ECONOMICS

SUMMARY
CHAPTER 2 – BUDGET CONSTRAINT
The economic theory of the consumer is very simple. Economists assume that consumers choose the best
bundle of goods they can afford. To give content to this, we have to describe what we mean by “best” and
“can afford”.

The budget constraint

Suppose there is a set of goods from which the consumer can choose. In real life, there are many goods to
consume, but for our purpose, it is convenient to consider only the case of two goods, since we can then depict
the consumer’s choice behavior graphically.

We will indicate the consumer's consumption bundle by (x1, x2). This is simply a list of numbers that tells us
how much the consumer is choosing to consume of good 1, x1 and how much the consumer is choosing to
consume of good 2, x2. Sometimes it is convenient to denote the consumer’s bundle by X, where X is an
abbreviation for the list of two numbers.

We can observe the prices of two goods and the amount of money the consumer has to spend, m. Then the
budget constraint of the consumer can be written as

p1x1 + p2x2 ≤ m.

Here, p1x1 is the amount of money the consumer is spending on good 1, and p2x2 is the amount of money the
consumer is spending on good 2. The budget constraint of the consumer requires that the amount of money
spent on the two goods to be no more than the total amount the consumers has to spend. The consumer’s
affordable consumption bundles are those that don’t cost any more than m. We call this set of affordable
consumption bundle at prices (p1,p2) and income m the budget set of the consumer.

Two Goods Are Often Enough

The two-good assumption is more general than you might think at first, since we can often interpret one of the
goods as representing everything else the consumer might want to consume. For example, if we are interested
in studying a consumer’s demand for milk, we might let x1 measure his consumption of milk in quarts per
month. We can then let x2 stand for everything else the consumer might want to consume.

When we adopt this interpretation, it is convenient to think of good 2 as being the dollars that the consumer
can use to spend on other goods. Price of good 2 will automatically be 1, since the price of 1 dollar is one
dollar. Thus, the constraint will be,

p1x1 + x2 ≤ m.

This says that the amount of money spent on good 1, plus the amount of money spent on all other goods must
be no more than the total amount of money the consumer has to spend.

We say that good 2 represents a composite good that stands for everything else. Such a composite good is
invariably measured in dollars to be spent on goods other than good 1.
Properties of the Budget Set
The budget line is a set of bundles that cost exactly m:

p1x1 + p2x2 = m.

These are the bundles of goods that just exhaust the consumer’s income. The budget set is depicted here.

The heavy line is the budget line – the bundles that cost exactly m – and the bundles below this line are those
that cost strictly less than m.

We can rearrange the budget line to give us the formula

𝑚 𝑝1
𝑥2 = − 𝑥
𝑝2 𝑝2 1

This is the formula for a straight line with a vertical intercept of m/p2 and a slope of -p1/p2. It tells us how many
units of good 2 the consumer needs to consume in order to just satisfy the budget constraint if she is
consuming x1 units of good 1.

The slope of the budget line has a nice economic interpretation. It measures the rate at which the market is
willing to “substitute” good 1 for good 2. Suppose the consumer is going to increase the consumption of good
1 by dx1. How much will her consumption of good 2 have to change?

p1dx1 + p2dx2 = 0

The total value of the change in her consumption must be zero. Solving this gives
This is just the slope of the budget line. The negative sign is there since dx1 and dx2 must always have opposite
signs. If you consume more of good 1, you have to consume less of good 2 and vice versa if you continue to
satisfy the budget constraint. Alternatively we could have taken the implicit derivative of both sides of the
budget constraint with respect to x1 and obtained the same result.

Economists sometimes say that the slope of the budget line measures the opportunity cost of consuming good
1. In order to consume more of good 1, you have to give up some consumption of good 2. Giving up the
opportunity to consume good 2 is the true economic cost of more good 1 consumption; and that cost is
measured by the slope of the budget line.

How the Budget Line Changes

When prices and incomes change, the set of
goods that a consumer can afford changes as
well. How do these changes affect the budget
set?

