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Summary Microeconomics 2
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Summary of Microeconomics 2 for BA2 Business Economics at the VUB.
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INTERMEDIATE MICRO IIBUSINESS ECONOMICS II, SEMESTER I
Consumer theory:
- Chapter 2: Budget Constraint p. 1
- Chapter 3: Preferences p. 9
- Chapter 4: Utility p. 19
- Chapter 5: Choice p. 27
- Chapter 6: Demand p. 39
- Chapter 15: Market Demand (NO exercises) p. 51
Producer Theory:
- Chapter 19: Technology p. 53
- Chapter 20: Profit maximization p. 63
- Chapter 21: Cost minimization p. 71
- Chapter 23: Firm supply (NO exercises) p. 81
- Chapter 24: Industry supply (NO exercises) p. 87
Essential topics in Microeconomics:
- Chapter 25: Monopoly p. 95
- Chapter 31: Behavioral economics p. 109
- Chapter 35: Externalities p. 117
- Chapter 38: Asymmetric information (NO exercises) p. 123
,INTERMEDIATE MICROECONOMICS BUSINESS ECONOMICS II
CHAPTER 2: Budget Constraint: p. 20-32
The economic theory of the consumer is very simple: economists assume that consumers choose the best bundle of goods
they can afford. To give content to this theory, we have to describe more precisely what we mean by “best” and what we
mean by “can afford”.
The Consumer theory:
- Consumers choose the “best” bundles of goods they can afford
o Can “afford” à budget constraint
o “best” à utility and preferences
The Budget Constraint:
- Suppose that there is some set of goods from which the consumer can choose.
o In real life there are many goods to consume, but for out purposes it is convenient to consider only the
case of 2 goods, since we can then depict the consumer’s choice behavior graphically.
o We indicate the consumer’s consumption bundle (by x1, x2)
§ This is simply a list of 2# that tells us how much the consumer is choosing to
consume of good 1, x1, and how much the consumer is choosing to consume
of good 2, x2.
• Sometimes it is convenient to denote the consumer’s bundle by a single symbol like
X, where X is simply an abbreviation for the list of 2 numbers (x1, x2)
o We suppose that we can observe the prices of the 2 goods (p1, p2),
o The amount of money the consumer has to spend, m
o Then the budget constraint of the consumer can be written as:
p1x1 + p2x2 ≤ m
The amount of The amount of
money the consumer money the consumer
is spending of good 1 is spending of good 1
§ The budget constraint of the consumer requires that the amount of money
spent on the 2 goods be no more than the total amount the consumer has to
spend.
• The consumer’s affordable consumption bundles are those that don’t
cost any more than m à we call this set of affordable consumption
bundles at prices (p1, p2) and income m the budget set of consumer.
- Consumption bundle:
o (x1, x2) à how much of each good is consumed
o (p1, p2) à prices of the 2 goods
o m à amount of money the consumer has to spend
o p1x1 + p2x2 ≤ m à budget constraint
o all (x1, x1) that satisfy the budget constraint à budget set
Two Goods Are Often Enough:
- The 2-good assumption is more general than you might think at first, since we can often interpret one of the goods
as representing everything else the consumer might want to consume.
o Ex.: if we are interested in studying a consumer’s demand for milk, we might let x1 measure his/her
consumption of milk in quarts per month. We can then let x2 stand for everything else the consumer
might want to consume.
- When we adopt this interpretation, it is convenient to think of good 2 as being the dollars
that the consumer can use to spend on other goods.
o The price of good 2 will automatically be 1, since the price of 1 dollar is 1 dollar. Thus,
the budget constraint will take the form:
p1x1 + x2 ≤ m
1
,INTERMEDIATE MICROECONOMICS BUSINESS ECONOMICS II
§ This expression simply says that the amount of money spent on good 1, p1x1,
plus the amount of money spent on all other goods x2, must be no more than
the total amount of money the consumer has to spend, m.
