Introduction and

Budget Constraint
Dr. Roberto Veneziani
ECN 111 Microeconomics 1
Lecture 1
1

PLEASE TURN MOBILE

PHONES OFF!

 A little bit about myself

and about the rules of the game

 Aim
Overview the theory of consumer behaviour

Objectives
Become familiar with the maximisation of
utility using indifference curves and budget
constraints to model consumer choice
Grasp the concepts of market demand and
elasticities
Understand how we can expand this
framework to consider choice over time
Understand how demand and supply are
brought together to determine price and
quantity in a market

Topics
Week
Week
Week
Week
Week
Week
Week
Week
Week
Week
Week
Week

1 Introduction & Budget constraint

2 Preferences
3 Utility
4 Choice
5 Demand
6 Slutsky Equation
7 Reading Week
8 Intertemporal Choice
9 Consumer Surplus
10 Market Demand
11 Equilibrium
12 Summary and Revision
5

Textbooks
H. Varian, Intermediate Microeconomics,
Norton, 9th ed., 2014
Available from campus bookstore

Workbook: H. Varian and T. Bergstrom,

Workouts in Intermediate Microeconomics,
Norton.
Available from campus bookstore

Assessment
Two tests during the semester.
They will count 30% towards your
overall mark for the course.
There will be a final exam. The
final exam takes the form of a twohour paper and is counting for 70%
of the overall course mark.

Problem Sets
There will be weekly problem sets.
We will go over the solutions in classes.
SOLUTIONS WILL NOT BE POSTED ON THE
WEB, SO COME TO CLASS!
If you miss a class, then ask classmates for
solutions, come to office hours to review
questions you had trouble with, ask in the next
class if time permits.

But, you should work on them

independently (or with peers) before class!
8

Office Hours
I will have office hours on Tuesdays
15:00-17:00 in W308. Please feel free
to stop by!
If you have questions and absolutely
cannot make the scheduled office
hours, then please email me. I am
pretty good with email and will
respond as soon as possible.
9

Consumer Decision Model

Taking his constraints into account,
individual attempts to reach highest
feasible level of satisfaction.
Preferences what the
individual wants to do

Budget Constraint what

he can afford to do

Decision

10

Budgetary Constraints
(Varian, chap.2)

11

Budget Constraints Notation

m = Income of the Individual
(sometimes see Y or I used)
K types of goods that an individual
can buy
x1, x2, , xk are the quantities of each of
the k goods purchased
p1, p2,,pk are the prices of those goods

12

Budget Constraints
Assumptions

Make it easier to present the model.

Relaxing the assumptions would not alter
basic results.
1. Assume income (m) is exogenous.
Income is a given in the model. The individual
does not decide how much to work.

2. Assume no saving or borrowing and that

all goods are consumed when purchased.
No stockpiling.
For now, abstracting from intertemporal
decisions. Just 1 time period.
13

Budget Constraints
Assumptions

3. Assume only two goods. Common to label

them x1 and x2 or x and y.
Primarily for convenience. Much easier to
draw two dimensional graphs!
Can also define one of the goods to be a
bundle of all other goods . (not actually very
restrictive assumption)

4. Assume the consumer is a price taker.

. Each consumer faces a budget constraint.
They cant spend more than their income.
14

Budget Constraint
Amount spent = Amount earned
(income).
Budget constraint for two
commodities:
p1x1 + p2x2 = m

More generally, for k commodities:

p1x1 + p2x2 ++ pkxk = m
15

Budget Set and Constraint for Two

Commodities
x2
Budget constraint is
m /p2
p1x1 + p2x2 = m.

m /p1

x1
16

Budget Set and Constraint for Two

Commodities
x2
m /p2

Budget constraint is
p1x1 + p2x2 = m.

m /p1

x1
17

Budget Set and Constraint for Two

Commodities
x2
m /p2

Budget constraint is
p1x1 + p2x2 = m.
Just affordable

m /p1

x1
18

Budget Set and Constraint for Two

Commodities
x2
m /p2

Budget constraint is
p1x1 + p2x2 = m.
Not affordable
Just affordable
Affordable

m /p1

x1
19

Budget Set and Constraint for Two

Commodities
x2
m /p2

Budget constraint is
p1x1 + p2x2 = m.

