Life would be easy if it was just a question of deciding what we would like most. The answer would probably be more of everything! Of course, economic decisions are not that simple, and the reason is that we are constrained in what we can choose: constrained by the amount of income, the amount of time, or any one of a number of factors. In this lecture we will analyze how consumers make choices when they face a budget constraint.
Our monetary income constrains our consumption. Image courtesy of allison.johnston on Flickr.
Keywords: Budget constraints; marginal rate of transformation; opportunity cost; constrained utility maximization; corner solutions.
Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:
- [R&T] Chapter 7, “The Analysis of Consumer Choice.” Sections 7.3.
- [Perloff] Chapter 4, “Consumer Choice.” (optional)
This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.
Which of the following concepts is equivalent to the marginal rate of transformation between two goods?
These are all equivalent ways to express the concept of the marginal rate of transformation.
What happens to a consumer when the price of a good she consumes increases, or her income decreases?
Her opportunity set has been restricted: choices that were available to her before are no longer available to her.
How do we graphically represent the utility maximizing bundle that consumers can afford?
The point at which the indifference curve and the budget constraint cross is incorrect, because if the indifference curve is crossing the budget constraint the consumer could select another bundle on a higher indifference curve (where she or he obtains more utility) and still be within the budget set. The point where the budget constraint crosses the X or Y axis is incorrect, as this point is not relevant to the consumer's preferences. A point on the indifference curve that is to the right of the budget constraint is incorrect, as a point to the right of the budget constraint is not affordable.
You are consuming two goods, pizzas and movies. At your current bundle, the marginal utility you would gain from spending an extra dollar on pizza is higher than the marginal utility you would gain from spending an extra dollar on movies. What should you do?
At the optimal consumer bundle, the marginal utility per dollar spent (bang for your buck) should be equal across all goods. If you can obtain more utility from spending an extra dollar on pizza, you should increase your pizza expenditure until the point where the marginal utility per dollar of the two goods is equalized.
What is the definition of a corner solution?
Graphically, the optimal bundle lies on one of the axes, and thus is referred to as a corner solution. Note that 'an optimal bundle of two consumer goods in which the consumer does not spend all of his/her income' is a case that we rule out in our analysis by assuming that the consumer always spends all of his/her income on consumption, and does not save.
These optional resources are provided for students that wish to explore this topic more fully.
Textbook Study Materials
See the [Perloff] chapter for the topics covered, as well as quizzes, applications, and other related resources.