Book cover for Intermediate Microeconomics: A Modern Approach

Intermediate Microeconomics: A Modern Approach

Hal R. Varian

ISBN #9780393927023

7th Edition

224 Questions

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7,544 Students Helped

Homework Questions

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Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

This section on Budget Constraint outlines how consumers are restricted by their income and the prices of goods, using the budget line as a visual tool to understand these limitations. Key points include the concept of the budget set, the simplifying role of the numeraire, and the significant effects of external factors such as taxes, subsidies, and rationing on consumer choices. Understanding these concepts is crucial for analyzing consumer behavior and evaluating government policy impacts.

Learning Objectives

1

Describe the concept of a budget constraint and its significance in consumer decision-making.

2

Explain how income and prices determine the budget line and the overall budget set.

3

Analyze the role of the numeraire in simplifying economic analysis.

4

Evaluate the impact of government policies—such as taxes, subsidies, and rationing—on shifting the budget constraint.

Key Concepts

CONCEPT

DEFINITION

Budget Constraint

The limitation faced by consumers, imposed by their income and prevailing prices, which restricts the combinations of goods they can purchase.

Budget Line

A graphical representation of all possible combinations of two goods that can be bought with a given income at fixed prices.

Budget Set

The set of all affordable bundles of goods that a consumer can purchase given their income and the prices of the goods.

Numeraire

A reference good used as a benchmark or unit of account in economic analysis to simplify comparisons and calculations.

Taxes, Subsidies, and Rationing

Government policies that alter effective prices and available quantities, thereby shifting or reshaping the budget constraint.

Example Problems

Example 1

Originally the consumer faces the budget line $p_{1} x_{1}+p_{2} x_{2}=m .$ Then the price of good 1 doubles, the price of good 2 becomes 8 times larger and income becomes 4 times larger. Write down an equation for the new budget line in terms of the original prices and income.

Example 2

What happens to the budget line if the price of good 2 increases, but the price of good 1 and income remain constant?

Example 3

If the price of good 1 doubles and the price of good 2 triples, does the budget line become flatter or steeper?

Example 4

What is the definition of a numeraire good?

Example 5

Suppose that the government puts a tax of 15 cents a gallon on gasoline and then later decides to put a subsidy on gasoline at a rate of 7 cents a gallon. What net tax is this combination equivalent to?
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Step-by-Step Explanations

QUESTION

How does an increase in taxes affect the consumer's budget line?

STEP-BY-STEP ANSWER:

Step 1: Recognize that taxes effectively increase the price of the good on which they are levied.
Step 2: Understand that a higher price reduces the number of units a consumer can buy while staying within the same income.
Step 3: Observe that this results in a new, steeper budget line when taxes are imposed, representing fewer affordable combinations.
Step 4: Conclude that the consumer's budget set is reduced because of the tax, limiting the options available for consumption.
Final Answer: An increase in taxes shifts the budget line inward (or makes it steeper for the taxed good), reducing the set of affordable choices.

Budget Constraint Shift due to Taxes

QUESTION

What is the function of the numeraire in analyzing a budget constraint?

STEP-BY-STEP ANSWER:

Step 1: Define the numeraire as a standard or benchmark good used for measuring value.
Step 2: Use the numeraire to simplify comparisons across different goods by expressing their prices relative to it.
Step 3: Understand that by setting one good as the numeraire, economists can focus analysis on relative rather than absolute prices.
Step 4: Recognize that this approach reduces complexity in models and helps clarify consumer choices.
Final Answer: The numeraire serves as a reference point to simplify budget constraint analysis by enabling all other prices to be expressed relative to it.

Role of the Numeraire

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Common Mistakes

  • Confusing changes in income with changes in prices when analyzing shifts in the budget line.
  • Misinterpreting the role of the numeraire and overlooking its importance in simplifying economic analysis.
  • Assuming that all shifts in the budget line are parallel, rather than recognizing that policies like taxes and subsidies can change the slope.
  • Neglecting the fact that rationing and other non-price policies also affect the consumer's available options.