Budget
Set

the collection of all

affordable/feasible
bundles.
m /p1

x1
20

Budget Set and Constraint for Two

Commodities

x2

m /p2

p1x1 + p2x2 = m is
x2 = m/p2 -(p1/p2)x1
so slope is -p1/p2.
Budget
Set
m /p1

x1
21

What does the slope of the budget

constraint tell us?
Recall that slope = -p1/p2
The slope indicates the rate at which the
market permits you to substitute one good for
another.
Let p1=$2 and p2 =$3, then slope = -2/3.
For every unit of x1 you give up, you get 2/3 unit
of x2.
Or give up 2 units of x2 to get 3 units of x1.
px/py is the price of x in terms of y.
The price of one unit of x1 is 2/3 units of x2.

Can think of slope as opportunity cost of

consuming good 1.

22

CONCEPT REVIEW QUESTIONS

Peter spends his income on two
goods chips and beer.
Chips cost 2 pounds per unit and
beer costs 1.5 pounds per unit.
His income is 20 pounds.

23

What is Peters budget

constraint?
1.
2.
3.
4.

2B + 1.5C = 20
2B + 1.5C = 10
1.5B + 2C = 20
None of the above

24

If beer is on the x-axis and chips are

on the y-axis, what is the x-intercept?
1.
2.
3.
4.

10
13.33
1.5
2

25

What is the slope of the budget

constraint?
1.
2.
3.
4.

0.75
1.333
2
None of the above

0%
0%
0%
0%

26

How do the budget set and budget

constraint change as income m
increases?
x2

Original
budget set
x1
27

Higher income gives more choice

x2
m /p2

New affordable consumption

choices
Original and
m /p2
new budget
constraints are
parallel (same
slope).
Original
budget set
m /p1 m /p1 x1
28

How do the budget set and budget

constraint change as p1 decreases from
p1 to p1?
x
2

m/p2
-p1/p2
Original
budget set
m/p1

m/p1
29

x1

How do the budget set and budget

constraint change as p1 decreases from
p1 to p1?
x
2

m/p2

New affordable
choices
-p1/p2
Original
budget set
m/p1

m/p1
30

x1

How do the budget set and budget

constraint change as p1 decreases from
p1 to p1?
x
2

m/p2

New affordable
choices
Budget constraint
-p1/p2
pivots; slope flattens
from -p1/p2 to
Original
-p1/p2
-p1/p2
budget set
m/p1

m/p1
31

x1

 BC2 price of x2
increases
BC3 price of x2
x2decreases

BC2 price of x1
increases
BC3 price of x1
x2
decreases

BC3
BC2

BC1

BC3
BC1
BC2

x1

x1
32

Economic Policies and the Budget

Constraint
Taxes, subsidies, and rationing.
Quantity tax or per unit tax consumer pays
certain amount to government for each unit
purchased.
U.S. gasoline tax is on per gallon basis.

Value or Ad Valorem tax - tax on the price of a

good usually expressed in percentage terms.
Sales tax is typical example.

Lump sum tax - fixed amount of money,

regardless of consumers behavior.
Quantity subsidy, ad valorem subsidy, lump sum
subsidy.
33

Quantity or Per Unit Tax

p10 = price of x1 before tax
p11 = p10 + t = price of x1 after tax
Tax effectively increases the price of x 1.
The budget constraint rotates in (gets steeper)!
Quantity or per unit subsidy effectively
decreases the price of x and the budget
constraint rotates out.

34

Uniform Ad Valorem Sales Taxes

A uniform sales tax (applied to both
goods 1 and 2) levied at rate t
changes the constraint from
p 1x 1 + p 2x 2 = m
to
(1+t)p1x1 + (1+t)p2x2 = m
i.e.
p1x1 + p2x2 = m/(1+t).
What effect does this have on the
budget constraint?

35

Uniform Ad Valorem Sales Taxes

x2

m
p2

p1x1 + p2x2 = m

m
p1

36

x1

Uniform Ad Valorem Sales Taxes

x2

m
p2

m
(1 t ) p2

p1x1 + p2x2 = m
p1x1 + p2x2 = m/(1+t)

m
(1 t ) p1

m
p1

37

x1

Ad Valorem Sales Tax Applied to

Just One Good
Consider sales tax on good x1 levied
at rate t
Changes the constraint from
p 1 x 1 + p 2x 2 = m
to
(1+t)p1x1 + p2x2 = m
Like the per unit sales tax, this is just
an increase in the price of good x 1.
The budget constraint will rotate in.
38

Lump Sum Tax or Subsidy

Acts like a change in income.
Slope doesnt change since relative
prices havent changed.
Budget line shifts in for lump sum
tax.
Budget line shifts out for lump sum
subsidy.

