INTERMEDIATE

MICROECONOMIC THEORY
ECNM 611

Mr. Khumalo J.
Email: john.khumalo@nwu.ac.za
Office hour: By appointment
Office: Room number 131, 1st floor
Contact: 082 590 2827 (9am-4pm)
 Core Texts
§ Varian H. Intermediate
Microeconomics: A modern
approach (6th/7th/8th edition), W.W.
Norton & Co, 2003/2006/2010

§ Complementary Texts (Refer to

your Course Outline footnote 1
 Lecture Structure
1. Budget Constraint
2. Properties of budget set
3. Changes in Budget Line
4. Taxes, Subsidies, and Rationing
 Budget Constraint
Consumer theory: consumers
choose the best bundles of goods
they can afford.
üThis is virtually the entire theory in
a nutshell
üBut this theory has many
surprising consequences
 Budget Constraint
Two parts to theory

ü"can afford" - budget constraint

ü"best" - according to consumers'
preferences
 Budget Constraint
üThe definition of "best" depends
on the consumer preferences.
üBudget constraint determines
what a consumer can afford
 Budget Constraint
Consumption bundle
ü (x1, x2) - how much of each good
is consumed
ü ( p1 , p2 ) - prices of the two goods
üm - money the consumer has to
spend
 Budget Constraint
üConsumption bundle: (Xl, X2) -
two numbers that tell us how
much the consumer is choosing to
consume of good 1 and how
much the consumer is choosing to
consume of good 2.
 Budget Constraint
budget constraint: p1 x1 + p2 x2 ≤ m
üWhere p1 x1 is spending on good
1 and p2 x2 is spending on good 2.
The budget constraint tells us that
total spending cannot exceed m.
üAffordable consumption bundles
are those that don't cost any more
than m.
 Budget Constraint
üAll (x1, x2) that satisfy this
constraint make up the “budget
set” of the consumer
üBudget set is a set of affordable
consumption bundles at prices
ü(p1, p2) and income m.
 Budget Constraint
üBudget Set (Shaded)
 Properties of the Budget Set
üBudget line is the set of bundles
that cost exactly m
üFrom p1 x1 + p 2 x 2 = m make x2
the subject of the formula
m p1
üYou get x2 = − x1
p2 p2
p1
üWhere −
p2 is the slope the BL
 Properties of the Budget Set
üHow to draw the BL given P’s & m
1.Calculate how much of good 2
will be bought if all m spent on
m
good 2( x = p )
2
2

2.Calculate how much of good 1

will be bought if all income spent
m
on goo1(x = p )
1
1
 Properties of the Budget Set
üThe slope measures the rate at
which the market is willing to
substitute good 1 for good 2
üMeasures the opportunity cost of
good 1
 Changes in the Budget Line
üIncreasing m makes parallel shift
out.
üChange in income affects only the
intercept & not the slope.
üConsider fig 2.2 below
 Changes in income

Figure 2.2 Increasing income

 Changes in income
üDraw the figure/diagram that
depicts a decline in income

üDRAW NOW
 Changes in prices
üIncreasing PI makes budget line
steeper. See Figure 2.3.
üIncreasing P2 makes budget line
flatter.
üJust see how intercepts change.
 Changes in prices

Figure 2.3 Increasing price

 Changes in prices
üMultiplying all prices by t is just
like dividing income by t
üMultiplying all prices and income
by t doesn't change budget line
 Taxes, Subsidies & Rationing
Economic policy often uses tools
that affect a consumer's BC.
üQuantity tax: the consumer has
to pay a certain amount to the
government for each unit of the
good purchased (e.g. fuel tax)
üp' =p+t
 Taxes, Subsidies & Rationing
üValue tax ('ad valorem' tax): tax
on the value (the price) of a good,
rather than the quantity purchased
of a good (e.g. VAT)
üp' = (1 + r)p
üi.e. the consumer has to pay p to
the supplier and –rp government
for each unit of the good.
 Taxes, Subsidies & Rationing
üQuantity subsidy: the govt gives
an amount to the consumer that
depends on the amount of the
good purchased
üp' =p- s
 Taxes, Subsidies & Rationing
üAd valorem subsidy: subsidy
based on the price of the good
being subsidized p'=(1-σ)p

üSubsidy is just the opposite of a

tax.
 Taxes, Subsidies & Rationing
üDraw up a diagram that shows
rationing
 Taxes, Subsidies & Rationing
üPRACTICE THE REVIEW
QUESTIONS ON CHAPTER 2
ATTACHED HERE

THANK YOU