Micro Economics I Introduction and Budget Constraint

Econ 111. Instructor: Mr. Chandra Sekhar

Introduction to Theory of Consumer Demand

Theory of demand seeks to establish relationship between the quantity demanded of a

commodity and its price. It also explains variations in demand.

The purpose of the theory of demand is to determine the various factors that affect
demand. Demand is a multivariate relationship, that is, it is determined by many
factors simultaneously. Some demand for a particular product are its own price,
consumer’s income, prices of other commodities, consumer’s tastes, income
distribution, total population, consumer’s wealth, credit availability, government
policy, past levels of demand and past levels of income.

There are different approaches known to the economists to the theory of demand. The
oldest among them is the marginal utility approach. The marginal utility analysis
explains consumer’s demand for a commodity and derives a law of demand, which
shows an inverse relationship between the quantity demanded and the price of the
commodities. It should be noted that the traditional theory of demand examines only
the consumer’s demand for durables and non-durables. It is partial in its approach in
that it examines the demand in one market in isolation from the conditions of the
demand in other markets. An important implicit assumption of the theory of demand
is that firms sell their products directly to the final consumers.

All desires of a consumer are not of equal urgency or importance. Since his resources
are limited and he cannot fulfill all his desires, he must pick and choose more
important and more urgent desires for satisfaction. Thus, some desires take
precedence of others. This is how a consumer ranks his desires and builds up a scale
of preferences. Scarcity forces him to choose. Ability to arrange preferences in order
of importance or urgency is inherent in human nature.

A prudent consumer exercises a lot of discrimination in his purchases. We find him

substituting one commodity, partly or wholly, for another. He purchases a certain
quantity of a commodity and no more. All the time, he is aspiring to reach an
equilibrium position, i.e., a position in which he derives maximum satisfaction from
the use of money at his disposal. The consumer’s scale of preferences are independent
of the prices ruling in the market. He builds up his scale of preferences from the
commodities he consumes. Because of this scale of preferences, he knows that one
combination of the goods yields him the same satisfaction as another.

In the following tutorial material of this, we shall learn in detail Consumer

Preferences, Budget Constraints, Utility, Consumer Choice, Offer curve analysis
of price and income, Slutsky’ Equation, Consumer surplus, Derivation of the
Market Demand, and Elasticity of Demand.

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Micro Economics I Introduction and Budget Constraint
Econ 111. Instructor: Mr. Chandra Sekhar

1.1 BUDGET CONSTRAINTS

The budget constraints are that consumers face because of their limited incomes.
People are compelled to determine their behavior in light of limited financial
resources. For the theory of consumer behavior, this means that each consumer has a
maximum amount that can be spent per period of time. The consumer’s problem is to
spend this amount in the way they yield maximum satisfaction.

The Consumption Basket of a consumer (x 1,x2) is simply a list of two numbers that
tells us how much the consumer is choosing to consume of good 1, x 1, and how much
the consumer is choosing to consume of good 2, x2. Sometimes it is convenient to
denote the consumer’s bundle by a single symbol like X, where X is simply an
abbreviation for the list of two numbers (x1,x2).

We suppose that we can observe the prices of the two goods, (p 1,p2) and the amount of
money the consumer has to spend m, then the budget constraint of the consumer can
be written as

p1x1 + p2x2 < m (1)

Here p1x1 is the amount of money the consumer is spending on good 1, and p 2x2 is the
amount of money the consumer is spending on good 2. The budget constraint of the
consumer requires that the amount of money spent on the two goods be no more than
the total amount the consumer has to spend. The consumer’s affordable consumption
bundles are those that do not cost any more than m.

1. Two Goods Are Often Enough.

The two-goods assumption is more general. Because it is often interpreted as one of

the goods are representing everything else the consumer might want to consume.

For example, if we are interested in studying a consumer’s demand for milk, let x1
measure his or her consumption of milk in quarts per month. Then let x 2 stand for
everything else the consumer might want to consume.

When you adopt this interpretation, it is convenient to think of good 2 as being the
money that the consumer can use to spend on other goods. Under this interpretation,
the price of good 2 will automatically be 1, since the price of one birr is one birr.
Thus, the budget constraint will take the form

p1x1+x2 < m (2)

This expression simply says that the amount of money spent on good 1, p 1x1, plus the
amount of money spent on all other goods, x2, must be no more than the total amount
of money the consumer has to spend, m.

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Micro Economics I Introduction and Budget Constraint
Econ 111. Instructor: Mr. Chandra Sekhar

Good 2 represents a composite good that stands for everything else that the consumer
might want to consume other than good 1. Such a composite good is invariably
measured in birrs to be spent on goods other than good 1. As far as the algebraic form
of the budget constraint is concerned, equation (2) is just a special case of the formula
given in the equation (1)., with p 2 = 1, so everything that we have to say about the
budget constraint in general will hold under composite good interpretation.