Changes in income

It is easy to see that an increase in income will

increase the vertical intercept ant not affect the
slope of the line. Thus, an increase in income
will result in a parallel shift outward of the
budget line, as seen in this figure.

Similarly, a decrease in income will cause a

parallel shift inward.

Changes in prices

Increasing price 1 while holding price 2 and

income fixed will not change the vertical
intercept, but will make the budget line slope
steeper, since p1/p2 will become larger.

Easy trick is to put all money on good 2 and see

that the vertical intercept doesn’t change. Spend
all your money on good 1 and see that your
consumption of good 1 must decrease. The
horizontal intercept must shift inward.
Change in prices of good 1 & 2, simultaneously

Suppose we double the prices of both goods 1 and 2. In this case both the horizontal and vertical intercepts
shift inward by a factor of one half, and therefore the budget line shifts inward by one-half as well. Multiplying
both prices by two is just like dividing income by 2.

We can also consider price and income changes together. If both prizes go up and income goes down- if m
decreases and both p1 and p2 both increase, then the intercepts must both decrease. This means that the budget
line will shift inward.

The numeraire
The budget line is defined by two prices and one income, but one of these variables is redundant. We could
peg one of the prices, or the income, to some fixed value, and adjust the other variables so as to describe
exactly the same budget set. Thus the budget line

p1x1+p2x2 = m

is exactly the same budget line as

𝑝1 𝑚
𝑥1 + 𝑥2 =
𝑝2 𝑝2

Or
𝑝1 𝑝2
𝑥1 + 𝑥 =1
𝑚 𝑚 2

Since the first budget line results from dividing everything by p2, and the second budget line results from
dividing everything by m. In the first case, we’ve pegged p2 = 1, and in the second case, we’ve pegged m = 1.
Pegging the price of one of the goods or income to 1 and adjusting the other price and income appropriately
doesn’t change the budget set at all.

When we set one of the prices to 1, as we did above, we often refer to that price as the numeraire price. The
numeraire price is the price relative to which we are measuring the other price and income. It will occasionally
be convenient to think of one of the goods as being a numeraire good, since there will be one less price to
worry about.

Taxes, Subsidies and Rationing

Economic policy often uses tools that affect customer’s budget constraint, such as taxes. For example, if the
government imposes a quantity tax, this means that the consumer has to pay a certain amount to the
government for each unit of the good he purchases. In the U.S., for example, we pay about 15 cents a gallon as
a federal gasoline tax.

How does quantity tax affect the budget line of a consumer? From the viewpoint of the consumer, the tax is
just like a higher price. Thus, a quantity tax of t dollars per unit of good 1 simply changes the price of good 1
from p1 to p1+t. As we’ve seen, this implies that the budget line must get steeper.
Another kind of tax is a value tax. As the name implies this is a tax on the value – the price – of a good, rather
than the quantity purchased of a good. A value tax is usually expressed in percentage terms. Most states in the
U.S. have sales taxes. If the sales tax is 6%, then a good that is priced a $1 will sell for $1.06. Also known as
ad valorem taxes.

If good 1 has a price of p1, then the price facing the consumer is (1+T)p1. The consumer has to pay p1 to the
supplier and Tp1 to the government.

A subsidy is the opposite of a tax. In the case of quantity subsidy the government gives an amount to the
consumer that depend on the amount of good purchased. E.g. if consumption of milk were subsidized, the
government would pay some amount of money to each consumer of milk depending on the amount that
consumer purchased. If the subsidy is s dollars per unit of consumption of good 1, then from the viewpoint of
the consumer, the price of good 1 would be p1 – s. This would therefore make the budget line flatter.

Similarly, an ad valorem subsidy is a subsidy based on the price of the good being subsidized. If the
government gives you back $1 for every $2 you donate to charity, then your donations to are being subsidized
at a rate of 50%.

We see that taxes and subsidies affect prices in exactly the same way except for the algebraic sign. A tax
increases the price to the consumer, a subsidy decreases it.