39

Review question: A per unit subsidy

for the good on the y-axis will rotate
the budget constraint in?
1. True
2. False

40

Rationing Constraints
Consumption of some
good is fixed to be no
larger than some
amount

x2

butter and meat in WWII

What if ration good 1

so that you can
consume no more than
x1*?

Original
budget set
x1
41

Rationing Constraints
Part of the budget
x
set gets lopped off. 2

New
budget
set
x1 *

x1
42

The Food Stamp Program

How does food stamp program affect consumer
behavior?
U.S. food stamp program
Type of in-kind transfer
19 million participants in 1985 and cost > $11 billion
Almost 26 million participants in 2005 and cost >
$28 billion

Lets consider a very simplified food stamp

program.
Suppose family with income of $100 per
week gets 40 food stamps.
These can only be used to purchase food and
not all other goods.
43

The Food Stamp Program

G

F + G = 100: before stamps.

100

Note: Can either think of

prices of F and G as equal to
one or that F is the total
amount spent on F and G is
the total amount spent on G

100

F
44

The Food Stamp Program

G

F + G = 100: before stamps.

100

Budget set after 40 food

stamps issued.

40

100 140

F
45

The Food Stamp Program

G

F + G = 100: before stamps.

100

Budget set after 40 food

stamps issued.
The familys budget
set is enlarged.
40

100 140

F
46

The Food Stamp Program

G

F + G = 100: before stamps.

Budget constraint after 40
food stamps issued.
Budget constraint with
black market trading.

120
100

40

100 140

F
47

Shapes of Budget Constraints Quantity Discounts

Suppose p2 is constant at $1 but that
p1=$2 for 0 x1 20 and p1=$1 for
x1>20. Then the constraints slope is
- 2, for 0 x1 20
-p1/p2 =
- 1, for x1 > 20
and the constraint is

48

Shapes of Budget Constraints with a

Quantity Discount
x2

100

m=
Slope = - 2 / 1 = - 2 $100
(p1=2, p2=1)
Slope = - 1/ 1 = - 1
(p1=1, p2=1)
20

50

x1

80
49

Shapes of Budget Constraints with a

Quantity Discount
x2

100

m=
Slope = - 2 / 1 = - 2 $100
(p1=2, p2=1)
Slope = - 1/ 1 = - 1
(p1=1, p2=1)

20
50
80
Buy first 20 units at $20 each and
50
next 60 units at $1 each.

x1

Shapes of Budget Constraints with a

Quantity Discount
x2

m=
$100

100

Budget Constraint

Budget Set
20

50

x1

80
51

Shapes of Budget Constraints with a

Quantity Penalty
x2

Budget
Constraint

Budget Set

Slope increases, as x1
becomes relatively
more expensive with
large quantity.

x1

E.g. Tax excessive

consumption
52

Shapes of Budget Constraints - One

Price Negative
Commodity 1 is stinky garbage.
You are paid $2 per unit to accept
it; i.e. p1 = - $2. p2 = $1. Income,
other than from accepting
commodity 1, is m = $10.
Then the constraint is
- 2x1 + x2 = 10
or
x2 = 2x1 +
10.
53

Shapes of Budget Constraints - One

Price Negative
x2

x2 = 2x1 + 10
Budget constraints slope is
-p1/p2 = -(-2)/1 = +2

10
x1
54

Shapes of Budget Constraints - One

Price Negative
x2

10

Budget set is
all bundles for
which x1 0,
x2 0 and
x2 2x1 + 10.
x1
55

To Keep in Mind (This

Lecture)
1. Meaning of a budget line and how to draw it
(slope, axes, intercepts, etc.)
2. Slope of a budget line and how it changes
in response to changes in price and income.
3. Impacts of policies on the budget constraint

Per unit taxes and subsidies

Ad Valorem taxes and subsides
Lump sum taxes and subsidies
Rationing
Quantity discount or penalty

4. Positively sloped budget constraint

56