2 - budget constraints

Question 1

what is a consumption choice set?

Answer 1

A consumption choice set is the collection of all consumption choices available to the consumer.

Question 2

what constrains consumption choice?

Answer 2

Budgetary, time, calories, and other resource limitations

Question 3

what is a budget set?

Answer 3

the set of all affordable bundles

Question 4

what is a budget line?

Answer 4

the line connecting all the consumption bundles on which the whole budget is spent

Question 5

what is the equation of the budget line?

Answer 5

x2=M/P2 - P1*x1/P2

Question 6

what is the equation of the budget line slope?

Answer 6

• p1/p2

Question 7

what does the slope of the budget line represent?

Answer 7

it measures the opportunity cost of consuming good 1

Question 8

what is the numeraire price?

Answer 8

it is the price relative to which we are measuring the other price and income

Question 9

what occurs to the budget line when there is an increase in income?

Answer 9

when there is an increase in income there is a parallel shift outward of the budget line

Question 10

what occurs to the slope of the budget line when there is an increase in income

Answer 10

the slope is unaffected by an increase in incoem

Question 11

what occurs when there is an increase in the price of good 1 but good 2 and M remain the same?

Answer 11

good 1 will become relatively more expensive and therefore it is possible to buy the smaller quantity of good 1 with same income. therefore the budget line will rotate around the good 2 axis causing the budget line to intersect at a smaller quantity of good 1. the slope will increase as p1/p2 will be greater as p1 has increased whilst p2 is the same

Question 12

what is a quantity tax?

Answer 12

suppose consumer has to pay a fixed amount of tax per each unit of product bought

Question 13

what occurs to the budget line when there is a quantity tax?

Answer 13

suppose the consumer has to pay a fixed amount of t per each unit of product 1 bought then the price of product 1 will increase from p1 to p1+t. as a result the budget line will rotate around good 2 axis and will intersect the good 1 axis as a lower quantity. the curve will be steeper

Question 14

what occurs to the budget line when there is a subsidy?

Answer 14

suppose the consumer has a subsidy of size s on each unit of product 1 bought. this will mean the price they are paying is equal to p1 - s . as a result, there will be a rotation along the good 2 axis and cause the good 1 axis intercept to be greater. this will result in a flatter slope

Question 15

what is an ad valorem tax?

Answer 15

consumers pay extra percentage on the price

Question 16

how will an ad valorem tax on good 1 affect the slope of the budget line?

Answer 16

the price of good 1 will change from p1 to p1(1+t) meaning the slope of the budget line will change to p1(1+t)/p2

Question 17

what occurs to the budget line when a VAT is introduced for all goods>

Answer 17

if a uniform VAT of 20% is added to all goods, then the price of all goods will increase by 1.2 x . as a result, there will be an inward shift of the budget line resulting in the new intercepts being M/[p2(1+t)] for the x2 axis and M/[p1(1+t)] for the x1 axis. however the slope of the budget line will remain the same as the vat will cancel out leaving only p1/p2 as the slope

Question 18

what occurs to the budget line if the prices depend on the quantity bought ie bulk discount?

Answer 18

if the prices depend on the quantity bought then the budget constraint will no longer be a linear function

Question 19

how can you represent a bulk discount on a budget line?

Answer 19

you can show it by a kinked budget line. assume there is a bulk discount on good x so up to 20 goods it costs 2 pounds but after 20 it costs 1 pound. this will result in the slope halving in steepness at 20 goods of good x1

Question 20

how can you show rationing constraints on a budget line?

Answer 20

you can show rationing on a budget line by the budget line decreasing at a fixed rate until the rationing limit has been reached then no more of the good can be consumed so as a result the line is straight down to the axis