Topic 1 Budget

Question 1

What does the economics study?

Answer 1

The allocation of resources

Question 2

What is microeconomics centred around and how does this differ from macroeconomics?

Answer 2

Microeconomics is centred around individual and firm choices/behaviour, strategic behaviour, demand and supply, how markets work (what determines prices and allocations of goods and services as well as resources) and lastly policy interventions such as taxes

on a much smaller scale than macroeconomics which talks about aggregates (pooling data or information together on a much larger scale)

Question 3

What is analysis in microeconomics based on?

Answer 3

It is based on models which are simplified representations of the real world

Question 4

What do models make use of and why?

Answer 4

Models in economics make use of mathematics to keep them consistent - this also allows the estimating of parameters of the model using the data collected

Question 5

Do markets always work?

Answer 5

No markets do not always work - there are some circumstances in which they do and some in which they don’t

Question 6

How many types of equilibrium are there and what are they?

Answer 6

There are two types

1) Competitive market equilibrium
2) Nash equilibrium

Question 7

What is the competitive market equilibrium?

Answer 7

The price and quantity at which what consumers want to buy is the price and quantity at which producers want to sell - where the quantity demanded is equal to the quantity supplied and so is price

Question 8

What is the Nash equilibrium?

Answer 8

The idea that no one has anything to gain by changing behaviour/making a different choice or opting for a different strategy and that they should continue making the same choices/having the same behaviour/maintaining the same strategy

Question 9

What is the fundamental assumption underlying microeconomics analysis?

Answer 9

Every actor (consumer) chooses what is optimal for them among the options that are feasible (practical or affordable - subject to the budget constraint)

Question 10

In a competitive market, what must you remember about prices?

Answer 10

Sellers and buyers are price takers and have no bargaining power to change prices

Question 11

What letters are used to denote things and what do they mean?

Answer 11

n - number of available goods (normally assumed to be just 2 goods - apples and bananas for example)
p - prices for each good I.e p1 (1 in subscript denotes the price for good 1) - remember prices are linear (no discount for large purchases)
x - quantity of each good either bought or consumed I.e x1 (1 in subscript means that quantity consumed/bought of good 1)
m - income

Question 12

What do assume bundles to be?

Answer 12

As we often assume that there are just 2 goods, a bundle of goods (x1, x2, xn - quantities of goods 1, 2 and n) often becomes just a pair of goods I.e (x1, x2)

Question 13

How would you express the consumption/buying of 4 units of good 1 and 3 units of good 2?

Answer 13

As there are only 2 goods, n=2
x1 = 4, x2 = 3 (amount/quantity bought/consumed)

… bundle (pair) becomes vector (4,3)

Question 14

What does the budget constraint mean?

Answer 14

That the consumption of goods must be less than or equal to the available income (m)
…
p1x1 + p2x2 <= m

So the price * quantity of good 1 (expenditure on good 1) plus the price * quantity of good 2 (expenditure on good 2) must be less than the available income

Question 15

What does the budget line/budget constraint look like and how would you go about drawing it?

Answer 15

It is a straight line usually

You typically have x2 (quantity consumed of good 2) on the y-axis with the intersection with the axis being the maximum quantity consumable of good 2 given the income (so that value can be calculated by dividing the income (m) by the price of good 2 (m/p2) - this is a feasible/consumable bundle as you can consume 0 of good 1 and only consume good 2

The opposite on the x-axis is also the same where you would you have x1 (quantity consumed of good 1) - here again you would find the intersection of the budget line with this axis by dividing m (total income) by the price of good 1 (m/p1)

These 2 maximum points consumable for good 1 and 2 respectively would be joined by a straight line, the budget line

The triangular area contained by this line is known as the budget set which consists of available bundles which don’t use all the income available - only the bundles on the budget line cost the entire income available (m)

The budget line will have a negative gradient calculated by dividing the maximum quantity consumable of good 2 over the maximum quantity consumable of good 1 (change in y / change in x)

(Note that I don’t think matters too much on which axis you plot which good but I think best to stick to what they have done above)

Question 16

What would happen to the budget line and the budget set if the price of a good was to increase/decrease?

Answer 16

An increase in the price of good 1 (p1) would mean that if no units of good 2 were consumed (x2 = 0) then a consumer would be able to buy and consume less of good 1 (hence x2 would be smaller)

… if quantity of good 1 (x1) is drawn on the x-axis, then the maximum quantity consumable of good 1 (denoted by the intersection with the x-axis) would become smaller and hence the budget line would become steeper leading to a smaller budget set (fewer consumable bundles)

The opposite would be true is the price of good 1 (p1) drawn on the x-axis decreased

NOTE - the axis on which a good is drawn is very much relevant to the explanation above (above explanation assumes that x1 drawn on x-axis and x2 drawn on y-axis) - if asked in exam also do the same to minimise any confusion

Question 17

What would happen to the budget line and the budget set if the income of the consumer was to increase/decrease?

Answer 17

An increase in income, assuming no change in the price of good 1 and 2 (p1 and p2) - ceteris paribus, would mean the maximum quantities consumable of both good 1 and 2 (x1 and x2) would increase hence causing the budget line to shift outwards and the budget set to increase in triangular area (meaning that there are more consumable bundles available to the consumer)

Question 18

What would happen to the budget line and the budget set if there was a currency change?

Answer 18

If the currency of a nation strengthened or weakened then this would have the same proportionate affect on both prices and income and hence no change overall - the budget line would remain the same and so would the budget set

Question 19

What is another way in which the budget constraint may be written?

Answer 19

The normal budget constraint:
p1x1 + p2x2 <= m

If you were to divide the budget constraint equation above by p1 you would get:
x1 + p2/p1*x2 <= m/p1

This can further be simplified by writing it as the following:
x1 + p (with hat on top ^)*x2 <= m (with hat on top ^)

So essentially you have used p1 to find p hat ^ which is represents the relative price of the second good over the first and m hat ^ which represents relative income (how many units of good 1 can a consumer buy)

… the equation: x1 + p (with hat on top ^)*x2 = m (with hat on top ^) treats good 1 as numeraire good which just means that the price of good 1 is used to find the relative price of good 2 as well as relative income