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Budget Constraints

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budget line - indicates all combinations where total spent is equal to income

 

  • I = PA A + PB B
  • slope = negative ratio of prices of 2 goods
  • intercepts on the graph represent how much of each good you could buy if you only bought that certain good
  • income change >> changes vertical/horizontal intercepts, not slope
    • increase >> shifts outward; decrease >> shifts inward
    • income consumption curve positive >> normal good (quantity increases w/ income)
    • income consumption curve negative >> inferior good (less desire w/ increased income, ex. hamburger vs steak)
  • price change >> slope change (or none if both prices change by same rate)
    • changes intercept of one of the axes (or both of both prices changed)
    • may not change consumption of other good
  • purchasing power - determined by income and prices

 

  • original budget line
  • possible income changes
  • possible price changes
  • both price changes could change in such a way that it appears to be an income change (increase in purchasing power through either income increase or price decrease)

maximizing basket - must fulfill 2 conditions 

  • (1) located on budget line - can’t go past budget line, can’t leave income unused
    • assuming that satisfaction from goods now exceeds saving income for goods later
    • can’t spend more, can’t spend less
  • (2) must give consumer more preferred combination of goods
    • goes w/ the highest indifference curve
  • satisfaction maximized where marginal rate of substitution (MRS) equal to ratio of prices
    • marginal benefit = marginal cost
    • MRS = PA/PB = -DB / DA
    • if MRS doesn’t equal PA/PB, than utility can be increased
  • corner solutions - when 1 good is not consumed at all.
    • in this case, MRS doesn’t necessarily equal price ratio (only holds true when positive quantities of goods are consumed)
    • restrictions can change shape of budget line

 

  • most satisfying basket lies on the intersection between the indifference curve offering the highest good and the budget line
  • indifference curves found through utility function
  • can use both the budget line formula and given utility function to find most satisfying basket
Subject: 
Economics
Subject X2: 
Economics

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