Scribd
Upload
21 views

Chapter Two: Budgetary and Other Constraints On Choice

The document discusses budget constraints and how they determine the set of affordable consumption bundles for a consumer given prices and income. It defines the budget set as all bundles where spending is less than or equal to income. The budget constraint is the upper boundary of this set. For two goods, the constraint is a line with slope equal to the negative price ratio. The budget set expands when income rises or a price falls, and contracts when income falls or a price rises. A uniform sales tax shifts the constraint inwards, reducing purchasing power.

Uploaded by

rushid
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
21 views

Chapter Two: Budgetary and Other Constraints On Choice

The document discusses budget constraints and how they determine the set of affordable consumption bundles for a consumer given prices and income. It defines the budget set as all bundles where spending is less than or equal to income. The budget constraint is the upper boundary of this set. For two goods, the constraint is a line with slope equal to the negative price ratio. The budget set expands when income rises or a price falls, and contracts when income falls or a price rises. A uniform sales tax shifts the constraint inwards, reducing purchasing power.

Uploaded by

rushid
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 20

Chapter Two

Budgetary and Other


Constraints on Choice
Budget Constraints
 Q: When is a consumption bundle
(x1, … , xn) affordable at given prices
p1, … , pn?
 A: When the cost of the bundle
p1x1 + … + pnxn  m
where m is the (disposable) income
level of the consumer.
Budget Constraints
 The consumer’s budget set is the set
of all affordable consumption
bundles;
B(p1, … , pn, m) =
{ (x1, … , xn) | x1  0, … , xn 0 and
p1x1 + … + pnxn  m }
 The budget constraint is the upper
boundary of the budget set.
Budget Set and Constraint for
x
Two Commodities
2
Budget constraint is
m /p2
p1x1 + p2x2 = m.

m /p1 x1
Budget Set and Constraint for
x
Two Commodities
2
Budget constraint is
m /p2
p1x1 + p2x2 = m.
Not affordable
Just affordable
Affordable

m /p1 x1
Budget Set and Constraint for
x
Two Commodities
2
Budget constraint is
m /p2
p1x1 + p2x2 = m.

The budget set is the collection


of all the affordable bundles.
Budget
Set
m /p1 x1
Budget Constraints
 Forn = 2 and x1 on the horizontal
axis, the slope of the budget
constraint is -p1/p2. What is the
interpretation of this slope?
p1 m
x2   x1 
p2 p2
 Soincreasing x1 by 1 must reduce x2
by p1/p2.
Budget Constraints
x2
Slope is -p1/p2

p1/p2
1

x1
Budget Constraints
x2
So the opp. cost of an extra unit of
commodity 1 is p1/p2 units
foregone of commodity 2.
-p1/p2
+1

x1
How do the budget set and budget
constraint change as income m
x2 increases?

Original
budget set
x1
Higher income gives more choice
x2 New affordable consumption
choices
The original and
the new budget
constraints are
parallel (same
Original slope).
budget set
x1
How do the budget set and budget
constraint change as income m
x2 decreases?
Consumption bundles
that are no longer
affordable.
Old and new
New, smaller constraints
budget set are parallel.
x1
Budget Constraints - Income
Changes
 Since no original choices are lost
and new choices are added when
income increases, an income
increase cannot make the consumer
worse off.
 But an income decrease may
(typically will) make the consumer
worse off.
How do the budget set and budget
constraint change as p1 decreases
x2 from p1’ to p1”?
m/p2
New affordable choices

-p1’/p2

Original
budget set
m/p1’ m/p1 x1
”
How do the budget set and budget
constraint change as p1 decreases
x2 from p1’ to p1”?
m/p2
New affordable choices
Budget constraint
-p1’/p2 pivots; slope flattens
from -p1’/p2 to
Original
-p ”/p -p1”/p2
1 2
budget set
m/p1’ m/p1 x1
”
Budget Constraints - Price
Changes
 Soreducing the price of just one
commodity pivots the budget
constraint outward. No old choices
are lost and new choices are added,
so reducing one price cannot make
the consumer worse off and typically
makes her better off.
Budget Constraints - Price
Changes
 Similarly,
increasing just one price
pivots the budget constraint inwards,
reduces choice and may (typically
will) make the consumer worse off.
Uniform Ad Valorem Sales Taxes
 An ad valorem sales tax levied at a
rate of 5% increases all prices by 5%,
from p to (1+005)p = 105p.
 An ad valorem sales tax levied at a
rate of t increases all prices by tp
from p to (1+t)p.
 A uniform sales tax is applied
uniformly to all commodities.
Uniform Ad Valorem Sales Taxes
 Soa uniform sales tax levied at rate t
changes the budget constraint from
p1x1 + p2x2 = m
to
(1+t)p1x1 + (1+t)p2x2 = m
which is the same as
p1x1 + p2x2 = m/(1+t).
Uniform Ad Valorem Sales Taxes
x2
m p1x1 + p2x2 = m
p2
m p1x1 + p2x2 = m/(1+t)
(1  t ) p2

m m x1
(1  t ) p1 p1

You might also like