Introduction and Budget

Constraints
Required Readings: Perloff Ch 1 and 3.3

ECO 206: Microeconomic Theory

Prof. Freitas, University of Toronto

Introduction to ECO 206

Topic:Introduction and Budget Constraints

ECO 206: Microeconomic Theory

Prof. Freitas, University of Toronto

Video Learning Objectives

Quick overview of

• Topics and how we will approach them in 206.

• How we will develop your skills and assess the learning

objectives of the course.
 What do Economists Do?

• Microeconomics: Individual Choices ⇒ Markets.

• Understand the ’why’ behind certain real-world observations.

• Models: simplified representation of reality that captures

the argument and makes a prediction.
• Policy: What can change incentives?

Models and Assumptions

Individual Choices ⇒ Markets.

• Assumptions: Rational + self-interested +...

• Realistic vs. “good” assumptions.

• Data provides a reality check.

Course Learning Objectives

• 206 is a basic tools course: Constrained Optimization.

• Goals:
• Mastery of tools

• Applying them to real world questions and critical evaluation.

• Communicating analysis
 Mastery of Tools

4) X is an hourly wage worker whose utility over hours of leisure and the
composite good is given by U(l, c) = min{4l, c}. Her current hourly
wage rate is $10 and she has non-labor income of $20. She has a
maximum hours of 40 hours to allocate between leisure and work.

4a) [10 points] Calculate her labor supply function. Show all the steps
of your working clearly.

Critical Evaluation

4d) [8 points] A politician looking at X’s choices says, there is no point

in increasing wages for X. They claim “when her wages increase, X will
work less because she can get the same income by working fewer hours
and so her labor income will not change.” Do you agree? Explain your
reasoning and the intuition behind it. Show all the steps of your working
clearly.

Application

1) A consumer describes their preferences over goods x and y with the

following sentences.
“Only the x good in my bundle has value to me. The more x I have the
worse off I am. For a given amount of x it doesn’t matter how much y I
have–adding or subtracting y holding fixed the amount of x doesn’t
change my well-being.”

1a) [8 points] (1) Write down a utility function U(x, y ) that

capture these preferences. (2) Draw 2 clearly labeled indifference
curves using the axes below.
 Writing Assignment

A university education is expensive and students are working while

taking classes to pay for it. The organization wants to provide
scholarships to allow students to devote more time to studying instead
of working. Your task is design the details of this scholarship. What
will this scholarship look like and what type of students to get it? The
goal is to find the best way to achieve the goals of this organization.

How are we going to achieve this?

Support Goal Evaluation

 Lectures,  Problem Solve  Test- Math
Tutorials using Math and special cases
 Homeworks,  Apply and  Test- Explain
Office Hours Communicate
 Ungraded  Critical  Writing
Problem Sets Evaluation and Assignments
Analysis

206 vs 101

• What are the trade-offs? - In a world of scarcity,

more of something comes at a cost of something else.

• Thinking at the margin - decision making is made

based on marginal costs/ benefits.

• What are the assumptions? - They describe the

world in which we are conducting our analysis.
 Topics Overview

Summary

• Goals of 206: how we will develop and evaluate you

skills.

• Topics Overview.

Exogenous Income
Topic: Introduction and Budget Constraints

ECO 206: Microeconomic Theory

Prof. Freitas, University of Toronto
Video Learning Objectives

• Introduce definitions: Bundle, composite good.

• Generate and graphically represent a budget constraint
(BC) equation.
• Calculate and explain the intuition behind Marginal Rate
of Transformation (MRT).
• Calculate, graph and explain how the BC changes when
income and prices (inc. taxes, subsidies) change.

Budget as a Constraint

• Constraints: More general, here focus on constraints on

ability to purchase goods in market.
• Bundle.

• Assumptions: price takers.

• Income: Exogenous, i.e. cash.
• Amount of money unaffected by changes in the market.

Notation - Bundle

• You spend on income on a combination of goods. This

combination is called a bundle.

• If we have n goods. Then x1A represents a quantity (x)

of good 1 in bundle A.

(x1A , x2A , ...xnA )

 Two Dimensions

E.g. (10, 4) contains 10 Meat and 4 Veggies

Veg.

4
Meat
10

Composite Good

• Composite good: $1 worth of “other” goods the

consumer can buy

• Price is $1 by definition.

• Useful when consumer has many alternatives and you

want to focus on one good relative to “everything else”.

Budget Set

• Income is important because it determines what the

consumer can afford.

• Budget set: Set of all affordable consumption bundles.

Assume: Consumers are price-takers so they treat

prices as given and can’t affect them .
Budget Constraint: Equation

• Consumer walks into market with a fixed amount of

cash .

• Bundle is affordable if
expenditure on good in bundle ≤ consumer’s income

pM x M + pV x V ≤ I

Budget Set and Budget Line

Veg.

pM x M + pV x V = I

Budget Set
Meat

Marginal Rate of Transformation (MRT)

• MRT: Rate at which one good can be traded for

another though the market.
• It is expressed in units of a good.
• e.g.: To get another unit of good 1 how many units of
good 2 do I need to give up?
• It captures what the consumer is able to trade at
market prices, NOT what the consumer is willing to
trade.
Intuition

• To get 1 more unit of x I need $px .

