budgetary and other constraints on choice
DESCRIPTION
Consumption Choice Sets A consumption choice set is the collection of all consumption choices available to the consumer. What constrains consumption choice? Budgetary, time and other resource limitations.TRANSCRIPT
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Budgetary and Other Constraints on Choice
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Consumption Choice Sets
A consumption choice set is the collection of all consumption choices available to the consumer.
What constrains consumption choice?
Budgetary, time and other resource limitations.
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Budget Constraints
A consumption bundle containing x1 units of commodity 1, x2 units of commodity 2 and so on up to xn units of commodity n is denoted by the vector (x1, x2, … , xn).
Commodity prices are p1, p2, … , pn.
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Budget Constraints
Q: When is a consumption bundle (x1, … , xn) affordable at given prices p1, … , pn?
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Budget Constraints Q: When is a bundle (x1, … , xn)
affordable at prices p1, … , pn?
A: When p1x1 + … + pnxn mwhere m is the consumer’s (disposable) income.
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Budget Set and Constraint for Two Commoditiesx2
x1
Budget constraint isp1x1 + p2x2 = m.
m /p1
m /p2
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Budget Set and Constraint for Two Commoditiesx2
x1
Budget constraint isp1x1 + p2x2 = m.m /p2
m /p1
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Budget Set and Constraint for Two Commoditiesx2
x1
Budget constraint isp1x1 + p2x2 = m.
m /p1
Just affordable
m /p2
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Budget Set and Constraint for Two Commoditiesx2
x1
Budget constraint isp1x1 + p2x2 = m.
m /p1
Just affordableNot affordable
m /p2
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Budget Set and Constraint for Two Commoditiesx2
x1
Budget constraint isp1x1 + p2x2 = m.
m /p1
AffordableJust affordable
Not affordable
m /p2
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Budget Set and Constraint for Two Commoditiesx2
x1
Budget constraint isp1x1 + p2x2 = m.
m /p1
BudgetSet
the collection of all affordable bundles.
m /p2
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Budget Set and Constraint for Two Commoditiesx2
x1
p1x1 + p2x2 = m is x2 = -(p1/p2)x1 + m/p2
so slope is -p1/p2.
m /p1
BudgetSet
m /p2
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Budget Constraints For n = 2 and x1 on the horizontal
axis, the constraint’s slope is -p1/p2. What does it mean?
x pp
x mp2
121
2
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Budget Constraints For n = 2 and x1 on the horizontal
axis, the constraint’s slope is -p1/p2. What does it mean?
Increasing x1 by 1 must reduce x2 by p1/p2.
See Notes
x pp
x mp2
121
2
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Budget Sets & Constraints; Income and Price Changes
The budget constraint and budget set depend upon prices and income. What happens as prices or income change?
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How do the budget set and budget constraint change as income m
increases?
Originalbudget set
x2
x1
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Higher income gives more choice
Originalbudget set
New affordable consumptionchoices
x2
x1
Original andnew budgetconstraints areparallel (sameslope).
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How do the budget set and budget constraint change as income m
decreases?
Originalbudget set
x2
x1
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How do the budget set and budget constraint change as income m
decreases?x2
x1
New, smallerbudget set
Consumption bundlesthat are no longeraffordable.Old and new
constraintsare parallel.
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Budget Constraints - Income Changes
Increases in income m shift the constraint outward in a parallel manner, thereby enlarging the budget set and improving choice.
Decreases in income m shift the constraint inward in a parallel manner, thereby shrinking the budget set and reducing choice.
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Budget Constraints - Income Changes
No original choice is lost and new choices are added when income increases, so higher income cannot make a consumer worse off.
An income decrease may (typically will) make the consumer worse off.
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Budget Constraints - Price Changes
What happens if just one price decreases?
Suppose p1 decreases.
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How do the budget set and budget constraint change as p1 decreases
from p1’ to p1”?
Originalbudget set
x2
x1
m/p2
m/p1’ m/p1”
-p1’/p2
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How do the budget set and budget constraint change as p1 decreases
from p1’ to p1”?
Originalbudget set
x2
x1
m/p2
m/p1’ m/p1”
New affordable choices
-p1’/p2
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How do the budget set and budget constraint change as p1 decreases
from p1’ to p1”?
Originalbudget set
x2
x1
m/p2
m/p1’ m/p1”
New affordable choices
Budget constraint pivots; slope flattens from -p1’/p2 to -p1”/p2
-p1’/p2
-p1”/p2
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Budget Constraints - Price Changes
Reducing the price of one commodity pivots the constraint outward. No old choice is lost and new choices are added, so reducing one price cannot make the consumer worse off.
