Simple Economics on the Web

 Your handy guide to economics


The Budget Constraint

The theory of consumer choice involves two value systems. One is the value of a bundle of goods measured in dollars. The other is the value of a bundle of goods to you. This may sound strange at first but consider this example. You plan to spend $8.00 tonight on pizza and beer for dinner. Does this mean that you feel just as good spending your $8.00 on four $2.00 tubes of toothpaste and having that for dinner? The two bundles do cost the same after all.

The consumer’s problem is to choose the bundle of goods that they value the most – that brings them the highest utility – among all those bundles of goods that they can afford.

 The purpose of the budget constraint is to map out the bundles of goods that the consumer can afford

In the example below, you have two goods to purchase – Wraps and Gas -- and $10 in your pocket. If the price of wrap $2 and the price of Gas is $1 per gallon (in your dreams), how many wraps and gallons of gas can you buy?

Move the red dot around the graph and you will see the cost of each combination of wraps and gas. For example, 2 wraps and 6 gallons of gas will cost you $10.

Using this graph, explain to yourself why the pink line is the budget constraint in this problem.

The budget constraint depends on the consumer’s income and the prices the consumer faces. It follows that if income or prices change, the budget constraint will change as well.

Click (2) on the right of the figure and you will see how the budget constraint changes when the price of a wrap drops to $1.00 while income and the price of gasoline are unchanged. Explain to yourself why the constraint should move in this particular way.

Click (3) on the right of the figure to see the budget constraint changes when the price of gasoline drops to 50 cents per gallon (very hard to believe) in addition to the $1.00 price of a wrap. Question: Suppose that the prices of wraps and gasoline had stayed at $2.00 and $1.00 respectively but income had doubled from $10.00 to $20.00. How would that budget constraint have differed from the budget constraint you see now (when you click on (3))?

 

Created by Frank Levy and Myounggu Kang
Last Updated on September 26, 2003