Week Three: Budget Constraints Flashcards
What are the goals of bugdet bundles?
Understand human behavior, understanding factors influence it
Assumptions:
- Preferences stable over time
- Perfectly competative markets
Assumptions for budgets:
Assumptions:
- Preferences stable over time
- Perfectly competative markets
Core Postulate for indifference curves
🧙🏼 Core Postulate: People do the best they can with what they have (optimize output with a cost constraint)
- Rely changes in incentives to explain changes in preferences
- Changes in incentives represents consumer budget constraint changes
Choice set and Budget Constraints:
Choice set: “collection all consumption choices avalaible”
- Prices: (p_1, p_2), and total amount of money to spend $m$
Budget Constraint: p_1x_1+p_2x_2 >= m
So affordable bundle is not more than m
Types of Constraints: (1) time, (2) income, (3) imperfect memory, and (4) calculations`
What is a consumption bundle?
Consumption bundle (x_1,x_2) depicting two goods to choose from
- Denote vector: x_1, x_2, …,x_n
- Commodity Prices: p_1, p_2,…,p_n
Budget Constraint assuming two goods?
Two-good assumption more general: often seen as one good vs. all else consumer wants to consume
New Budget Constraint: p_1x_1+x_2 >= m, where p_1x_1 is the amount spent on good one, x_2 is the money spent all other goods
- Good x_2 → composite good
What is the budget line?
Budget Line set of bundles (exactly exhausts consumer’s income) costs exactly m:
p1x1 + p2x2 = m
Alternatively: (Not exhaust income)
p_1x_1 +p_2x_2 >= m
- Horizontal Intercept: =m/p_1 (When you spend all your money on good one)
- Vertical Intercept = m/p_2 (When you spend all your money on good two)
What are the intercepts on the budget line?
Alternatively: (Not exhaust income)
p_1x_1 +p_2x_2 >= m
- Horizontal Intercept: =m/p_1 (When you spend all your money on good one)
- Vertical Intercept = m/p_2 (When you spend all your money on good two)
What is the slope of the bugdet line and its relation to relative price:
Therefore, Slope of Budget Line:
(Slope \equiv Relative Price)
m = -p1/p2
Slope of line measures opportunity costs of consuming goods
Relative prices: sets the good one in terms of good two
What assumptions about markets are made?
Assume: Perfectly competative market → consumers are price takers
What is the Budget Set?
<aside>
🧙🏼 **Budget Set** set of all affordable consumption bundles
</aside>
Alternatively: Set of all (x_1, x_2) that: x1>0, x2>0 and p1x1 + p2x2 >= m
How does the Budget set relate to opportunity cost?
Opportunity Cost: Relative price of good one in terms of good two
(Increase x_1 by 1 must reduce x_2 by p_1/p_2)
Measures resources in terms of best alternative useage
Zero sum game
Normal vs. relative prices
🧙🏼 Normal price: measure rate consumer gives up currency to aquire a unit of good
🧙🏼 Relative prices: measure rate which consumer can exchange one good for another (unit of goods and not currency)
Budget line changes
When income changes?
(Assumption) More is always better
Budget line changes
When price changes?
When price changes?
- Reduce price: constant outwards
No old choices lost and more are added
Better off
- Increase price: shift inwards
Less choices than before
Worse off