• Each unit of y is worth $py .
• To get $px I need to sell px
py units of y

• i.e. MRT = dy
dx = − ppyx
• The negative sign is important as it indicates that you
need to give up units of y for additional units of x.

Marginal Rate of Transformation (MRT)

• On a graph, the MRT is the Slope of Budget line.

• It is the units of the y-axis good, the consumer needs to
give up to get an additional unit of the x-axis good.
• i.e. dy
dx = − ppyx
• Notice that relative prices matter for MRT and that how
you label your axes matters for your interpretation of the
MRT number.

Notes

• I will often (if not always) refer to the Marginal Rate of

Transformation (MRT) as Opportunity Cost (OC).
• Why? Because to get more of one good while keeping
expenditure the same, the slope tells you how many units of
the other good you have to give up.
• i.e. the slope is the opportunity cost of one good in terms of
the other good.

• I’m switching between the Meat/Vegetables, and x/y in the notation on the
slides as it reminds you to pay attention to the axes.
 Recap: Exogenous Income

pM = $10, pV = $10, I = $30

p M x M + pV x V ≤ I

Veg.

Meat

Income Change

pM = $10, pV = $10, I = $30

p M x M + pV x V ≤ I

Veg.

Meat
3

Price Change

pM = $10, pV = $10, I = $30

p M x M + pV x V ≤ I

Veg.

Meat
3
 Kinked Budget Constraint

Example: Government wants you to eat more vegetables so they

subsidize price of the first two units. First 2 veggies cost $5 and after
that $10 each. pM = $10, I = $30

Veg.

Meat
3

Summary

• Choices represented by bundles

• Composite good is a good that represents $1 of
everything else.
• Changes in exogenous income result in a parallel shift of
the budget constraint.
• Changes in prices results in a rotation of the budget
constraint.

Endogenous Income
Topic:Introduction and Budget Constraints

ECO 206: Microeconomic Theory

Prof. Freitas, University of Toronto
 Video Learning Objectives

• Explain the difference between Endogenous and

Exogenous income.
• Generate and graphically represent a budget constraint
(BC) equation.
• Calculate the Marginal Rate of Transformation (MRT).
• Calculate, graph and explain how the BC changes when
income and prices (inc. taxes, subsidies) change.

Endogenous Income
Key: the endowment bundle can only contain the good on the axes.

Consumer walks into a market without cash.

• They have a bundle of goods called an endowment

which is denoted by (ωM , ωV ).
• They can sell these goods at market prices which makes
the dollar value of the endowment

pM ωM + pV ωV

Is this Realistic?

• Bundle of composite good and x.

• Useful for modeling markets where the x is

• Labor.

• Financial Assets in capital markets.

 Endogenous Income - Example

• Endowment: (5, 2), p1 = 2, p2 = 5

• $ Value of endowment: 5p1 + 2p2 = $20

Assume: Consumers are price-takers so they treat

prices as given and can’t affect them .
x2

(5, 2)
x1

Budget Constraint: Equation

• Endowment is (ωM , ωV )

• Affordable bundles: Spending on goods ≤ Income i.e.

pM xM + pV xV ≤ pM ωM + pV ωV

Intercepts

Endowment is (ωM , ωV ), Affordable if pM xM + pV xV ≤ pM ωM + pV ωV

• Intercepts: If spend all income on one good, what is the

maximum number of units you could buy?
pM ωM +pV ωV
• x-axis (Meat) : pM = ωM + pM ωV ,
pV

pM ωM +pV ωV
• y-axis (Veg.): pV = pV ωM
pM
+ ωV
 Marginal Rate of Transformation (MRT)

• MRT: Rate at which one good can be traded for

another though the market, expressed in units of a
good.
• On a graph, the MRT is the Slope of Budget line. It is
the units of the y-axis good, the consumer needs to give
up to get an additional unit of the x-axis good.
• i.e. dy
dx = − ppyx

Recap: Endogenous Income

pM = $10, pV = $10, ωM = 1, ωV = 2
pM xM + pV xV ≤ pM ωM + pV ωV

Veg.

Meat

Income Change

pM = $10, pV = $10, ωM = 1, ωV = 2
pM xM + pV xV ≤ pM ωM + pV ωV

Veg.

Meat
3
 Price Change

pM = $10, pV = $10, ωM = 1, ωV = 2
pM xM + pV xV ≤ pM ωM + pV ωV

Veg.

Meat
3

Recap: Price Change

• When pV ↑
• Your endowment basket is worth more money ⇒Richer
• V is more expensive ⇒ Poorer

• Combination ⇒ rotation through the endowment

point.
• Intuition: Can always afford to consume your endowment.

Note: Parallel shift in budget constraint when just

endowment changes

Income Change
Black: Initial and Red: after Income change

Exogenous Inc. Endogenous Inc.

I pM ωM + pV ωV
Veg. Veg.

E
E
Meat Meat
Price Change
Black: Initial and Red: after price change

Exogenous Inc. Endogenous Inc.

pV ↑ pV ↑
Veg. Veg.

E
Meat Meat

Summary
MRT: Marginal Rate of Transformation

• Endogenous income determined by value of consumer’s

endowment bundle of market goods.
• MRT (i.e. Opportunity Cost) the same as exogenous
income.
• Changes in income require a change in endowment.
• Changes in prices results in a rotation of the budget
constraint through the endowment point.