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4Chapter Highlights
Chapter 2
Budget Constraint
Most of the material here is pretty straightforward. Drive home the formula
for the slope of the budget line, emphasizing the derivation on page 23. Try
some different notation to make sure that they see the idea of the budget line,
and don’t just memorize the formulas. In the workbook, we use a number of
different choices of notation for precisely this reason. It is also worth pointing
out that the slope of a line depends on the (arbitrary) choice of which variable
is plotted on the vertical axis. It is surprising how often confusion arises on this
point.
Students sometimes have problems with the idea of a numeraire good. They
understand the algebra, but they don’t understand when it would be used. One
nice example is in foreign currency exchange. If you have English pounds and
American dollars, then you can measure the total wealth that you have in either
dollars or pounds by choosing one or the other of the two goods as numeraire.
In the workbook, students sometimes get thrown in exercises where one of
the goods has a negative price, so the budget line has a positive slope. This
comes from trying to memorize formulas and figures rather than thinking about
the problem. This is a good exercise to go over in order to warn students about
the dangers of rote learning!
Budget Constraint
A. Consumer theory: consumers choose the best bundles of goods they can
afford.
B. Two parts to theory
Chapter 2 5
C. What do we want to do with the theory?
1. test it — see if it is adequate to describe consumer behavior
2. predict how behavior changes as economic environment changes
D. Consumption bundle
1. (x1,x
2) — how much of each good is consumed
2. (p1,p
2) — prices of the two goods
E. Two goods
1. theory works with more than two goods, but can’t draw pictures.
2. often think of good 2 (say) as a composite good, representing money to
spend on other goods.
F. Budget line
1. p1x1+p2x2=m
2. also written as x2=m/p2−(p1/p2)x1.
3. budget line has slope of −p1/p2and vertical intercept of m/p2.
G. Changes in budget line
1. increasing mmakes parallel shift out. See Figure 2.2.
2. increasing p1makes budget line steeper. See Figure 2.3.
H. The numeraire
1. can arbitrarily assign one price a value of 1 and measure other price relative
to that
I. Taxes, subsidies, and rationing
1. quantity tax — tax levied on units bought: p1+t
2. value tax — tax levied on dollars spent: p1+τp1. Also known as ad
3. subsidies — opposite of a tax
6Chapter Highlights
4. lump sum tax or subsidy — amount of tax or subsidy is independent of
J. Example — food stamps
1. before 1979 was an ad valorem subsidy on food
2. after 1979 got a straight lump-sum grant of food coupons. Not the same