Another kind of tax or subsidy that the government might use is a lump sum tax or subsidy. In the case of tax,
this means that the government takes away some fixed amount of money, regardless of the individual’s
behavior. Thus, a lump-sum tax means that the budget line of a consumer will shift inward, because his money
income has been reduced. Similarly, a lump-sum subsidy means that the budget line will shift outward.

Governments also sometimes impose

rationing constraints. This means that the level
of consumption of some good is fixed to be no
larger than some amount. This happened to
food during WW2.
Budget Line Changes
We observe that since the budget set doesn’t change when we multiply all prices and income by a positive
number, the optimal choice of the consumer from the budget set can’t change either. Without even analyzing
the choice process itself, we have derived an important conclusion: a perfectly balanced inflation – one in
which all prices and all incomes rise at the same rate – doesn’t change anybody’s budget set, and thus cannot
change anybody’s optimal choice.

Suppose the consumer’s income increases and all prices remain the same. We know that this represents a
parallel shift outward of the budget line. Thus every bundle the consumer was consuming at the lower income
is also a possible choice at the higher income. But then the consumer must be at least as well-off at the higher
income as the lower income – since he or she has the same choices available as before plus some more.
Similarly, if one price declines and all other stay the same, the consumer must be at least as well off.

Summary
1. The budget set consists of all bundles of goods that the consumer can afford at given prices and
income. We will typically assume that there are only two goods, but this assumption is more general
than it seems.
2. The budget line is given p1x1+p2x2 = m. Slope -p1/p2, a vertical intercept of m/p2 and a horizontal
intercept of m/p1.
3. Increasing income shifts the budget line outward. Increasing the price of good 1 makes the budget line
steeper. Increasing the price of good 2 makes the budget line flatter.
4. Taxes, subsidies and rationing change the slope and position of the budget line by changing the prices
paid by the consumer.
CHAPTER 3 – PREFERENCES
We saw in Ch.2 that the economic model of consumer behavior is very simple. People choose the best things
they can afford.

We call the objects of consumer choice consumption bundles. This is a complete list of the goods and
services that are involved in the choice problem that we’re investigating. The word “complete” deserves
emphasis: when you analyze a consumer’s choice problem, make sure that you include all of the appropriate
goods in the definition of the consumption bundle.

We’ll, however, often adopt the idea described earlier of using just two goods and calling one of them “all
other goods” so that we can focus on the tradeoff between one good and everything else. In this way we can
consider consumption choices involving many goods and still use two-dimensional diagrams.

Consumer Preferences
We will suppose that given any two consumption bundles, (x1,x2) and (y1,y2), the consumer can rank them as
to their desirability. That is, the consumer can determine that one of the consumption bundles is strictly better
than the other, or decide that she is indifferent between the two.

We will use the symbol ← to mean that one bundle is strictly preferred to another, so that (x1,x2) ← (y1,y2)
should be interpreted as saying that the consumer strictly prefers the bundles of x to y, in the sense that she
definitely wants the x-bundle rather than the y-bundle. This preference relation is meant to be an operational
notion. If the consumer prefers one, it means that she would choose it, given the opportunity.

The idea of preference is based on the consumer’s behavior. In order to tell, we see how the consumer behaves
in choice situations involving two bundles.

If the consumer is indifferent between two bundles, we use the symbol ~. Means that the consumer would be
just as satisfied, according to her own preferences.

If the consumer prefers or is indifferent, we say she weakly prefers.

These relations of strict preference, weak preference and indifference are not independent concepts. The
relations are themselves related.

Assumptions about Preferences

Economists usually make assumptions about the “consistency” of consumers preferences.

Axioms of consumer theory.

Complete. We assume that any two bundles can be compared. Given two bundles, we assume that one is
preferred over the other, or the case of the consumer is indifferent between the two bundles.

Reflexive. We assume that any bundle is at least as good as itself.

