Budget Constraint –Budget constraints limit an individual’s ability to consume in light of the...
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Budget Constraint – Budget constraints limit an individual’s ability to consume in light of the prices they must pay for various goods and services. • The budget constraint indicates all combinations of two commodities for which total money spent equals total income.
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Transcript of Budget Constraint –Budget constraints limit an individual’s ability to consume in light of the...
Budget Constraint
– Budget constraints limit an individual’s ability to consume in light of the prices they must pay for various goods and services.
• The budget constraint indicates all combinations of two commodities for which total money spent equals total income.
Budget Constraint
• Let F equal the amount of food purchased, and C is the amount of clothing.
• Pf = Price of food
Pc = Price of clothing • Then Pf F is the amount of money spent
on food, and Pc C is the amount of money spent on clothing.
Budget Constraint
• The budget constraint can be written:
• It summarizes the combination of bundles that the consumer is able to buy.
– Its position is determined jointly by income and prices.
ICPFP CF
Budget Line F + 2C = $8040
Budget Constraint
Food(units per week)40 60 8020
10
20
30
0
A
B
D
E
G
Clothing(units
per week)
Pc = $2 Pf = $1 I = $80
As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other.
(I/PC) = 40
Budget Constraint
Food(units per week)40 60 80 = (I/PF)20
10
20
30
0
A
B
D
E
G
Clothing(units
per week)
Pc = $2 Pf = $1 I = $80
The vertical intercept (I/PC), illustrates the maximum amount of C that can be purchased with income I.
The horizontal intercept (I/PF), illustrates the maximum amount of F that can be purchased with income I.
CF/PPFC - 2
1- / Slope
10
20
(I/PC) = 40
Budget Constraint
Food(units per week)40 60 80 = (I/PF)20
10
20
30
0
A
B
D
E
G
Clothing(units
per week)
Pc = $2 Pf = $1 I = $80
The slope of the line measures the relative cost of food and clothing. The slope is the negative of the ratio of the prices of the two goods.
Budget Constraint
• The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent.
Effect of a Change in Income
Food(units per week)
Clothing(units
per week)
80 120 16040
20
40
60
80
0
A increase inincome shifts
the budget lineoutward
(I = $160)L2
(I = $80)
L1
L3
(I =$40)
A decrease inincome shifts
the budget lineinward
FP
P
P
IC
c
F
c
Food(units per week)
Clothing(units
per week)
80 120 16040
40
(PF = 1)
L1
An increase in theprice of food to$2.00 changes
the slope of thebudget line and
rotates it inward.
L3
(PF = 2)(PF = 1/2)
L2
A decrease in theprice of food to$0.50 changes
the slope of thebudget line and
rotates it outward.
Effect of a Change in Price
FP
P
P
IC
c
F
c
Effects of Changes in Prices
Food (units per week)
Clothing(units
per week)
80 120 16040
20
40
60
80
0
If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change.
Same as an increase in income
If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change.
Same as an increase in income
Pc = $1, PF=$0.5Pc = $1, PF=$0.5L2L2
L1
L3
Pc = $4, PF =$2
If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change.
Same as a decrease in income.
If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change.
Same as a decrease in income.
Pc = $2 PF = $1 I = $80
Example: Tina’s Budget Line
TINA’S CONSUMPTION POSSIBILITIES
• The Budget Line– Tina’s budget line describes the limits to
consumption choices and depends on her budget and the prices of water and gum.
CONSUMPTION POSSIBILITIES
–Figure 11.1 shows consumption possibilities.
The figure graphs Tina’s budget line.
Points A through E on the graph represent the rows of the table.
CONSUMPTION POSSIBILITIES
The budget line separates combinations that are affordable from combinations that are unaffordable.
CONSUMPTION POSSIBILITIES
• Changes in Prices• If the price of one good rises when the prices of
other goods and the budget remain the same, consumption possibilities shrink.
• If the price of one good falls when the prices of other goods and the budget remain the same, consumption possibilities expand.
CONSUMPTION POSSIBILITIES
On the initial budget line, the price of water is $1 a bottle (and gum is 50 cents a pack), as before.
Figure 11.2 shows the effect of a fall in the price of water.
CONSUMPTION POSSIBILITIES
When the price ofwater falls from $1 a bottle to 50¢ a bottle, the budget line rotates outward and becomes less steep.
CONSUMPTION POSSIBILITIES
Figure 11.3 shows the effect of a rise in the price of water.
Again, on the initial budget line, the price of water is $1 a bottle (and gum is 50 cents a pack), as before.
CONSUMPTION POSSIBILITIES
When the price ofwater rises from $1 a bottle to $2 a bottle, the budget line rotates inward and becomes steeper.
CONSUMPTION POSSIBILITIES
• Prices and the Slope of the Budget Line– You’ve just seen that when the price of one
good changes and the price of the other good remains the same, the slope of the budget line changes.
– In Figure 11.2, when the price of water falls, the budget line becomes less steep.
– In Figure 11.3, when the price of water rises, the budget line becomes steeper.
– Recall that slope equals rise over run.
CONSUMPTION POSSIBILITIES
–Let’s calculate the slope of the initial budget line.
When the price of water is $1 a bottle, the slope of the budget line is 8 packs of gum divided by 4 bottles of water, which equals 2 packs of gum per bottle.
CONSUMPTION POSSIBILITIES
When the price of water is 50 cents a bottle, the slope of the budget line is 8 packs of gum divided by 8 bottles of water, which equals 1 pack of gum per bottle.
–Next, calculate the slope of the budget line when water costs 50 cents a bottle.
CONSUMPTION POSSIBILITIES
When the price of water is $2, a bottle, the slope of the budget line is 8 packs of gum divided by 2 bottles of water, which equals 4 packs of gum per bottle.
–Finally, calculate the slope of the budget line when water costs $2 a bottle.
CONSUMPTION POSSIBILITIES
– You can think of the slope of the budget line as an opportunity cost.
– The slope tells us how many packs of gum a bottle of water costs.
– Another name for opportunity cost is relative price, which is the price of one good in terms of another good.
– A relative price equals the price of one good divided by the price of another good, and equals the slope of the budget line.
CONSUMPTION POSSIBILITIES
• A Change in the Budget– When a consumer’s budget increases,
consumption possibilities expand.– When a consumer’s budget decreases,
consumption possibilities shrink.
CONSUMPTION POSSIBILITIES
An decrease in the budget shifts the budget line leftward.
Figure 11.4 shows the effects of changes in a consumer’s budget.
The slope of the budget line doesn’t change because prices have not changed.
CONSUMPTION POSSIBILITIES
An increase in the budget shifts the budget line rightward.
Again, the slope of the budget line doesn’t change because prices have not changed.
