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PROFESSOR: All right, so today we're going to continue our discussion of consumer choice.

If you remember the set-up from last time, the main motivation is you're trying to understand what underlies demand curves, how consumers ultimately decide to trade off price and quantity of goods.

We said that ultimately that came from the principle of utility maximization, and that utility is maximized when individuals maximize the utility function, which is this mathematical representation of preferences.

And last time we talked about how if individuals were unconstrained how they choose what they want, they would just like more of everything, and their ranking across different bundles would depend on that underlying utility function.

Now, of course, what's stopping individuals from consuming everything they want is their budget constraints. And so today we're going to turn to the second part of the problem, which is talking about budget constraints.

Now, we're going to make a very simplifying assumption here for most of the semester, which is we are going to assume that your income equals your budget. That is, you spend your entire income. That is, we're going to ignore the possibility of savings until about the third lecture from the end.

Now, this turns out not to be a terrible assumption for the typical American.

The typical American doesn't save. So actually, it's not a terrible assumption for us to work with if we think about typical consumers. In practice, savings is going to turn out to be a very critical part of what we're going to do to think about economics, so we'll come back to that. But we're going to ignore savings for now and assume that your budget equals your income.

So let's say that your parents, probably a good model is you guys, you guys probably aren't in saving mode. You've got some budget saved from your parents. Let's call it y.

And let's say that your parents give you some budget at the start of the semester, y, and they say this is your money you have to spend, say each month or for the whole semester. And let's imagine that you have to allocate that budget only across two goods, pizza and movies. So once again, unrealistic, but this is the kind of simplifying assumption that lets us understand how people make decisions.

So that gives you your budget constraint. You've got some income y that your parents have given you, and you can allocate that across pizza and movies. So how do you allocate that? Well, you can buy movies, the number of movies you can get, plus the number of pizzas.

Well, how many of each you can get, that depends on their price. In particular, budget constraint is the number of movies times the price per movie plus the number of pizzas — plus the number of pizzas times the price for pizza. That's your budget constraint. It's the number of movies times the price per movie or the number of pizzas times the price for pizza.

And this is easiest to see graphically. If you go to figure 5-1, this is a graphical illustration of a budget constraint. Now, let's just carefully talk through this for a moment. You're going to be really good at dealing with budget constraints. You're going to have to be this semester. So let's carefully talk about where this comes from.

OK, the x-axis is going to be how many movies you could have if all you did with your income was consume movies. Well, if all you did with your income was consume movies, you could have y over p sub m movies.

If you remember the set-up from last time, the main motivation is you're trying to understand what underlies demand curves, how consumers ultimately decide to trade off price and quantity of goods.

We said that ultimately that came from the principle of utility maximization, and that utility is maximized when individuals maximize the utility function, which is this mathematical representation of preferences.

And last time we talked about how if individuals were unconstrained how they choose what they want, they would just like more of everything, and their ranking across different bundles would depend on that underlying utility function.

Now, of course, what's stopping individuals from consuming everything they want is their budget constraints. And so today we're going to turn to the second part of the problem, which is talking about budget constraints.

Now, we're going to make a very simplifying assumption here for most of the semester, which is we are going to assume that your income equals your budget. That is, you spend your entire income. That is, we're going to ignore the possibility of savings until about the third lecture from the end.

Now, this turns out not to be a terrible assumption for the typical American.

The typical American doesn't save. So actually, it's not a terrible assumption for us to work with if we think about typical consumers. In practice, savings is going to turn out to be a very critical part of what we're going to do to think about economics, so we'll come back to that. But we're going to ignore savings for now and assume that your budget equals your income.

So let's say that your parents, probably a good model is you guys, you guys probably aren't in saving mode. You've got some budget saved from your parents. Let's call it y.

And let's say that your parents give you some budget at the start of the semester, y, and they say this is your money you have to spend, say each month or for the whole semester. And let's imagine that you have to allocate that budget only across two goods, pizza and movies. So once again, unrealistic, but this is the kind of simplifying assumption that lets us understand how people make decisions.

So that gives you your budget constraint. You've got some income y that your parents have given you, and you can allocate that across pizza and movies. So how do you allocate that? Well, you can buy movies, the number of movies you can get, plus the number of pizzas.

Well, how many of each you can get, that depends on their price. In particular, budget constraint is the number of movies times the price per movie plus the number of pizzas — plus the number of pizzas times the price for pizza. That's your budget constraint. It's the number of movies times the price per movie or the number of pizzas times the price for pizza.

And this is easiest to see graphically. If you go to figure 5-1, this is a graphical illustration of a budget constraint. Now, let's just carefully talk through this for a moment. You're going to be really good at dealing with budget constraints. You're going to have to be this semester. So let's carefully talk about where this comes from.

OK, the x-axis is going to be how many movies you could have if all you did with your income was consume movies. Well, if all you did with your income was consume movies, you could have y over p sub m movies.

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