Subject 3. The Opportunity Set

Assume a world with only two consumer goods, X and Y. Px is the price of good X. X is also the quantity of good X that is purchased by the consumer. Px x X is the consumer's expenditure on good X.

Total expenditure is Px x X + Py x Y.

M is the consumer's income or budget. The consumer cannot spend more than her budget allows. Px x X + Py x Y <= M is the consumer's budget constraint.

To draw a budget constraint, a line that shows the maximum amount of goods a buyer can purchase with her available funds, you need to know two things: 1) how much money she has, and 2) the prices of the two goods being considered.

Assume a consumer has an income of $24. The two goods are rice (price: $2) and beans (price: $3).

This is the basic budget line. Its slope is an indication of relative prices ($2/$3).

This is when the price of rice decreases and the consumer can purchase more rice.

When income doubles, the line will shifts outward, parallel to the original constraint.

Similarly, a company's production opportunity set represents the greatest quantity of one product that a company can produce for any given amount of the other good it produces. The investment opportunity set represents the highest return an investor can expect for any given amount of risk undertaken.

Practice Question 1

B1 is a consumer budget constraint.

Now the line moves to B2. This indicates that ______

A. the consumer's budget has increased.
B. the price of wine has dropped.
C. the price of glasses has dropped.
Correct Answer: A

An increase in budget will shift the budget constraint line out from the original line.

Practice Question 2

Select the correct statement(s).

I. When the price of one good changes, the budget constraint line will rotate.
II. A consumer's choices of goods are affected by her budget.
III. A consumer's budget is affected by her choices of goods.
Correct Answer: I and II

Practice Question 3

B1 is a consumer budget constraint.

Now the line moves to B2. This indicates that ______

A. the consumer's budget has increased.
B. the price of wine has dropped.
C. the price of glasses has dropped.
Correct Answer: B

The budget line rotates out because the consumer can buy more wine.

Practice Question 4

Select the correct statement(s).

I. Different incomes will have differing budget constraint positions. Higher incomes will be closer to the origin while lower incomes will be farther from it.
II. "More is better" implies budget exhaustion.

A. I only
B. II only
C. Both I and II
Correct Answer: B

I is false. Lower incomes will be closer to the origin while higher incomes will be farther from it. II is true. The consumer cannot spend more than her budget allows.