The budget constraint

and choice

The problem of limited resources

and its effect on choice

The budget constraint and choice

Last week:
We

saw that preferences can be represented by

utility functions ...
That indifference curves can be used to map a
utility function into consumption space
But we still dont know how consumers choose
amongst the different bundles...

This week:
We

introduce the concept of a budget,

This is the 2nd half of consumer theory

The budget constraint and choice

The budget constraint

The optimal consumer choice

Income and substitution effects

The budget constraint

The basic concept is really straightforward:

The

consumer has a limited income (I) to

purchase different goods
Each type of good has a defined price
(p) per unit
We assume that the consumer does not
save and spends all his income
This possibility will be examined later

The budget constraint

The general budget constraint for n

goods is:
n

I pi x i
i 1

If we only look at 2 goods (Same

simplification as last week), it can be
expressed as:

I p1 x1 p 2 x 2

The budget constraint

Imagine the following student

entertainment budget
You

have 50
The price of a meal is 10
The price of a cinema ticket is 5

Your budget constraint is:

I p1 x1 p 2 x 2
50 5 tickets 10 meals

The budget constraint

Diagram in consumption space
Meals
max
meal

max
meal

I
p meal

Maximum amount of
meals you can buy

Cinema

The budget constraint

Meals
max
meal

Maximum amount of
cinema tickets you
can buy

max
cin.

max
x cin.

I
pcin.

Cinema

The budget constraint

Meals
max
meal

Budget constraint

max
x cin.

Cinema

The budget constraint

The budget constraint is I p1 x1 p 2 x 2
Meals
max
meal

Dividing by p1 and rearranging:

I p2
x1
x2
p1 p1

intercept

slope

x meal

I
p meal

max
x cin.

p cin.

x cin.
p meal
Cinema

The budget constraint

Meals
max
meal

Any bundle within the budget

constraint is affordable , but
not all the budget is spent
(C,D).
H

Any bundle beyond the

budget constraint cannot be
afforded (H,G).

C
D

Any bundle on the budget

constraint is affordable and
ensures all the budget is
spent (E,F).

max
x cin.

Cinema

The budget constraint

Meals
max
meal

Budget set

Budget constraint

max
x cin.

Cinema

The budget constraint

The position of the budget constraint

depends on

I p2
x1 x 2
p1 p1

The income of the agent (I)

The price of the two goods (p1 and p2)

The budget constraint

Effect of a fall in income (I)
Meals
max
meal

max
x cin.

Cinema

The budget constraint

Increase in the price of cinema
tickets
Meals
max
meal

max
x cin.

Cinema

The budget constraint and choice

The budget constraint

The optimal consumer choice

Income and substitution effects

The optimal consumer choice

This requires bringing in the two elements

of the theory
The

indifference curves, which show how

agents rank the different bundles
The budget constraint, which shows which
bundles are affordable, and which are not

Both of these are defined over the

consumption space, so they can be
superposed easily

The optimal consumer choice

Which is the best bundle ?
Meals
max
meal

Optimal bundle

max
x cin.

Cinema

The optimal consumer choice

Meals
max
meal

The budget constraint is

tangent to the
indifference curve at F

Definition of the
MRS at F !!!

max
x cin.

Cinema

The optimal consumer choice

The optimal bundle is on the tangency

between the budget constraint and the
indifference curve.

This means that for the optimal bundle the

slope of the IC is equal to the slope of the
budget constraint
MRS = ratio of prices

The optimal consumer choice

This condition gives a central result of

consumer theory:
mU 2
p2
MRS

mU1
p1

mU1 mU 2

p1
p2

The optimal bundle is the one which

equalises the marginal utility per spent
If

you were to receive an extra of income,

your marginal utility will be the same
regardless of where you spend it

The optimal consumer choice

Example of optimal choice with concave preferences

The optimal solution is a

corner solution

Meals
max
meal

max
x cin.

Cinema

The budget constraint and choice

The budget constraint

The optimal consumer choice

Income and substitution effects

Income and substitution effects

Consumer theory is used to understand

how choice is affected by changes in the
environment
These can be complex, and the theory
helps to isolate these different effects
The separation of income and substitution
effects is a good illustration of the concept
of ceteris paribus
Each

variable is isolated and analysed

separately from the others

Income and substitution effects

An increase in the price of cinema tickets has 2 effects :

Meals
max
meal

1: A change in real income

A previously affordable bundle

(A) is no longer affordable

2: A relative price change

The slope of the budget

constraint changes, and meals
become relatively cheaper

max
x cin.

Cinema

Income and substitution effects

Effect of an increase in the price of cinema tickets on
consumer choice
Meals
max
meal

Fall in the consumption of

cinema
Increase in the consumption of
meals
Question: How can we separate
the effect of the change in real
income from the effect of the
change in relative prices ?

max
x cin.

Cinema

Income and substitution effects

In order to separate the 2 effects, we add an imaginary
budget constraint

Meals
max
meal

Im

Parallel to the new budget constraint

Tangent to the original IC
There is only a single curve that
satisfies these two requirements
This gives an imaginary optimal
bundle (Im)

max
x cin.

Cinema

Income and substitution effects

The substitution effect

Meals
max
meal

From A to Im, real income is held

constant

Im

We are still on the same

indifference curve, so utility is
the same

The change of bundle is due

entirely to the change in relative
price
This is the substitution effect

max
x cin.

Cinema

Income and substitution effects

The income effect

Meals
max
meal

From Im, to B, relative prices are

held constant

Im

The two budget constraints are

parallel, so the slope is the same

The change of bundle is due

entirely to the fall in income.
This is the income effect

max
x cin.

Cinema

Income and substitution effects

The overall effect

Meals
max
meal

Im

By combining the two, one gets

the overall effect
One can see that the interaction
is different for the two goods

The 2 effects can work against

each other, or add up
Depending on the relative
strength of the effects, this can
lead to increases or falls in
consumption

max
x cin.

Cinema

Income and substitution effects

This type of approach is fundamental to microeconomic analysis

Any

price change is always accompanied by

income and substitution effects.

So this helps understand the effects of

taxation, shocks to prices, taste changes, etc.
Look

at the complex effects of oil price

increases on consumption

Price change Complex change in bundle

Clearly,

this will also help understand how

demand curves are built (next week)