Budget Constraint Notes PDF

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Budget constraints in economics...

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Chapter 2 - Individual Choices ●

PRICE IS NOT THE SAME AS VALUE

Individual Choices ● Individuals make choices with a budget constraint ● Firms produce goods with cost constraint ● Every choice implies some tradeoff ○ What set of goods you can purchase ○ Linear combinations that does not exceed your budget ○ Set of resources ●

Budget constraint - the set of all possible consumption combinations of goods that someone can afford, given the prices of goods when all income is spent ○ The boundary of the opportunity set ■ Every possibility below the constraint is less than $10 so feasible ■ Every combination above the constraint is impossible

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Opportunity set - the set of all possible combinations of consumption that someone can afford given the prices of goods ad the individual’s income ○ All income does not need to be spent ○ These are determined by the budget and prices ○ Consumers choose a feasible option that they deem best ■ Every choice has an opportunity cost ● Opportunity cost of a burger is four bus tickets ○ Of any good or behavior is the value of the next best alternative ○ Or the opportunity cost of something is equal to the value of what you give up to get something ■ Example - you buy a laptop for $1000 ● The opportunity cost is $1000 of other goods ■ You go to college for four years ● Costs include tuition, textbooks, room and board ● You are unable to work ■ Bec could go to a local university for $25000 a year and earn a degree OR she could work at a nearby company and earn $40000 a year ● Assumer everything else is the same ● Ceteris paribus ● What is the opportunity cost of going to college? ○ Bec’s college degree is $260000 economic cost ○ Bec’s college degree is $100000 accounting cost ○ The accounting cost is what Bec actually pays for the degree, but the economic cost is a better measure of what she gave up in exchange for the degree ○ She would make the decision based on the economic cost

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Economics costs include opportunity costs Accounting costs do not include lost opportunities

Marginal Analysis - The practice of making decisions based on local costs and benefits of one or more unit of a good Utility - the concept of “satisfaction” ● Usefulness or value one obtains from consuming goods and services ● Chinese buffet principle The Law of Diminishing Marginal Utility ● Requires that the marginal utility of a good must decrease as you consume more of that good Sunk Costs - costs that cannot be recovered once spent ● Irrelevant ○ Examples ■ Half of a project ■ A train to nowhere ■ High budget movie that fails to attract viewers to theaters ■ Bad box office movie with a pricey production budget but no crowd ■ If you put more into it than you get out of it ● That difference lost is sunk cost Production Possibilities ● The set of possible combinations that could be produced with a given level of inputs ○ Similar to a budget, the slope of the PPF shows the opportunity costs ■ Example: can produce more education by giving up some healthcare ■ How much do I have to give up to get one more x ■ Any point above the curve is impossible

Health care Education Diminishing Returns ● The law of diminishing returns states that “as additional resources are added to produce a good or service, the marginal benefits declines”

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Can still produce more but not as efficiently as before The same concept as the law of diminishing marginal utility ○ Chinese buffet example

Budget Constraint vs. PPF ● The budget constraint is linear ○ Firms have a similar budget constraint ○ Linear budget for inputs for a fixed level of cost, which is their budget ● PPF is curved because diminishing returns implies that the cost of each additional good increases ● people have something like a PPF for household production and for their use of time ● There is a PPF for the entire economy and it is also curved this way Efficiency ● It is possible to produce more of one good without producing less of another ● An economy achieves productive efficiency when all resources have been used to their maximal effect ○ Any point on the PPF is efficient in this way ○ Any point inside the PPF is inefficient because it is possible to increase production of one good without sacrificing another ● Allocative efficiency - occurs when a mix of goods produced is socially optimal ○ There is no other ix that society would prefer Comparative Advantage ● A nation (or a firm) has a comparative advantage when it is able to produce more of a good for the same cost, that means it has a lower marginal cost (lower opportunity cost) ○ Countries have comparative advantages in different goods due to climate, geography, technology, skills ○ Whether a country produces a good/import it can be influenced by these advantages Greed is good ● Self interested behavior can lead to positive social outcomes ● Markets can produce the maximum amount of goods at the lowest possible cost ● The invisible hand of the market is the force that guides prices and quantities to equilibrium (by individuals’ selfish behavior) ○ Are people completely selfish? ● Altruism - the practice of concern for the wellbeing of others ○ An altruistic agent can act to benefit others in the “selfish” economic framework ○ There is no conflict between rational economic behavior and charity, philanthropy, and altruism ○ Economists are not supposed to make value judgements ■ A positive statement describes the world as it is using only facts ■ A normative statement applies value judgement to how things should be

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