Consumer Theory and Budget Constraints
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Questions and Answers

What does the budget line represent in a microeconomic context?

  • The set of bundles that cost less than m
  • The maximum consumption of good 1 only
  • The set of bundles that cost exactly m (correct)
  • The minimum consumption necessary to meet m

    • What does the slope of the budget line indicate?

  • The overall market demand for good 1
  • The opportunity cost of consuming good 1 in terms of good 2 (correct)
  • The vertical distance between goods 1 and 2
  • The total consumption of both goods

    • How can the two intercepts of the budget line be determined?

  • By setting p1 equal to m
  • By averaging the prices of both goods
  • By substituting x1 and x2 values into the budget equation
  • By determining the maximum quantities of each good based on prices (correct)

    • How is the rate of substitution between good 1 and good 2 expressed mathematically?

    <p>By using the slope of the line as ∆x2/∆x1</p> Signup and view all the answers

    When a consumer increases their consumption of good 1, what must occur to maintain the budget constraint?

    <p>The amount consumed of good 2 must decrease</p> Signup and view all the answers

    What does the budget constraint equation represent?

    <p>The maximum expenditure on goods compared to available income</p> Signup and view all the answers

    In the context of the budget constraint, if p1 increases, what happens to the budget set?

    <p>The budget set shrinks</p> Signup and view all the answers

    How is good 2 defined in the two-good model?

    <p>As a composite good representing all other goods</p> Signup and view all the answers

    If a consumer's income (m) increases, what is the immediate effect on the budget constraint?

    <p>The budget constraint line shifts outward</p> Signup and view all the answers

    Which statement about the budget constraint is true?

    <p>It determines the affordability of goods based on income</p> Signup and view all the answers

    In the equation $p_1x_1 + p_2x_2 \leq m$, what does the term $p_2x_2$ represent?

    <p>The spending on good 2</p> Signup and view all the answers

    Which of the following would decrease the set of affordable consumption bundles?

    <p>An increase in the price of good 1</p> Signup and view all the answers

    If a consumer spends all their income on good 1, what can be inferred about their consumption of good 2?

    <p>They cannot afford good 2</p> Signup and view all the answers

    What does the budget constraint formula represent?

    <p>The total expenditure on goods must equal the consumer's income.</p> Signup and view all the answers

    How does increasing the income (m) affect the budget line?

    <p>It leads to a parallel outward shift of the budget line.</p> Signup and view all the answers

    What would happen if the price of good 1 (p1) increases?

    <p>The budget line becomes steeper.</p> Signup and view all the answers

    When a consumer's consumption of good 1 (x1) is less than or equal to x̄1, what is the slope of the budget line?

    <p>−(p1 / p2)</p> Signup and view all the answers

    What does it mean to assign one price a value of 1 in economic theory?

    <p>It defines a numeraire, simplifying the measurement of other prices.</p> Signup and view all the answers

    In terms of budget lines, how does multiplying all prices by a factor t affect the budget line?

    <p>It does not change the position of the budget line.</p> Signup and view all the answers

    What is represented by the vertical intercept of the budget line?

    <p>The maximum amount of good 2 that can be consumed when good 1 is not purchased.</p> Signup and view all the answers

    What does the term 'budget set' refer to?

    <p>All combinations of goods that do not exceed the budget constraint.</p> Signup and view all the answers

    What happens to the budget line if price 2 increases more than price 1?

    <p>The budget line becomes flatter.</p> Signup and view all the answers

    What is the formula for the budget line if good 2 is pegged as the numeraire?

    <p>p1 x1 + p2 x2 = p2</p> Signup and view all the answers

    How does a quantity tax affect the price of good 1?

    <p>It increases by the amount t.</p> Signup and view all the answers

    If an ad valorem subsidy is applied, how is the price of good 1 affected?

    <p>It decreases to (1 - σ)p1.</p> Signup and view all the answers

    When price 2 is set to 1, what do p1 and income m represent?

    <p>Relative price of good 1 and relative income.</p> Signup and view all the answers

    What is the result of a value tax (ad valorem tax) on the budget line?

    <p>The budget line becomes steeper.</p> Signup and view all the answers

    How does a quantity subsidy influence the budget line?

    <p>It makes the budget line flatter by decreasing the price of good 1.</p> Signup and view all the answers

    What is the effect on the budget line if price 2 increases less than price 1?

    <p>The budget line steepens.</p> Signup and view all the answers

    What happens to the budget line when income increases from m to m0, where m0 > m?

    <p>The budget line shifts outward.</p> Signup and view all the answers

    When the price of good 1 increases while holding the price of good 2 and income fixed, what is expected to happen to the slope of the budget line?

    <p>The slope becomes steeper.</p> Signup and view all the answers

    If both prices (p1 and p2) increase by a factor of t where t > 1, what effect does this have on the budget line?

    <p>The budget line shifts inward.</p> Signup and view all the answers

    What is the effect on the budget line when both prices and income decrease?

    <p>The budget line shifts inward.</p> Signup and view all the answers

    When price p1 increases to p10, which equation represents the new budget line?

    <p>x2 = m/p2 - p1 x1</p> Signup and view all the answers

    What happens to the intercepts of the budget line when income decreases?