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Budget Constraints - Price Changes
Similarly, increasing one price pivots the constraint inwards, reduces choice and may (typically will) make the consumer worse off.
The rate of exchange chance (see an example).
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Uniform Ad Valorem Sales Taxes A uniform sales tax levied at rate t
changes the constraint from p1x1 + p2x2 = mto (1+t)p1x1 + (1+t)p2x2 = m
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Uniform Ad Valorem Sales Taxes A uniform sales tax levied at rate t changes
the constraint from p1x1 + p2x2 = mto (1+t)p1x1 + (1+t)p2x2 = mi.e. p1x1 + p2x2 = m/(1+t).
Case for tax quantity Case for tax on both sales tax and income
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Uniform Ad Valorem Sales Taxesx2
x1
mp2
mp1
p1x1 + p2x2 = m
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Uniform Ad Valorem Sales Taxesx2
x1
mp2
mp1
p1x1 + p2x2 = m
p1x1 + p2x2 = m/(1+t)
mt p( )1 1
mt p( )1 2
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Uniform Ad Valorem Sales Taxesx2
x1
mt p( )1 2
mp2
mt p( )1 1
mp1
Equivalent income lossis
m mt
tt
m
1 1
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Uniform Ad Valorem Sales Taxes Case for tax quantity
Case for sales tax and income tax Quantity subsidy (see notes) Value Subsidy (see notes) Lump-sum tax or subsidy (see notes)
Budget set with rationing (see notes)
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Preferences
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Rationality in Economics
Behavioral Postulate:A decisionmaker always chooses its most preferred alternative from its set of available alternatives.
So to model choice we must model decisionmakers’ preferences.
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Preference Relations Comparing two different consumption
bundles, x and y: strict preference: x is more preferred
than is y. weak preference: x is as at least as
preferred as is y. indifference: x is exactly as preferred as
is y.
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Preference Relations
Strict preference, weak preference and indifference are all preference relations.
Particularly, they are ordinal relations; i.e. they state only the order in which bundles are preferred.
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Preference Relations
denotes strict preference; x y means that bundle x is preferred strictly to bundle y.
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Preference Relations
denotes strict preference so x y means that bundle x is preferred strictly to bundle y.
denotes indifference; x y means x and y are equally preferred.
denotes weak preference;x y means x is preferred at least as much as is y.
~~
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Assumptions about Preference Relations
Completeness: For any two bundles x and y it is always possible to make the statement that either x y or y x.
~
~
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Assumptions about Preference Relations
Reflexivity: Any bundle x is always at least as preferred as itself; i.e.
x x.~
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Assumptions about Preference Relations
Transitivity: Ifx is at least as preferred as y, andy is at least as preferred as z, thenx is at least as preferred as z; i.e.
x y and y z x z.~ ~ ~
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Indifference Curves
Take a reference bundle x’. The set of all bundles equally preferred to x’ is the indifference curve containing x’; the set of all bundles y x’.
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Indifference Curves
xx22
xx11
x”x”
x”’x”’
x’ x’ x” x” x”’ x”’x’
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Indifference Curves
xx22
xx11
zz xx yy
x
y
z
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Indifference Curves
x2
x1
xAll bundles in I1 arestrictly preferred to all in I2.
y
z
All bundles in I2 are strictly preferred to all in I3.
I1
I2
I3
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Indifference Curves
x2
x1
I(x’)
x
I(x)
WP(x), the set of bundles weakly preferred to x.
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Indifference Curves
x2
x1
WP(x), the set of bundles weakly preferred to x.
WP(x) includes I(x).
x
I(x)
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Indifference Curves
x2
x1
SP(x), the set of bundles strictly preferred to x, does not include I(x).
x
I(x)
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Indifference Curves Cannot Intersect
xx22
xx11
xxyy
zz
II11
I2 From IFrom I11, x , x y. From I y. From I22, x , x z. z.Therefore y Therefore y z. z.
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Indifference Curves Cannot Intersect
xx22
xx11
xxyy
zz
II11
I2 From IFrom I11, x , x y. From I y. From I22, x , x z. z.Therefore y Therefore y z. But from I z. But from I11 and Iand I22 we see y z, a we see y z, a contradiction. contradiction.
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Slopes of Indifference Curves
When more of a commodity is always preferred, the commodity is a good.
If every commodity is a good then indifference curves are negatively sloped.
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Slopes of Indifference Curves
BetterBetter
Worse
Worse
Good 2Good 2
Good 1Good 1
Two goodsTwo goodsa negatively sloped a negatively sloped indifference curve.indifference curve.
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Slopes of Indifference Curves
If less of a commodity is always preferred then the commodity is a bad.
