Question

The neoclassical theory of consumption can be summarized as individuals having “Champagne tastes on beer budget”. Explain what this quote means in terms of preferences and budget constraints. How does this quote help us understand the neoclassical theory of how individuals make consumption choices?

Answer 1

Very broad, overarching question;
feel free to use the comment feature below and clarify any doubts
regarding the question or my answer-

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This can alternately be understood as squeezing the most value out of money, or maybe even making lemonade from lemons.

In neoclassical microeconomics, we decompose the consumer's decision making into two independent component aspects:

i) their preference profile,which is represented by the utility function
ii) their range of options, represented as the budget constraint

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i) Preference profiles

tell us which good will be preferred to which if both options are available e.g. when given the choice of a plain donut or a chocolate donut at the same price, some people will prefer going for the plain one and others the chocolate donut.

If you expand your mind to think about "bundles of goods" as goods - e.g. (2 Apples, 1 Oranges) is a different bundle from (1 Apple, 2 Oranges) so is a different (composite) "good" - then this is what a utility function does;

the utility function establishes an ordering of these composite commodities or bundles of goods or just "goods" such that higher ranked options are more preferred, or equivalently bring more utility and thus (by construction) are ascribed higher utility numbers by the utility function

ii) Budget Constraint

a consumer's money income M
and the set of prices P = {Px, Py} (assuming a simple two-good case)
limits the consumer's range of options

e.g. say X is apples, Y is bananas; apples cost $2 so Px = 2, bananas cost $1 so Py = 1 and I have ten dollars so M = 10

I would like to have 10 or even 15 apples - but I can't, because my income endowment of ten dollars doesn't permit it.

Likewise I may want 5 apples and 5 oranges - but my income endowment doesn't permit this choice either.

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The budget line in the 2 dimensional plane
- which is the geometric construct representing the algebraic budget constraint; the budget line with the X and Y axes makes the budget set bounded

- is an easy way of visualizing the actual tradeoff
i.e. the actual rate at which two goods can be substituted at that specific price-income situation

^ in the apples and oranges example describing the Budget Constraint,
2 oranges can be sacrified for 1 apple; that's the rate of tradeoff, 2-for-1

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The consumer picks a point on this budget line such that

the rate at which he can tradeoff (aka slope of the budget constraint)
equals the rate at which he wants to trade off (aka slope of the indifference curve, which gives the rate of substitution between goods which leaves the consumer indifferent i.e. no reduction or increase in utility)

e.g. at M=10, P(apples) = 2 and P(oranges) = 1, I choose to have 3 apples and 2 oranges.
Maybe my preferences are such that to give up one orange when I'm consuming (3apples, 2 oranges) I would want 1 apple. But the market can only provide me half an apple in exchange for 1 orange, so I choose to keep consuming (3 apples, 2 oranges)

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Thus in the neoclassical framework consumers are maximizing utility by choosing to spend the next dollar of income on that commodity offers a greater utility for that dollar spent;

this process of choosing the option with the highest marginal utility continues until the entire sum of income has been expended.

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