Consumer Theory - Budget Constraints and Optimal Choice I

Question 1

What are linear Budget Constraints?

Answer 1

Expenditure Allocation constrained by price and income (these factors exogenous)

PxX + PyY equal to or less than M (Income)

Px - Price of good x
X - Quantity of good x

Py - Price of Good Y
y - Quantity of Good Y

Question 2

What does an increase in income and reduction in prices look like for budget constraints?

Answer 2

SEE Y1 GRAPHS

Question 3

What is an Interior Solution?

Answer 3

Where Optimal Points involves the consumer buying positive amount of both points

Means marginal utility per pound equal for both goods

Question 4

How do you calculate MRT? (Marginal Rate of Transformation)

Answer 4

• Px/Py

- Means negative

Question 5

What is the tangency condition?

Answer 5

MRS=MRT

Question 6

How do you calculate Optimal Choices?

Answer 6

STEP 1:
Find Optimal ratio of 2 goods

STEP 2:
Insert Optimal Ratio into budget constraint

SIDE NOTE:Through non-satiation, we know the consumer will want to spend all their
income

Question 7

What is a Corner Solution?

Answer 7

A situation where no corner solution can be reached as MRT does not equal MRS in any possible point

Its where the optimal quantity of one of the goods is zero and where MRS is either greater or less than MRT

Question 8

When can a Corner Solution happen?

Answer 8

i) the price of a good is very high (e.g. Ferrari’s), (MRSMRT)

I.E Budget Constraint too steep or too shallow

SEE DIAGRAM FOR BOTH CASES

Question 9

How do you calculate a Corner Solution?

Answer 9

STEP 1: Calculate MRS and MRT

STEP 2: Identify whether MRS or MRT is greater
- If MRSMRT then X=O units so all units into Y

Question 10

What are some Non-linear budget constraints?

Answer 10

Rationing
Staggered Pricing (e.g. Gas and Electricity Tariffs)
Non-Linear Pricing (e.g. Photo prints, Photocopying, Bulk Purchasing)

SEE Y1 GRAPHS