Transitive. If x-bundle is preferred over y-bundle and y-bundle is preferred over z-bundle, then we assume
that x is preferred over z. In other words, if consumer thinks that X is at least as good as Y and that Y is at
least as good as Z, then the consumer thinks that X is at least as good as Z.

The firs axiom, completeness is hardly objectionable, at least for the kinds of choices economists generally
examine. To say any two bundles can be compared is simply to say that the consumer is able to make a choice.

Reflixivity is trivial. Any bundle is certainly at least as good as an identical bundle.

Transitivity is more problematic. Isnt clear. Hypothesis about choice behavior, not a statement of pure logic.

Indifference Curves
It turns out the whole theory of consumer choice can be formulated in terms of preferences that satisfy the
three axioms described above, plus a few more technical assumptions. Indifference curves.

Consider this figure. Shaded area: weakly preferred set. Bundles on the boundary of this set – the bundles for
which the consumer is just indifferent – form the indifference curve.

We can draw an indifference curve through any consumption bundle we want. The indifference curve through
a consumption bundle consists of all bundles that leave the consumer indifferent to the given bundle.

One problem with using indifference curves to describe preferences is that they only show you the bundles the
consumer perceives as being indifferent to each other – they don’t show you which bundles are better or which
bundles are worse.

If we make no further assumptions, indifference curves can take very peculiar shapes indeed. Indifference
curves representing distinct levels of preference cannot cross.
Perfect Substitutes
Two goods are perfect substitutes if the consumer is willing to substitute one good for the other at a constant
rate. The simplest case of perfect substitutes occurs when the consumer is willing to substitute the goods on a
one-to-one basis.

The indifference curves have a constant slope.

Perfect Complements
Perfect complements are goods that are always
consumed together in fixed proportions. The
goods “complement” each other. Right shoes
and left shoes. Having only one doesn’t do any
good.

Adding 1 left shoe doesn’t do the consumer any

good, thus, the indifference curve are L shaped.
Bads
A bad is a commodity that the consumer
doesn’t like. Don’t like anchovies but
pepperoni. Tradeoff between. 1 anchovy on the
pizza gets compensated by 3 pepperonis.

Thus, the indifference curve slopes up and to

the right.

Neutrals
A good is a neutral good if the consumer
doesn’t care about it. Anchovies. He doesn’t
care about it. Only cares about the amount of
pepperoni.

Satiation
There is some overall best bundle for the
consumer, and the “closer” he is to that best
bundle, the better off he is. Satiation.

In this case, the curve has a negative slope when

the consumer has “too little” or “too much” of
both goods.
Discrete Goods
Usually we think of measuring goods in units where fractional amounts make sense – you might on average
consume 12.43 gallons of milk a month even though you buy it a quart at a time.

Demand for automobiles: We could define the demand for automobiles in terms of the time spent using an
automobile, so that we would have a continuous variable, but for many purposes it is the actual number of cars
demanded that is of interest.

Suppose x2 is money to be spent on other goods and x1 is a discrete good that is only available in integer
amounts. We have illustrated the appearance of indifference “curves” and weakly preferred set for this kind of
good. In this case the bundles indifferent to a given bundle will be a set of discrete points. The set of bundles at
least as good as a particular bundle will be a set of line segments.

Well-Behaved Preferences
Defining features for well-behaved indifference curves:

1. Assume that more is better, that is, that we are talking about goods, not bads. Monotonicity is saying
only that we are going to examine situations before a point is reached – before any satiation sets in –
while more still is better. Economics would not be a very interesting subject in a world where
everyone was satiated in their consumption of every good.
2. Monotonicity imply that indifference curves have a negative slope.
3. Assumption of convexity is the assumption of strict convexity. Weighted average of two indifferent
bundles is strictly preferred to the two extreme bundles.

