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Revision Notes for First Year Microeconomics – University Level
Hello, I am a recent First-Class Honours Graduate in Economics and Finance. Given the cir...
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Consumer decision model
Preferences (what the individual wants to do) + Budget Constraint (what the individual can afford) = Decision
Economists assume that consumers choose the best bundle of goods they can afford that will reach the highest
feasible level of satisfaction.
The Budget Constraint
Assumptions:
- Income (m) is exogenous – it is given and the individual does not decide how much to work
- No saving or borrowing, all goods are consumed when purchased, and no stockpiling
- Only two goods exist, X1 and X2. X1/X2, can be a collection of bundle of goods
- Consumer is a price taker (each consumer faces a budget constraint and cannot spend more than their
income)
- Amount spent = Amount earned (income)
Consumption bundle denoted by (X1, X2) and price of the two goods, (P1, P2) and the amount of money the
consumer has to spend, m. Budget constraint of the consumer:
p1x1 + p2x2 = m
Slope = how many units of g2 the
consumer needs to consume in
order to just satisfy the B.C if they
are consuming x1 units of g1.
Budget set = all the bundles that are affordable at the given prices and income
Slope = rate at which the market permits you to substitute one good for another = opportunity cost of
consuming g1
Changes in budget line:
Change in income: affects the vertical intercept and not slope. Increase in income = parallel shift outward of the
B.C, and a decrease in income = parallel shift inwards.
,Change in price: Increase in P1, while holding P2 and income fixed = budget line steeper, P1/P2 will become
larger. Spending all your money on G1, and G1 becomes more expensive, then your consumption of G1 must
decrease, horizontal intercept of the B.L must shift inwards:
,Economic Policies and the Budget Constraint:
Quantity/Per unit Tax:
Uniform Ad Valorem Sales Tax:
, Lump sum tax – government takes away some fixed
amount of money, regardless of the individual
behaviour, as income is reduced, the B.L will shift
inwards.
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