• Good 2 represents a composite good that stands for everything else
that the consumer might want to consume other than good 1.
o Such a composite good is invariably measured in dollars to be spent on
goods other than good 1. As far as the algebraic form of the budget
constraint is concerned the equation (p1x1 + x2 ≤ m) is just a special case
of the formula given in equation (p1x1 + p2x2 ≤ m), with p2 = 1, so
everything that we have to say about the budget constraint in general will
hold under the composite good interpretation.
- Why the two-good assumption?
o Broader than only 2 goods
o Good 2:
§ Composite good: everything else the consumer might want to consume
§ Money to spend on other goods
o Budget constraint: p1x1 + p2x2 ≤ m
o Money spent on good 1 plus money spent on good 2 ≤ amount of money available
Properties of the Budget Set:
- The budget line is the set of bundles that cost exactly m:
p1x1 + p2x2 = m
o These are the bundles of goods that just exhaust the consumer’s income.
The budget set of all bundles that are affordable at the given prices and
income.
• The heavy line is the budget line – the bundles that cost exactly m –
and the bundles below this line are those that cost strictly less than
m.
- We can rearrange the budget line in previous equation to give us the formula:
m p
x2 = p - p1 x1
2 2
o This formula for a straight line with a vertical intercept of m/p2 and a slope of -p1/p2.
The formula tells us how many units of good 2 the consumer needs to consume in
order to just satisfy the budget constraint if she is consuming x1 units of good 1.
- Budget Line:
o p1x1 + p2x2 = m à budget line (equation 1)
o x2 = m/p2 – (p1/p2) x1 à budget line (equation 2)
o m/p2 à vertical intercept (x1=0)
o m/p1 à horizontal intercept (x2 = 0)
2
, INTERMEDIATE MICROECONOMICS BUSINESS ECONOMICS II
o p1/p2 à slope (opportunity cost of good 1)
o Try yourself!
§ m = 18 EUR
§ p1 = 2 EUR
§ p2 = 3 EUR
- An easy way to draw a budget line given prices (p1, p2) and income m
o Ask yourself how much of good 2 to consumer could buy if she spent all of her money on good 2. The
answer is m/p1. Thus, the horizontal and vertical intercepts measure how much the consumer could get
if she spent all of her money on goods 1 and 2, respectively. In order to depict the budget line just plot
these 2 points on the appropriate axes of the graph and connect them with a straight line.
§ The slope of the budget line has a nice economic interpretation. It measures
the rate at which the market is willing to “substitute” good 1 for good 2.
• Suppose for example that the consumer is going to increase her
consumption of good 1 by dx1. How much will her consumption of
good 2 have to change in order to satisfy her budget constraint? Let
us use dx2 to indicate her change in the consumption of good 2.
o Note that is she satisfies her budget constraint before and
after making the change she must satisfy:
p1x1 + p2x2 = m
and
p1 (x1 + dx1) + p2 (x2 + dx2) = m
§ Subtracting the first equation from the second gives:
p1dx1 + p2dx2 = 0
§ This says that the total value of the change in her consumption must be zero.
Solving for (dx2/dx1, the rate at which good 2 can be substituted for good 1
while still satisfying the budget constraint, gives:
dx2 p
=- 1
dx1 p2
§ This is just the slope of the budget line. The negative sign is there since dx1
and dx2 must always have opposite signs. If you consume more of good 1,
you have to consume less of good 2 and vice versa is you continue to satisfy
the budget constraint. Alternatively, we could have taken the implicit
derivative of both sides of the budget constraint with respect to x1 and
obtained the same result.
• Economists sometimes say that the slope of the budget line
measures the opportunity cost of consuming good 1. In order to
consume more of good 1 you have to give up some consumption of
good 2. Giving up the opportunity to consume good 2 is the true
economic cost of more good 1 consumption; and that cost is
measured by the slope of the budget line.
3
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