Marginal Rate of Substituion

We will often find it useful to refer to the slope
of an indifference curve at a particular point.
This slope is known as the marginal rate of
substitution. (MRS)

The name comes from the fact that MRS

measures the rate at which the consumer is just
willing to substitute one good for the other.
Suppose that we take a little of good 1, Δx1,
away from the consumer. Then we give him
Δx2 which is an amount that is just sufficient
to put him back on his indifference curve, so
that he is just as well off after this substitution
of x2 for x1 as he was before. We think of the
ratio Δx2/Δx1 as being the rate at which the
consumer is willing to substitute good 2 for good 1. The marginal rate of substitution measures an interesting
aspect of the consumer’s behavior. Suppose that the consumer has well-behaved preferences. Monotonic and
convex.
CHAPTER 19 – TECHNOLOGY

Study of firm behavior. When a firm makes choices, it faces many constraints. Imposed by customers,
competitors and by nature.

Inputs and Outputs

Inputs to production are called factors of production. Land, labor, capital and raw materials.

Capital goods are those inputs to production that themselves produced goods. Capital goods are machines of
one sort or another: tractors, buildings, computers etc.

Sometimes capital is used to describe the money used to start up or maintain a business. Financial capital.

Physical capital are produced factors of production.

We will usually want to think of inputs and outputs as being measured in flow units. A certain amount of labor
per week and a certain number of machine hours per week will produce a certain amount of output per week.

Technological constraints
Only certain combinations of inputs are feasible ways to produce a given amount of output, and the firm must
limit itself to technologically feasible production plans.

The set of all combinations of inputs and

outputs that comprise a technologically
feasible way to produce is called production
set. The fucntion describing the boundary of
this set is known as the production
function. Measures maximum possible
output you can get from a given amount if
input.

In two-input cases, there is a convenient way

to depict production relations known as the
isoquant. An isoquant is the set of all
possible combinations of inputs 1 and 2 that are just sufficient to produce a given amount of output.

Similar to indifference curves. Indifference curves depicts the different consumption bundles.

Difference: Isoquants are labaled with the amount of output they can produce; not with a utility level. The
labeling of isoquants is fixed by the tech.

COBB DOUGLAS
If the production function has the form f(x1, x2) = Ax1ax1b, we say it is a Cobb-Douglas production function.
The parameter A measures the scale of production: How much output we would get if we used one unit of each
input.
PROPERTIES
1. Monotonic
a. If you increase the amount of at least one of the inputs, it should be possible to produce at
least as much output as you were producing originally.
b. Property of free disposal: if the firm can costlessly dispose of any inputs, having extra inputs
around can’t hurt it.
2. Convex
a. If you have two ways to produce y units, (x1 ,x2), (z1, z2), then their weighted average will
produce at least y units of output.

SUMMARY
The technological constraints of the firm are described by the production set, which depicts all the
technologically feasible combinations of inputs and outputs, and by the production function, which
gives the maximum amount of output associated with a given amount of the inputs.

Another way to describe the technological constraints facing a firm is through the use of isoquants –
curves that indicate all the combinations of inputs capable of producing a given level of output.

We generally assume that isoquants are convex and monotonic, just like well-behaved preferences.

The marginal product measures the extra output per extra unit of an input, holding all other inputs fixed.
We typically assume that the marginal product of an input diminishes as we use more and more of that
input

The technical rate of substitution (TRS) measures the slope of an isoquant. We generally assume that
the TRS diminishes as we move out along an isoquant – which is another way of saying that the isoquant
has a convex shape.

In the short run some inputs are fixed, while in the long run all inputs are variable.

Returns to scale refers to the way that output changes as we change the scale of production. If we scale
all inputs up by some amount t and output goes up by the same factor, then we have constant returns to
scale. If output scales up by more than t, we have increasing returns to scale, and if it scales up by less
than t, we have decreasing returns to scale.
MACRO
Chapter 9

Income in both the present and the future, Yt & Yt-1.

𝐶 𝑌
𝑡+1
𝐶𝑡 + 1+𝑟 𝑡+1
= 𝑌𝑡 + 1+𝑟 is the intertemporal budget constraint. The present value of discounted value of
𝑡 𝑡

the stream of consumption must equal the present discounted value of the stream of income.