Microeconomics_4__Besanko

Microeconomics_4__Besanko


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for optimal
consumer choice.
\u2022 Solve for an optimal consumption basket, given 
information about income, prices, and marginal utilities.
\u2022 Explain why the optimal consumption basket solves
both a utility maximization problem and an expendi-
ture minimization problem.
\u2022 Explain why the optimal consumption basket could
occur at a corner point.
c04consumerchoice.qxd 7/14/10 3:16 PM Page 104
\u2022 Illustrate the budget line and optimal consumer choice graphically when one of the goods a consumer
can choose is a composite good.
\u2022 Describe the concept of revealed preference.
\u2022 Employ the concept of revealed preference to determine whether observed choices are consistent
with utility maximization.
4.1 THE BUDGET CONSTRAINT 105
Number of households 121,171,000 14,720,000 11,824,000 37,322,000
Average number 2.5 2.2 2.4 3.1
 of people in household
Age of reference person* 48.8 52.3 46.8 47.0
Percent (reference person) 60 44 59 79
 having attended college
Income before taxes $ 63,091 $ 24,893 $44,555 $130,455
Income after taxes $60,858 $24,709 $43,628 $ 124,613
Average annual expenditures $49,638 $29,704 $41,083 $ 84,072
Expenditure on
 selected categories
 Food $ 6,133 $ 4,071 $ 5,689 $ 9,464
 Housing (including $ 16,920 $ 10,994 $ 13,997 $ 27,408
 shelter, utilities, supplies,
 furnishings, and equipment)
 Apparel and services $ 1,881 $ 1,016 $ 1,517 $ 3,275
 Transportation $ 8,758 $ 5,434 $ 7,346 $ 14,362
 Health care $ 2,853 $ 2,841 $ 2,800 $ 3,928
 Entertainment $ 2,698 $ 1,375 $ 2,029 $ 4,927
All
Households
Households
with Income
$20,000\u2013
$29,999
Households
with Income
$40,000\u2013
$49,999
Households
with Income
over
$70,000
TABLE 4.1 U.S. Average Expenditures by Household, 2007
*Reference person: The first member mentioned by the respondent when asked to \u201cStart with the name of the person 
or one of the persons who owns or rents the home.\u201d
Source: Bureau of Labor Statistics. All data come from Table 2, Income Before Taxes: Average Annual Expenditures and
Characteristics, Consumer Expenditure Survey, 2007. The Consumer Expenditure Survey tables are available online at
www.bls.gov/cex/tables.htm, August 19, 2009.
4.1
THE BUDGET
CONSTRAINT
The budget constraint defines the set of baskets that a consumer can purchase with
a limited amount of income. Suppose a consumer, Eric, purchases only two types of
goods, food and clothing. Let x be the number of units of food he purchases each
month and y the number of units of clothing. The price of a unit of food is Px, and the
price of a unit of clothing is Py. Finally, to keep matters simple, let\u2019s assume that Eric
has a fixed income of I dollars per month.
c04consumerchoice.qxd 7/14/10 3:16 PM Page 105
106 CHAPTER 4 CONSUMER CHOICE
Eric\u2019s total monthly expenditure on food will be Pxx (the price of a unit of food times
the amount of food purchased). Similarly, his total monthly expenditure on clothing will
be Py y (the price of a unit of clothing times the number of units of clothing purchased).
The budget line indicates all of the combinations of food (x) and clothing ( y) that
Eric can purchase if he spends all of his available income on the two goods. It can be
expressed as
(4.1)
Figure 4.1 shows the graph of a budget line for Eric based on the following as-
sumptions: Eric has an income of I \ufffd $800 per month, the price of food is Px \ufffd $20
per unit, and the price of clothing is Py \ufffd $40 per unit. If he spends all $800 on food,
he will be able to buy, at most, I\ufffdPx \ufffd 800 \ufffd20 \ufffd 40 units of food. So the horizontal
intercept of the budget line is at x \ufffd 40. Similarly, if Eric buys only clothing, he will
be able to buy at most I \ufffdPy \ufffd 800 \ufffd40 \ufffd 20 units of clothing. So the vertical intercept
of the budget line is at y \ufffd 20.
As explained in Figure 4.1, Eric\u2019s income permits him to buy any basket on or inside
the budget line (baskets A\u2013F ), but he cannot buy a basket outside the budget line, such
as G. To buy G he would need to spend $1,000, which is more than his monthly income.
These two sets of baskets\u2014those Eric can buy and those he cannot buy\u2014exemplify what
is meant by the budget constraint.
Since the budget constraint permits a consumer to buy baskets both on and inside
the budget line, the equation for the budget constraint is somewhat different from
Px x \ufffd Py y \ufffd I
budget constraint
The set of baskets that a
consumer can purchase
with a limited amount of
income.
budget line The set of
baskets that a consumer can
purchase when spending 
all of his or her available 
income.
FIGURE 4.1 Budget Line
The line connecting baskets A and E is Eric\u2019s budget line when he has an income of I \ufffd $800
per month, the price of food is Px \ufffd $20 per unit, and the price of clothing is Py \ufffd $40 per unit.
The equation of the budget line is Px x \ufffd Py y \ufffd I (i.e., 20x \ufffd 40y \ufffd 800). Eric can buy any basket
on or inside the budget line\u2014baskets A\u2013F (note that basket F would cost him only $600).
However, he cannot buy a basket outside the budget line, such as basket G, which would cost
him $1,000, more than his monthly income.
A
B
C
G
I
Px
= 40
D
E
F
100
5
10
15
20
20 30
Budget line:
Income = $800 per month
Slope = \u2013
40
x, units of food
y,
 
