased of a good.
Suppose the original price of good x is pi. The government imposes a quantity tax of
Rs./per unit of good x, ceteris paribus. This would cause the price of good x to from
pi to p + t. In figure-7, the original budget line AB has been drawn with the slope
-pi/p2 and the new budget line (showing an inward pivot) has been drawn as AC with
a slope -p +t/p2
The new budget line is more steeper than the original budget line. We can say that
from a consumer's point of view a quantity tax is like the rise in price of the good.

slope p, *t/F:

HI i,
Lellward pivot

Figure-7

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B, Value Tax:
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A value tax (also called advalorem tax) is a tax on the value (i.e. the price) of the
good. It is generally expressed
in percentage terms. Suppose the price of good xj is
p
and a value tax of t is imposed then the actual price that the consumer shall pay will
be pi(l + r). The consumer shall pay pi to the seller and tpi to the government for
cach unit of the good purchased. In this case the slope of the budget line facing the
consumer shall be -P,(1+T)/p,. The figure will be similar to figure-7 with AC

having a slope of -p,(1 +t)/p,

C. Lumpsum Tax:
In case of a lump-sum tax, a fixed amount of money has to be paid by the consumer
to the government, (say T) irrespective of the magnitude of consumption. Effectively a
lump-sum tax reduces the money income of the consumer. A lumpsum tax causes the
budget line faced by the consumer to shift parallel leftwards. The figure will be similar
to figure- 4 with income falling to (m T). -

D. Quantity Subsidy:
In case of a quantity subsidy the government gives an amount to the consumer based
on the magnitude of good purchased. If the price of good x is p1 and the government
gives a subsidy of Rs. "S" per unit on good x1, then effectively the price faced by the
consumer for good x is p, -s. A quantity subsidy would cause a rightward pivot of
the budget line AB making it flatter to AC.

E. Advaiorem Subsidy
It is a subsidy that is based on the value (the price) of a good that is subsidized.
Suppose the price of good x is pi and an ad valorem subsidy of o per unit is given.
then the actual price faced by the consumershall be (1-o)p:. In this case the slope of
the budget line facing the consumer shall be -(1-o)p,/p,. The figure will be similar

to figure-8 with AC having a slope of -(1- o)p, /p .

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good x
s h p e =- p , /

slup (p, ) /

Figure-8
F. Lump-sum Subsidy
In case of a lump-sum subsidy, a fixed amount of money is paid to the consumer by
the government (say S), irrespective of the magnitude of consumption. Effectively a.
lump-sum subsidy increases the money income of the consumer. A Jump-sum subsidy
causes the budget line faced by the consumer to shift parallel rightward from AB to
FG.
good

7 Shye -P/

Sloyx P,/:

Figure-9

G. Rationing
In case of a rationing constraint. the government fixes the maximum level of
consumption of a defined good. A rationing constraint becomes a binding constraint

only when the maximum level allowed by the government is LESS than the level of
the consumer can afford.
consumption of the good that
In the following case we show a binding quantity constraint with respect to good X|. In
this case the government states that the consumer can consume not more than X units

good x.

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Given the budget line AB representing (p,x, + p,x, = m) all affordable bundles, the

budget set of the consumer is limited to the area OAFG. The area FGB gets deleted
from the area AOB because this area consists of all bundles that are affordable but
have x > Xia

good x i.
COIstri int
ittufy rntun!g

Figure-10
In the following show a
case we non-binding quantity constraint with respect to good
X1. In this case the government state that the consumer can consume not more than
A units of good xi

gvod x,

Non Binding
Quantity rationing constraint

X 00d x,
Figure-11
Given the budget line JK representing (piX + p>X2 =m) all the affordable bundles,
the,
budget constraint is fully within the maximum limit of the quantity constraint. In such
a case, the quantity constraint becomes non-binding as the consumer can. consume
OK units (maximum quantity of good xj that the consumer can
purchase given
m, pi
and p2.) which is less than ox1B.

The Food Stamp Program

During the 1960's the government of United States introduced many programs to help
the poorer sections of society. The Food Stamp Act of 1964, allowed the
eligible

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families with a. means to purchase additional, food items than their budget allowed.
The Food stamps were equivalent to cash at the grocery stores and could be used only
for purchasing food items. (They are similar to a free food coupon). They COUILD
NOT be used to purchase other goods. Further it was illegal to sell the food stamps.
Let us examine the effects of a food stamp program on the consumption behaviour of
an individual, say. Arnold, who has a weckly income of Rs. 100 and the price of food
is Rs. 5 per unit. Given the above information. we have drawn the budget line AB
where the Y-axis measures the expenditure on "all other goods." And the X axis
measures. units of food.
The consumer can purchase a maximum of 20 units of food. (shown as point A) or can
spend the entire income on other goods, where his expenditure on other goods will be
Rs. 100 (shown as point B in the following figure-12) Now let us assume that Arnold
receives Rs.50 worth of food stamps every week. This food stamp program causes the
budget line of Arnold to shift outward. The Rs.50 in food stamps acts like an increase

in income, however this increase can only be used to buy food, the Rs.50 CANNOT
be used to buy other goods. The new budget line becomes BCD with a horizontail

segment BC and a segment CD which is the original budget line. The new
parallel to
bud et line BCD has a KINK at point C. This is because over the range BC. the
consumer can purchase 10 units of food, using the food stamps and still have his
wants to purchase food units in
money income of RS.100 intact. If the consumer
excess of 10 units then he must be ready to pay Rs.5 r unit from his money income to
buy units of food. The CD segment of the budget line has a slope of -5/1 indicating
the price of food over this range.