2. Properties of the Budget Set.

The budget line is the set of bundles that cost exactly m:

p1x1 + p2x2 = m (3)

These are the bundles of goods that just exhaust the consumer’s income. The budget
set is depicted in Fig 1. The heavy line is the budget line – the bundles that cost
exactly m – and the bundles below this line are those that cost strictly less than m.

Figure 1 Budget Line.

X2
Vertical Budget line;
intercept = m/p2 slope = -p1/p2

Budget set

Horizontal Intercept = m/p1 X1

Fig . 1

The budget set consists of all bundles that are affordable at the given prices and
income.

Rearrange the budget line in equation (3) to get the formula

x2 = m/p2 – p1/p2 * x1 (4)

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Micro Economics I Introduction and Budget Constraint
Econ 111. Instructor: Mr. Chandra Sekhar

This is the formula for a straight line with a vertical intercept of m/p 2 and a slope of –
p1/p2. The formula tells how many units of good 2 the consumer needs to consume in
order to just satisfy the budget constraint if he or she consuming x1 units of good 1.

The slope of the budget line measures the rate at which the market is willing to
substitute good 1 for good2. For example that the consumer is going to increase her
consumption of good 1 by ∆x1.

How much will consumption of good 2 have to change in order to satisfy her budget
constraint?

p1x1 + p2x2 = m

and p1(x1+∆x1) + p2(x2+∆x2) = m.

Subtracting the first equation from the second gives

p1∆x1 +p2∆x2 = 0.

This says that the total value of the change in consumption must be zero. Solving for
∆x2/∆x1, the rate at which good 2 can be substituted for good 1 while still satisfying
the budget constraint, gives

This is just slope of the budget line. The negative sign is there since ∆x1 and ∆x2 must
always have opposite signs. Because consumption of more of good1 leads to
consumption of less of good 2 and vice versa, as long as the consumer continue to
satisfy the budget constraint.

3. How the Budget Line Changes

When prices and incomes change, the set of goods that a consumer can afford changes
as well. To find out, how these changes affect budget set? First consider changes in
income. It easy to see from equation (4) that all increase in income will increase the
vertical intercept and not affect the slope of the line. Thus an increase in income will
result in a parallel shift outward of the budget line as in the following figure 2.
Similarly, decrease in income will cause a parallel shift inward.

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Micro Economics I Introduction and Budget Constraint
Econ 111. Instructor: Mr. Chandra Sekhar

X2
m’/p1

m/p2

m/p1 m’/p1 X1
Fig. 2

To identify changes in prices? First, consider increasing price 1 while holding price 2
and income fixed. According to equation (4) increase in p1 will not change the
vertical intercept, but it will make the budget line steeper since p1/p2 will become
larger.

X2
m/p2 Budget Lines

Slope = -p1/p2
Slope =
-p1/p2

m/p`1 m/p1 X1
Fig. 3
Increasing Price. If good 1 becomes more expensive,
the budget line becomes steeper.

What happens to the budget line when we change the prices of good 1 and good 2 at
the same time? For example, if the prices of both goods 1 and 2 gets doubled, both the
horizontal and vertical intercepts shift inward by a factor of one-half, and therefore
the budget line shifts inwards by one-half as well. Multiplying both prices by two is
just like dividing income by 2.

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Micro Economics I Introduction and Budget Constraint
Econ 111. Instructor: Mr. Chandra Sekhar

To show this algebraically. Suppose our original budget line is

p1x1 + p2x2 = m

Now suppose that both prices become t times as large. Multiplying both prices by t
yields

tp1x1 +t p2x2 = m

However, this equation is same as

p1x1 + p2x2 = m/t.

Thus multiplying both prices by a constant amount t is just like dividing income by
the same constant t. It follows that if we multiply both prices by t and we multiply
income by t. then budget line will not change at all.

What happens if both prices go up and incomes go down?

If m decreases, p1, and p2 both increase, then the intercepts m/p1 and m/p 2 must both
decrease. This means that the budget line will shift inward. How about the slope of
budget line? If price 2 increases more than price 1, so that – p 1/p2 decreases ( in
absolute value) then the budget line will be flatter; if price 2 increases less than 1, the
budget line will be steeper.

The budget line is defined by two prices and one income, but one of these variables is
redundant. We could peg one of the prices, or the income, to some fixed value, and
adjust the other variables to describe exactly the same budget set. Thus the budget line
p1x1 + p2x2 = m

exactly the same budget line as

p1/p2. x1+x2 =m/p2

or
p1/m. x1 +p2/m. x2 = 1.

Since the first budget line results from dividing everything by p 2, and the second
budget line results from dividing everything by m. In the first case, we have pegged p 2
= 1, and in the second case, we have pegged m = 1. Pegging the price of one of the
goods or income to 1 and adjusting the other prices to 1, as we did above we often
refer to that as the numeraire price. The numeraire price is the price relative to which
we are measuring the other price and income. It will occasionally be convenient to
think of one of the goods and being a numeraire good, since there will then be one
less price to worry about.

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Micro Economics I Introduction and Budget Constraint
Econ 111. Instructor: Mr. Chandra Sekhar