1b. budget constraint Flashcards
What is the “opportunity set”?
all the bundles a consumer can buy, including all the bundles inside the budget constraint and on the budget constraint.
What is the “budget line”?
the bundles of goods that can be bought if the entire budget is spent on those goods at given prices.
What is the equation of the budget constraint?
What are some assumptions for a basic analysis of the consumer’s problem?
- Prices are fixed — no negotiation
- We can buy as much as we want of something without driving the price up (because of an increase in demand)
- There is no saving or borrowing, only buying
What is the slope of the budget line also called?
MRT - Marginal Rate of Transformation
How would you go about finding the equation for this budget line L1?
Y = 50, pZ = $1, pB = $2
So the budget constraint is:
Y = (pB * B) + (pZ * Z)
So rearrange for B
B = (Y / pB) - (pZ / pB) * Z
Plug in the variables
B = (50/2) - (1/2)Z
This basically shows that if the consumer purchases one more unit of Z, they must reduce the consumption of B by -1/2 to stay within budget.
So, the slope is delta B / delta Z, which is also called the marginal rate of transformation (MRT), which is -(pz/pb) and thus -1/2
What happens to this budget line if the price of pizzas doubles?
(a)
price of burrito remains $2, but pizza price increases from $1 to $2
The slope of the budget line increases from -1/2 to -1 (as - pZ/ pB is now -1)
What happens to this budget line if the consumers income doubles?
(b)
If the consumers income increases from 50 to 100 the slope of the curve remains the SAME, but the curve shifts outwards
-> The area between the previous income curve and the new income curve is called the “gain”
What is the optimal bundle (consumer maximisation) on this graph?
-> C and A are both affordable, and on the first indifference curve
-> E is on the higher indifference curve, I2, AND it is within my budget, therefore it is the BEST decision I can take
(Point F is obviously even better, as it is on the highest indifference curve, but it is BEYOND the budget curve)
What should a consumer do to MAXIMISE their utility?
To maximise your utility, you choose the combination of S and Z (The bundle), where the slope of the indifference curve is the SAME as the budget curve.
How do you express the condition for optimality?
MRS = slope of indifference curve
MRT = slope of budget line
So where the slope of indfference curve EQUALS the slope of the budget line
What does the condition of optimality really “mean”?
This means that the marginal utility per dollar spent on pizzas (Z) is equal to the marginal utility per dollar spent on sushi (S).D
What is a corner solution?
Occurs when a consumer really prefers one good over another that they ONLY buy the preferred good…
In this case, the consumer the optimal bundle, E, is where they consume 25 burritos and no pizzas,
The budget line and this indifference curve only touch once, at the top corner
-> hence why it is called a CORNER SOLUTION
