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MICROECONOMICS_4.Budget Line

The document explains the concept of a consumer's budget constraint, which outlines the combinations of goods they can afford based on their income and prices. It discusses how changes in income and prices affect the budget line, and the conditions for achieving optimal consumption choices, including interior and boundary solutions. Additionally, it covers special cases like perfect substitutes and complements, as well as the income-consumption curve and Engel curve, which illustrate the relationship between income and quantity demanded of goods.

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吴小瑶 WYY
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2 views

MICROECONOMICS_4.Budget Line

The document explains the concept of a consumer's budget constraint, which outlines the combinations of goods they can afford based on their income and prices. It discusses how changes in income and prices affect the budget line, and the conditions for achieving optimal consumption choices, including interior and boundary solutions. Additionally, it covers special cases like perfect substitutes and complements, as well as the income-consumption curve and Engel curve, which illustrate the relationship between income and quantity demanded of goods.

Uploaded by

吴小瑶 WYY
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Microeconomics_ 4.

Consumer Budget line

Budget Constraint
A consumer's budget constraint represents all the possible consumption bundles they
can afford, which is determined by their income and the prices of the goods they wish
to purchase. Indeed, consumers can afford to purchase specific consumption
bundles, provided that its cost does not exceed the income for that period.
M(income) = Pc·C+PF·F

The budget line is a graphical representation of the budget


constraint, showing all the combinations of goods x and y that
the consumer can purchase with their income.
The slope of the budget line is equal to the negative of the price
ratio -Px/Py, which represents the opportunity cost of one good
in terms of the other (how many units of good y the consumers has to
forgo for one unit of good x)

The budget line divides the consumption space into two areas: the unaffordable
bundles (above the line) and the affordable bundles (below the line).

Changes in income and prices


The changes in income have impact slope does not change if the price of goods

on the budget line: an remains constant).

increase in income
shifts the budget line The change in price of one good
outward, allowing the rotates the budget line: if the price of x
consumer to afford decreases, the budget line rotates
more of both goods. On outward along the x-axis, making more
the contrary, a decrease in income of x affordable. If the price of x
shifts the budget line inward, reducing increases, the budget line pivots
the consumer's purchasing power. (The inward along the x-axis, making less of x
affordable

Equilibrium choice of consumers


Equilibrium analysis brings together preferences and the budget line, in order to explain
consumer's choice. Indeed, given income and prices, the consumer’s
equilibrium choice is an affordable bundle and the best choice
among all the affordable bundles.

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The consumer's optimal consumption choice is the affordable bundle of goods that
maximizes their utility given their budget constraint.

This choice is determined by the interaction of indifference curves


and budget line. The optimal choice occurs at the point where the
budget line is tangent to the highest possible indifference curve.
This tangency condition ensures that the consumer is maximizing
their utility given their budget.

Interior solution Vs Boundary solution


 Interior solution: when the optimal bundle includes positive amounts of both goods, it is c
which the consumer is willing to trade one good for another) equals the
price ratio (Px/Py).

 Boundary solution: when the optimal bundle includes zero units of one good, it is called a b
chooses to spend all their income on one good because the MRS does not
equal the price ratio at any interior point.

Conditions for interior solutions under declining MRS


The key condition for an interior solution is that MRS = price ratio.
1. Affordability: the optimal bundle must lie on the
budget line.

2. Tangency condition: at the optimal bundle,


the MRS must equal the price ratio: MRSEXY = px/py
Since the MRS is the slope of the indifference curve, and the price ratio is the slope of
the budget line, the indifference curve is tangent to the budget line.

Conditions for boundary solutions


In case of the boundary solution, the optimal bundle must lie
on the budget line and the MRS does not equal the price ratio.
1. Affordability: the optimal bundle
lie on the budget line.

2. Stability condition: MRS does not equal the price


ratio.

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MRSEXY ≥ px/py and yE=0 or MRSEXY ≤ px/py and xE=0

Special Cases
 Perfect substitutes: i.e. the consumer is willing to trade two goods at a constant rate.
The optimal choice is usually a boundary solution, where the
consumer spends all their income on the cheaper good (MRS > price
ratio) or on the more expensive good (MRS < price ratio).

 Perfect complements:
i.e. when two goods are valuable only when consumed together in fixed proportions.

The optimal choice occurs at the point where the budget line
intersects the ray through the origin that represents the fixed
proportion of the two goods (ex: left and right shoes).

Price-consumption curve

The price-consumption curve shows how the optimal


consumption bundle changes as the price of one good changes,
holding income and the price of the other good constant.

This curve helps us derive the individual demand curve, which shows the
relationship between the price of a good and the quantity demanded
by a consumer.
A change in the price can shift the demand for another good.
Indeed, if the price of good decreases, the demand for its
substitutes decreases, shifting the demand curve to the left.
On the contrary, if the price of a good decreases, the demand for its
complements increases, shifting the demand curve to the right.

Income-Consumption Curve

The income-consumption curve shows how the optimal consumption


bundle changes as income changes, holding prices constant.
This curve helps us determine whether a good is normal or inferior.

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 Normal goods: as income increases, the quantity demanded of a normal good
increases. The income elasticity of demand is positive ( EdM >0).
 Inferior goods: as income increases, the quantity demanded of an inferior good
decreases. The income elasticity of demand is negative ( EdM <0).
⚠️At least one good must be normal starting from any particular income level.
⚠️No good can be inferior at all levels of income.

Engel curve
The Engel curve shows the relationship between income and the quantity
demanded of a good, holding prices constant. For normal goods, the Engel curve
slopes upward, while for inferior goods, it slopes downward.

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