Consumer Preference: Budget Constraint

Question 1

What is the economic theory of the consumer based on ?

Answer 1

The best bundle of goods he/she can afford.

Question 2

What is the equation that shows the limitation on what consumers can buy

Answer 2

Let: x= amount of good X.
Y= amount of good Y. 
Px= price of good X
Py= price of good Y. 
M= disposable income
XPx + YPy= M

We can rearrange this to get the budget constraint:
Y=M/Py+X.Px/Py

Question 3

What is the budget constraint ?

Answer 3

All the bundles on a linear graph that cost exactly the income

Question 4

What is the slope and y intercept of the budget constraint ?

Answer 4

Slope= Px/Py
Y intercept= M/Py

The y intercept shows how much goods of Y the consumer can buy if all income is spent on good Y.

The slope of the graph represents the marginal rate of substitution: how much of good y is the consumer willing to give up for and additional unit of x.

Question 5

How does changes in income change the budget constraint ?

Answer 5

It changes the y and x intercept but the slope remains constant

Question 6

How does changes in prices of good x or y change the budget constraint ?

Answer 6

It changes the slope of the budget constraint by changing the relevant intercept.

Question 7

Why does consumer choice preference only use two goods ?

Answer 7

For simplification.
One of the goods can represent a numeraire which means it can represent a number of goods or even money. This is also known as a composite good.

Question 8

What is a utility function ?

Answer 8

Consumer preference in terms of units of each good