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Slopes of Indifference Curves
Better
Better
WorseWorse
Good 2Good 2
Bad 1Bad 1
One good and oneOne good and onebad a bad a positively sloped positively sloped indifference curve.indifference curve.
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Utility Functions
A preference relation that is complete, reflexive, transitive and continuous can be represented by a continuous utility function.
Continuity means that small changes to a consumption bundle cause only small changes to the preference level.
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Utility Functions
A utility function U(x) represents a preference relation if and only if:
x’ x” U(x’) > U(x”)
x’ x” U(x’) < U(x”)
x’ x” U(x’) = U(x”).
~
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Utility Functions
Utility is an ordinal (i.e. ordering) concept.
E.g. if U(x) = 6 and U(y) = 2 then bundle x is strictly preferred to bundle y.
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Utility Functions & Indiff. Curves Consider the bundles (4,1), (2,3) and
(2,2). Suppose (2,3) (4,1) (2,2). Assign to these bundles any numbers
that preserve the preference ordering;e.g. U(2,3) = 6 > U(4,1) = U(2,2) = 4.
Call these numbers utility levels.
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Utility Functions & Indiff. Curves
An indifference curve contains equally preferred bundles.
Equal preference same utility level. Therefore, all bundles in an
indifference curve have the same utility level.
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Utility Functions & Indiff. Curves So the bundles (4,1) and (2,2) are in
the indiff. curve with utility level U
But the bundle (2,3) is in the indiff. curve with utility level U 6.
On an indifference curve diagram, this preference information looks as follows:
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Utility Functions & Indiff. Curves
U 6U 4
(2,3) (2,2) (4,1)
x1
x2
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Utility Functions & Indiff. Curves
Another way to visualize this same information is to plot the utility level on a vertical axis.
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U(2,3) = 6
U(2,2) = 4 U(4,1) = 4
Utility Functions & Indiff. Curves3D plot of consumption & utility levels for 3 bundles
x1
x2
Utility
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Utility Functions & Indiff. Curves
This 3D visualization of preferences can be made more informative by adding into it the two indifference curves.
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Utility Functions & Indiff. Curves
U
U
Higher indifferencecurves containmore preferredbundles.
Utility
x2
x1
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Utility Functions & Indiff. Curves
Comparing more bundles will create a larger collection of all indifference curves and a better description of the consumer’s preferences.
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Utility Functions & Indiff. Curves
U 6U 4U 2
x1
x2
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Utility Functions & Indiff. Curves
As before, this can be visualized in 3D by plotting each indifference curve at the height of its utility index.
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Utility Functions & Indiff. Curves
U 6U 5U 4U 3U 2U 1
x1
x2
Utility
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Utility Functions & Indiff. Curves
The collection of all indifference curves for a given preference relation is an indifference map.
An indifference map is equivalent to a utility function; each is the other.
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Utility Functions
There is no unique utility function representation of a preference relation.
Suppose U(x1,x2) = x1x2 represents a preference relation.
Again consider the bundles (4,1),(2,3) and (2,2).
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Utility Functions U(x1,x2) = x1x2, so
U(2,3) = 6 > U(4,1) = U(2,2) = 4;
that is, (2,3) (4,1) (2,2). Definir transformación monótona
(ver notas)
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Utility Functions U(x1,x2) = x1x2 (2,3) (4,1) (2,2). Define V = U2.
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Utility Functions U(x1,x2) = x1x2 (2,3) (4,1) (2,2). Define V = U2. Then V(x1,x2) = x1
2x22 and
V(2,3) = 36 > V(4,1) = V(2,2) = 16so again(2,3) (4,1) (2,2).
V preserves the same order as U and so represents the same preferences.
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Goods, Bads and Neutrals A good is a commodity unit which
increases utility (gives a more preferred bundle).
A bad is a commodity unit which decreases utility (gives a less preferred bundle).
A neutral is a commodity unit which does not change utility (gives an equally preferred bundle).
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Goods, Bads and NeutralsUtility
Waterx’
Units ofwater aregoods
Units ofwater arebads
Around x’ units, a little extra water is a neutral.
Utilityfunction
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Some Other Utility Functions and Their Indifference Curves
Instead of U(x1,x2) = x1x2 considerV(x1,x2) = x1 + x2. What do the indifference curves for
this “perfect substitution” utility function look like?
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Perfect Substitution Indifference Curves
5
5
9
9
13
13
x1
x2
x1 + x2 = 5
x1 + x2 = 9
x1 + x2 = 13
V(x1,x2) = x1 + x2.
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Perfect Substitution Indifference Curves
5
5
9
9
13
13
x1
x2
x1 + x2 = 5
x1 + x2 = 9
x1 + x2 = 13
All are linear and parallel.
V(x1,x2) = x1 + x2.