Econ 231- Notes 1 Budget Constraint Economics: The study of the allocation of scarce resources among alternative uses

Microeconomics: The study of the economic choices individuals and firms make and how those choices create markets MODELS: Simple theoretical descriptions that capture the essentials of how the economy works Used because the real world is too complicated to describe in detail Models tend to be unrealistic but useful While they fail to show every detail (such as houses on a map) they provide enough structure to solve the problem (such as how a map provides you with a way to solve how to drive to a new location) Examples of assumptions we made; Utility (profit) maximizing agents Atomistic suppliers and consumers Perfect information
Friedman: The test of the validity of a model is the accuracy of its predictions about real economic phenomena, not the realism of its assumptions. Friedman: A hypothesis is important if it explains much by little. Our approach: simple models, significant insights.

BUDGET CONSTRAINT What do we want with this Consumer theory? 1. See if it is adequate to describe consumer behavior 2. Predict how behavior changes as economic environment changes a) cost-benefit analysis b) predicting impact of some policy This is the can afford part of the consumer theory. For simplicity assume there are two goods that the consumer can choose. Consumption bundle (x1, x2): Amount of consumer is choosing good 1, x1, and good 2, x2. Prices: (p1, p2) Income (money) (m): The amount of consumer can spend on goods. Budget Set: The budget set consists of all bundles that are affordable at the given prices and income. Money spent on good 1 (p1x1) plus money spent on good 2(p2x2) has to be equal (or less) than total income (m). m p1 p1x1 + p2x2 = m x2 = x1 p2 p2

Budget Line: If x2 is on the vertical line and x1 on the horizontal m Vertical intercept: p2 p1 Slope: p2

Econ 231- Notes 1 Budget Constraint Set x1 to zero in order to get vertical intercept x2 to zero to get horizontal intercept.
X2

m/p2 Budget line slope= - p1/p2

B
Budget set

Points A and B are affordable but C is not.

X1 m/p1

Changes in Budget Line X1

Increase in m parallel shifts budget line outward.

m' p1 m p1

m p2

m
P2
'

X2

Increase in p2 makes budget line steeper p1

X1

m p1

X2

m' p2

m p2

Econ 231- Notes 1 Budget Constraint

Effect of inflation: If we multiply both prices and income by t tp1x1 + tp2x2 = tm same with old budget constraint p1x1 + p2x2 = m Inflation has no effect as long as it is perfectly balanced
Other goods

After government imposes OTV on cars

Cars

Other goods

Municipality increases the rate on water consumption after certain level

Water consumption

Other goods

Government buys sugar from farmers at a higher price and sell it to consumers for a low price. (subsidy on sugar)

Sugar

Econ 231- Notes 1 Budget Constraint

Other goods

Effect of Ramazan paketi on poors:

Food

Other goods

Budget Constraint of limited (4 gb per month) ADSL internet access

4 gb

Gigabytes of internet access

CONCLUSIONS 1. Perfectly balanced inflation is not bad 2. Increase in income holding prices constant makes consumer better off 3. Decrease in one price holding other prices and income constant makes consumer better off.

EXAMPLE 1: Ahmet buys five new college textbooks during his first year at school at a cost of $80 each. Used books cost only $50 each. When the bookstore announces that there will be 10% increase in the price of new books and 5% increase in the price of used books and Ahmets father offers him $40 extra. a) What happens to Ahmets budget line? b) Is Ahmet worse off? EXAMPLE 2: Mehmet has a job that requires her to travel out of every four weeks. He has an annual travel budget and can travel either by bus or airplane. The airline which he typically flies has a frequent flier program that reduces the cost of tickets according to the number of miles he has flown in a given year. When he reaches 25000 km, the airline reduces the price of his tickets by 25% for the remainder of the year, when he reaches 50000 km, the price

Econ 231- Notes 1 Budget Constraint lowered to 50% of the original price for the remainder of the year. Graph Mehmets budget line. EXAMPLE 3 : Green card is a government program which subsidizes the medical services for the poor. Prior to 2004 drug benefits were not included in this program. In 2004 legislators introduced drug benefits to the Green card holders, government started to pay 100% of the drug bills of green card holders. a) Draw the budget line of green card holders with the drug benefits. b) After unexpectedly high level of drus costs to the government, the government decided to lower subsidy level to 80%. Draw the budget line after this change. c) Facing with tight IMF constraints, ministry of health put another restriction on the drug benefit, with this new restriction subsidy level for each green card holder is limited to 2000 YTL annually. Draw the new budget line for the green card holder.