    <p>The intercepts decrease.</p> Signup and view all the answers

    If both prices and income simultaneously increase, what will be the overall impact on the budget line?

    <p>It will shift inward regardless of the amount of increase.</p> Signup and view all the answers

    In the equation of a budget line, which of the following best describes the meaning of 'mp2'?

    <p>Maximum affordable quantity of good 2.</p> Signup and view all the answers

    If the budget constraint is represented by the equation $x2 = mp2 - p2 x1$, which variable shows the quantity consumed of good 1?

    <p>x1</p> Signup and view all the answers

    From the changes in budget constraints, what is indicated by the notation 't < 1'?

    <p>The budget line shifts outward.</p> Signup and view all the answers

    Study Notes

    Consumer Theory

    • Consumers choose the best bundle of goods they can afford
    • The “best” bundle is the focus of the next chapter
    • The “can afford” is the budget constraint

    The Budget Constraint

    • The consumer's consumption bundle of goods is X = (x1, x2)
      • x1 is the amount of good 1 consumed
      • x2 is the amount of good 2 consumed
    • Prices are (p1, p2)
      • p1 is the price of good 1
      • p2 is the price of good 2
    • The consumer's income is m
    • The budget constraint equation is: p1x1 + p2x2 ≤ m
      • p1x1 represents the amount of money spent on good 1
      • p2x2 represents the amount of money spent on good 2
      • This means the total amount of money spent on both goods must be less than or equal to the consumer's total income
    • The budget set is the set of all affordable consumption bundles at prices (p1, p2) and income m

    The Budget Line

    • The budget line is the set of all consumption bundles that cost exactly m
    • The formula for the budget line is p1x1 + p2x2 = m
    • Rearranging it gives: x2 = (m/p2) - (p1/p2)x1
      • This formula shows the relationship between the amount of good 1 and good 2 that the consumer can purchase
    • The slope of the budget line is - (p1/p2)
    • The vertical intercept is (m/p2)
    • The horizontal intercept is (m/p1)

    Economic Interpretation of the Slope

    • The slope of the budget line represents the opportunity cost of consuming good 1
    • The opportunity cost is the rate at which the market is willing to substitute good 1 for good 2
    • The opportunity cost means if the consumer wants to consume one more unit of good 1, how much of good 2 must they give up to stay within their budget?

    Changes in the Budget Constraint

    • Changes in Income*
    • A change in income, from m to m0 will result in a parallel shift of the budget line
    • If m0 is greater than m then the shift will be outward, meaning the consumer can afford more of both goods
    • If m0 is less than m then the shift will be inward, meaning the consumer can afford less of both goods
    • Changes in Price of Good 1*
    • Increasing p1 to p10 will result in a change in the slope of the budget line
    • The slope of the budget line will become steeper
    • The vertical intercept will stay the same, but the horizontal intercept will change
    • This is because the consumer can afford less of good 1 at the higher price
    • Changes in the Price of Both Goods*
    • Multiplying p1 and p2 by t is the same as dividing income by t
    • If t is greater than 1 then the budget line will shift inward, meaning the consumer can afford less
    • If t is less than 1 then the budget line will shift outward, meaning the consumer can afford more
    • Changes in Both Price and Income*
    • If both prices increase and income decreases, then the budget line will shift inward as the consumer can afford less overall
    • If price 2 increases more than price 1, then the budget line will become flatter
    • If price 2 increases less than price 1, then the budget line will become steeper

    The Numeraire

    • The budget line is defined by two prices and one income, but one of these variables is redundant
    • You can set one of the prices to a fixed value and measure the other price and income relative to that
    • Choosing p2 = 1 makes good 2 the Numeraire
    • This means the price of good 1 (p1) is now relative to the price of good 2 (which is 1 dollar)
    • The income (m) is now also relative to the price of good 2

    Taxes, Subsidies and Rationing

    • Taxes*
    • Quantity tax: A fixed amount is paid for each unit of good 1 consumed
    • This increase the price of good 1 by the amount of the tax
    • Value tax (ad valorem tax): A tax on the value of good 1
    • This is usually in percentage terms
    • This increases the price of good 1 by a percentage of the original price
    • Subsidies*
    • Quantity subsidy: A fixed amount is given to the consumer for each unit of good 1 consumed
    • This decreases the price of good 1 by the amount of the subsidy
    • Ad valorem subsidy: A subsidy based on the price of the good
    • This is also usually in percentage terms
    • This decreases the price of good 1 by a percentage of the original price

    Rationing

    • Rationing is when the amount of a good that can be consumed is limited
    • This is represented by a kink in the budget line

    Summary

    • The budget constraint is a key concept in consumer theory and allows for a graphical representation of what consumers can afford given their income and prices
    • The slope of the budget line represents the opportunity cost of consuming good 1
    • Changes in income, prices or rationing all impact the budget constraint and the consumer's ability to choose different bundles of goods

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    Related Documents

    Chapter 2: Budget Constraint PDF

    Description

    This quiz focuses on the concepts of consumer theory, particularly the budget constraint and how it affects consumer choices. It covers the definitions and equations relevant to understanding how consumers decide on the optimal bundle of goods they can afford. Test your knowledge on the budget line and consumption choices in relation to income and prices.

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