Topic 2 - The Budget Constraint Flashcards
Consumer theory
Assumed consumers choose the best bundle they can afford.
Consumption bundle
X = (x1, x2)
x1= quantity of good 1
x2= quantity of good 2
How to calculate the budget constraint?
m= p1x1 + p2x2
m = income
p1 = price of good 1
p2 = price of good 2
x1 = quantity of good 1
x2= quantity of good 2
Budget set
Budget set consists of all bundles that are affordable at the given prices and income.
Two good assumption
Despite the fact we assume there are two goods. One good e.g. x2 could actually just be money spent somewhere else. A composite good measured in £. Good 2 is a numeraire. Budget set would become m >/= p1x1 + x2
Bundles on a budget line cost?
m (income) exactly
Vertical intercept
m/p2
Slope
-p1/p2. The opportunity cost of good 1. Quantity of good 2 that must be given up.
Horizontal intercept
m/p1
3 elements to calculate the budget line
There are three elements to calculate the budget line however 2 will be sufficient.
Vertical intercept m/p2
Horizontal intercept m/p1
Slope -p1/p2
Increasing income
Budget line shifts parallel outwards
Increasing price
Budget line become steeper
quantity (specific tax)
Tax paid on each unit bought.t= tax.
P1’ = p1 + t
Value (ad valorem) tax
This is paid as a proportion of the price. e.g. VAT
P1’ = (1+t) p1
Subsidy
The opposite of a tax.
