03BudgetsandOptimal__Choice.docVIP

3 Budgets and Optimal Choice Mar 11, 2011 The Budget Set The last lecture investigated which bundle of goods the consumer prefers. However, goods cost money and the consumer cannot afford to buy indefinite amounts of each good. Suppose the consumer has an income of m. Then the amount of money the consumer spends cannot exceed m. Suppose that the two goods have (non-negative) prices and respectively. The total amount of money spent on units of good 1 is then and on units of good 2 is . This yields the equation: Usually it is impossible to consume negative amounts of goods and so to be exact the budget set includes two other constraints: and . The budget set is therefore the triangle BS in the diagram. Properties of Budget Sets When prices change the budget set will clearly change. The budget line is the diagonal boundary line of the budget set, given by . The intercepts with the and 2 axis can be calculated. For example, when the equation reduces to . This is the intercept with the axis. The slope of the budget line can be calculated by dividing the vertical axis intercept by the horizontal axis intercept yielding (recall this is a downward sloping straight line). Now it is possible to investigate what will happen to the budget set when prices change. Changing Prices and Income Suppose income m is increased. In this case, the budget line shifts outward as below. Suppose one of the prices increases. The intercept of the budget line with the horizontal axis decreases and the budget pivots inwards. The same operation can be done for a price decrease, where the budget line pivots outward. Changes in are treated in a similar way. Budget sets increase in size if income increases and decrease in size if either of the prices increase ? as expected. Notice the slope changes when prices change. The slope represents the market rate of exchange between the two goods or the opportunity cost of consuming good 1. It is the rate at w