Question

I'm looking to learn about budget constraints and how to calculate Optimal levels of consumption during work period and retirement and also how to discuss the role of income and substitution effects in determining whether a person will increase, or decrease their savings in the work period.

Answer 1

Well, let me start from the beginning.

1.Budget Constraints

Budget Constraints can be simply defined as a constraint which shows all the possible combinations of goods and services in which a consumer can buy or purchase with the given prices and within his given income. It is that combination of two goods that yield the same level of satisfaction for the consumer with the given prices and within his income bracket. In some cases, the price of the product and the income of the consumer won't go together. In such cases, the consumer is supposed to make choices. If all the budget constraints are plotted on a graph sheet, it will form a straight line downward slopping to the right. This line is called as Budget line. Budget line is the graphical presentation of the budget constraints or budget schedule.

2.Calculation of Optimal Levels of Consumption

In any case the optimum level of consumption is determined by the tangency of indifference curve and the budget line. In other words, the indifference curve will touch the budget line at a point. At that point, the slope of the budget line will be equal to the slope of the indifference curve. The consumer will get maximum utility at that point.

At that point,

where MRS is the Marginal Rate of Substitution and Px and Py are the Price of the Goods.

3.Role of Income Effect and Substitution Effect

Income Effect: It can be defined as the change in demand due to change in income of the consumer's or change in consumer's buying capacity. For example: Let us consider College education itself, if the consumer has cash, he will sent his children to Harvard or Cambridge, if not he will sent them to a college with less tuition fees.

Substitution Effect: It is the change in demand due to change in price of its substitute good. For example, there are two goods X and Y. If the price of X rises, the consumer will feel that X is overpriced and he will opt for Y which is the substitute of X and less priced.

There are two cases.

i) Income effect > Substitution Effect

In this case, the consumer has higher purchasing power and he is willing to spend extra money which eventually ends up in reduction of savings.

ii) Substitution Effect > Income Effect

In this case, the consumer will have relatively less purchasing power or in other words he check the price of the commodity and price of its substitutes. He will buy the substitute product which is relatively cheap and ends up increasing his savings.