Thus thebudget line is BCD, with a kink at C, because the subsidy offered by the
10 units of food.
government ends at C. corresponding to
a cash grant of Rs. 50.
Instead of the food stamp program, had the government offered
shifted to ED. which includes the
the budget line of the consumer would have
could have been used by the consumer to spend
segment CD. This additional Rs. 50
or on other goods only (point E), or on both of
them to spend -

on food only (point D)

ED.
it the way he wished defined by the budget line
food stamp program and an
Therefore there is a marked difference between the
the consumer cannot purchase
outright cash grant. With a food stamp program
combinations of food and other represented by the segment EC.
goods
purchase nontood items.
This is because the food stamps cannot be legally used to

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Initial Budget Line BA
Budget line with Food Stamp Programe 3CDD
Budget Line with Cash Grant ECD

E
S(0,150
B
(0,100)

(10,0) A D X
(20,0 (30,0)
Units of Food

Figure-12
Now consider a case where there is no cash grant and the consumer has to pay a
certain amount of money, say Rs. 20, to acquire food stamps, say worth Rs.50.
In this particular case, the consumer, Anold, shall first pay Rs.20 to the government
to acquire food stamps worth Rs.50. His money income will be reduced to Rs.80 after
acquisition of the food stamps. Now when he wants to buy shall first use the food
stamps and acquire 10 units of food. He will be at point G with coordinates (10, 80) as
shown in figure-13. The slope of the segment BG shall be -2/1 because the consumer
is effectively paying Rs. 2 to acquire each unit of food. In case the consumer decides
to purchase more than 10 units of food, he will have to utilize his remaining income.
Each unit of food will cost Rs.5 and the consumer can purchase 16 more units of food.
Therefore will be able to purchase 10 units of food from the food stamps and 16 units
of food from the remaining income of Rs.80, allowing himself to have a maximum
total of 26 units of food. The consumer will be at point F. The slope of the segment GF
shall be -5/1 as the consumer has to pay Rs.5 to acquire food beyond the 10th unit.
Therefore the complete budget line shall be BGF,

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Initial Budget Line BA
Budget Line BG with Food Stamp
where a payment is made
Progiame
to acquire tood slamps
B
ro, 100
G C10,80)

(10,0 X
(,0)(26)

Unts ol Fcod

Figure-13

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CHAPTER - 2
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PREFERENCES
Introduction:
The economie model of consumer behaviour is based
the assumption that the
on
consumer is a rational human being who is guided by the objective of utility
maximization. In simple words it means, "people choose the best
afford. The order
things they can
to understand utility maximization make the
we
following
assumptions.
We will study the consumption
behaviour of a particular individual, consuming
two goods-good xi and x2. referred as consumption bundle(X1,X2).
The said consumer is a rational
human being guided by the objective of utility
maximization subject to the resource constraint.
The consumer is in a
position to rank/order his preferences, given his tastes.
This implies that utility from a
consumption bundle can be measured in ordinal
terms.

Representation of Preferences
We will be using the following symbols to rank
preferences. Let there be two
consumption bundles (X1.X2) and (y1.y2) that a consumer is supposed to rank.
(A) (X. X2) (y1. y2) means that the consumer strictly prefers (X1,X2) to (y1.y2).
This means that given the two bundles the
rather than
consumer definitely wants (X|.X2)
(y1. y2). ">" represents strictly preferred.
(B) (X1.X2) (y1. y2) means that the consumer is indifferent between bundles
(X1.X2) and (y1, Y2). Indifference means that the consumer has an
preference" for (X1,X2) and (y1.y2). Indifference however DOES NOT mean "equal
that
the consumer is NOT in a
position to make a choice. Indifference simply means
given bundle (xX |,X2 Jand bundle (y1.y2), the consumer is just as satisfied
that
consuming (X1, X2) as he would be consuming (y1.y2).
(C) (X1,X.) 2 (y1.Y2) means that the consumer
prefers or is indifferent between the
two bundles.
Technically say that(x1,X2) is weakly preferred to (y1. y2).
we

From the above relationships

(, and 2) given in A. B and C we draw the following
inferences
If(X1.X2) 2 (y1. y2) and (y1.y2)2 (X1,x2) then it can be
concluded that
(XX2)~ (y1. Y2).
II. If(X1, X2) 2 (y1. y2) and it is not the case that (X1, x2)(y1. Y2) then it can be
concluded that (X1, X2)> (y1. y2).

Assumptions with respect to Preferences

The following are also. referred as "AXIOMS" of consumer
consumer preferences:
theory with respect to

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