Budget constraint.
Shows the market
baskets of goods and services a consumer can afford? Given the
consumers income and the prices of goods and services in the baskets.
Px X +Py Y= I
Where:
Budget
line.
A line showing
all combinations of two goods that a consumer can afford if all
income is spent over a period. Points in the budget line imply
that the sum of all the expenditure on good X and Y must equal
the consumer's income.
| Market
baskets. |
Gallons
of oil. |
Cassettes
tape. |
Total
expenditure. |
| B1 |
0 |
5 |
15 |
| B2 |
2 |
4 |
15 |
| B3 |
4 |
3 |
15 |
| B4 |
6 |
2 |
15 |
| B5 |
8 |
1 |
15 |
| B6 |
10 |
0 |
15 |
The
horizontal and vertical intercepts measure how much the consumer
should get if s/he spent all his/her money on goods 1 and 2 respectively
X and Y. The slope of the budget line represents the amount of
good Y obtained by giving up each unit of good X.
Changes in income and prices.
A change in income.
A change in income
shifts the budget constraint outward (increase) or downward (decrease)
parallel to itself.
An increase in
income makes it possible for the consumer to purchase market baskets
of goods and services that were previously unaffordable.
.gif)
A
change in the price of X.
Change
in price of X rotates the budget line to a new intercept on the
X-axis without changing the intercept of the Y-axis.
.gif)
A
change in the price of good Y.
.gif)
Market
Basket.
Let
Px=$1.50; Py=$3.00 Also see table above.
.gif)
If
the consumer spent all of $15 on cassettes tapes, s/he can buy
5 cassettes during the week (B1) and s/he cannot purchase fuel.
Similarly
B6 s/he spent all income on fuel no cassettes.
B2
=> PxQx + PyQy=I => $3 * 4 + $ 1.5 * 2 = $15
Similarly
with all other baskets.
Market
baskets represented by points above the budget line require more
income per week that is currently unaffordable.
Foe
example B7 consisting of 8 cassettes and 4 gallons of fuel per
week would require a more income of $30 of which $24 will be needed
for cassettes tapes and $6 for the fuel.
$3
* 8 + $1.5 * 4 = $30.
Market
baskets below the budget line could be purchased without using
up all of his/her weekly income
B8
= $3 * 1 + $1.5 * 4 = $9 => $15 - $9 = $6 is left.
We
can use the equation for the budget constraint Px X +Py Y= I to
find out how the maximum amount of each good that the consumer
can purchase depends on the consumer income and the price of the
good.
Let
Qy=0 and so for Qx you'll get the maximum amount of good X the
consumer can purchase over a period Thus from
Px
X +Py Y= I
PxQx
+ Py (Qy =0) = I
Qx
= I / Px --- the maximum amount of good X.
Similarly
Qy = I / Py for maximum amount of good Y.
