Lecture 1 - Budget Constraint Flashcards
(19 cards)
Preferences
What the individual wants to do
Budget Constraint
What the individual can afford to do
Consumer Decision Model
Preferences + Budget Constraint = Decision
Budget Constraint Assumptions
- Assume income is exogeneous
- Assume no saving or borrowing and that all goods are consumed when purchased
- Assume only 2 goods
- Assume the consumer is a price taker
Assumption 1
- Assume income (m) is exogenous
- Income is a given in the model
- The individual does not decide how much to work
Assumption 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
Assumption 3
- Assume only 2 goods
- Common to label them x1 and x2 or x and y
- Primarily for convenience to draw 2D graphs
- Can also define one of the goods to be a bundle of all other goods (not actually very restrictive assumption)
Assumption 4
- Assume the consumer is a price taker
- Each consumer faces a budget constraint
- They can’t spend more than their income
Budget Set
The collection of all affordable/feasible bundles
What does the slope of the budget constraint tell us?
- The slope indicates the rate at which the market permits you to substitute 1 good for another
- Can think of slope as opportunity cost of consuming good 1
How do the budget set and budget constraint change as income increases?
- Higher income gives more choice
- New affordable consumption choices
- Original and new budget constraints are parallel (same slope)
Quantity tax (per unit tax)
Consumer pays certain amount to government for each unit purchased e.g. US gasoline tax is on per gallon basis
Value or Ad Valorem tax
Tax on the price of a good usually expressed in percentage terms e.g. sales tax
Lump sum tax
Fixed amount of money regardless of consumer’s behavior
Effect of quantity tax
- Tax increases price of x1
- Budget constraint rotates in (gets steeper)
- Quantity subsidy effectively decreases the price of x and the budget constraint rotates out
Effect of uniform ad valorem sales tax
- A uniform sales tax applied to both goods 1 and 2
- Parallel shift in
Effect of ad valorem sales tax applied to just one good
- Sales tax on good x1
- Like per unit sales tax, this is just an increase in the price of good x1
- The budget constraint will rotate in
Effect of lump sum tax or subsidy
- Acts like a change in income
- Slope doesn’t change since relative prices haven’t changed
- Budget line shifts in for lump sum tax
- Budget line shifts out for lump sum subsidy
Rationing Constraints
- Consumption of some good is fixed to be no larger than some amount e.g. butter and meat in WWII
- Part of the budget set gets lopped off
