Budget Constraint

Question 1

What are Budget Constraints? How do they work? What is included?

Answer 1

• Constraints are objective and preferences are subjective
• Consumption Bundles contain some of one good and others of another (x1, x2…xn)
• Commodity prices are denoted by price vectors (p1, p2…pn)

Question 2

When is a bundle affordable

Answer 2

• p1x1 + p2x2 + … </= m
• Where m is disposible income

Question 3

What is a budget set? What is the slope/intercept (only 2 goods) ?

Answer 3

• The consumer’s budget set is the set of all affordable bundle
• p1x1 + p2x2 = m is the consumption bundle with only two goods
• The slope is -p1/p2
• The intercepts are m/p2 and m/p1
• Number of bundles = number of dimensions

Question 4

What is the equation of the budget constraint (y=mx+c form) ? What does this mean in terms of opportunity cost?

Answer 4

• x2 = (-p1/p2)x1 + m/p2
• If x1 increases by 1, x2 would reduce by p1/p2
• The Opportunity Cost of an extra unit of good 1 would be p1/p2 units of x2

Question 5

What are the two things that affect Budget Sets/Budget Constraints?

Answer 5

• Price
• Income

Question 6

How do increases/decreases in m affect budget lines?

Answer 6

• If m increases/decreases, the budget line shifts outwards/inwards

Question 7

How do increases/decreases in p affect budget lines?

Answer 7

• If p increases/decreases, the budget line would become steeper/flatter

Question 8

What is an ad-valorem sales tax? What would this mean for the budget constraint?

Answer 8

• An ad-valorem tax increases all goods at all prices by (1+t) rate
• If the budget constraint was:
  p1x1 + p2x2 = m
• Then the budget constraint is:
  (1+t)p1x1 + (1+t)p2x2 = m,
• meaning:
  p1x1 + p2x2 = m/(1+t)
• This would reduce m by the tax rate (Budget Constraint shifts inwards by [mt / 1+t])

Question 9

What is the effect of a ration on good x1?

Answer 9

• The budget constraint would continue as normal and then would stop at x̄1 and become vertical

Question 10

What is the effect of a price levy on good x1?

Answer 10

• The budget constraint continues as normal and then will steepen after x̄1 to discourage consumption

Question 11

What is numeraire? What does it mean?

Answer 11

• Numeraire is the Unit of Account
• Changing the Numeraire doesn’t change the budget constraint or the budget set