u
n
its
 o
f c
lo
th
in
g
I
Py
= 20
= \u2013
Px
Py
1
2
c04consumerchoice.qxd 6/18/10 5:31 PM Page 106
4.1 THE BUDGET CONSTRAINT 107
equation (4.1) for the budget line. The budget constraint can be expressed as:
(4.1a)
What does the slope of the budget line tell us? The slope of the budget line is
\ufffdy/\ufffdx. If Eric is currently spending his entire income on basket B in Figure 4.1\u2014that
is, consuming 10 units of food (x) and 15 units of clothing ( y)\u2014and he wants to move
to basket C, he must give up 5 units of clothing (\ufffdy \ufffd \ufffd5) in order to gain 10 units
of food (\ufffdx \ufffd 10). We can see that, in general, since food is half as expensive as cloth-
ing, Eric must give up 1\ufffd2 unit of clothing for each additional unit of food, and the
slope of the budget line reflects this (\ufffdy \ufffd\ufffdx \ufffd \ufffd5\ufffd10 \ufffd \ufffd1\ufffd2). Thus, the slope of the
budget line tells us how many units of the good on the vertical axis a consumer must give up
to obtain an additional unit of the good on the horizontal axis.
Note that the slope of the budget line is \ufffdPx\ufffdPy.1 If the price of good x is three
times the price of good y, the consumer must give up 3 units of y to get 1 more unit of
x, and the slope is \ufffd3. If the prices are equal, the slope of the budget line is \ufffd1\u2014the
consumer can always get 1 more unit of x by giving up 1 unit of y.
HOW DOES A CHANGE IN INCOME
AFFECT THE BUDGET LINE?
As we have shown, the location of the budget line depends on the level of income and
on the prices of the goods the consumer purchases. As you might expect, when income
rises, the set of choices available to the consumer will increase. Let\u2019s see how the
budget line changes as income varies.
In the example just discussed, suppose Eric\u2019s income rises from I1 \ufffd $800 per
month to I2 \ufffd $1,000 per month, with the prices Px \ufffd $20 and Py \ufffd $40 unchanged. As
shown in Figure 4.2, if Eric buys only clothing, he can now purchase I2\ufffdPy \ufffd 1000\ufffd40 \ufffd
25 units of clothing, corresponding to the vertical intercept of the new budget line. The
extra $200 of income allows him to buy an extra 5 units of y, since Py \ufffd $40.
If he buys only food, he could purchase I2\ufffdPx \ufffd 1000\ufffd20 \ufffd 50 units, correspon-
ding to the horizontal intercept on the new budget line. With the extra $200 of in-
come he can buy an extra 10 units of x, since Px \ufffd $20. With his increased income of
$1,000, he can now buy basket G, which had formerly been outside his budget line.
The slopes of the two budget lines are the same because the prices of food and
clothing are unchanged (\ufffdy\ufffd\ufffdx \ufffd \ufffdPx