# 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.

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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.

Budget Constraint Let F equal the amount of food purchased, and C is the amount of clothing. P f = Price of food P c = Price of clothing Then P f F is the amount of money spent on food, and P c 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.

Budget Line F + 2C = \$80 40 Budget Constraint Food (units per week) 40608020 10 20 30 0 A B D E G Clothing (units per week) Pc = \$2 P f = \$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/P C ) = 40 Budget Constraint Food (units per week) 406080 = (I/P F )20 10 20 30 0 A B D E G Clothing (units per week) Pc = \$2 P f = \$1 I = \$80 The vertical intercept (I/P C ), illustrates the maximum amount of C that can be purchased with income I. The horizontal intercept (I/P F ), illustrates the maximum amount of F that can be purchased with income I.

10 20 (I/P C ) = 40 Budget Constraint Food (units per week) 406080 = (I/P F )20 10 20 30 0 A B D E G Clothing (units per week ) Pc = \$2 P f = \$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) 8012016040 20 40 60 80 0 A increase in income shifts the budget line outward (I = \$160) L2L2 (I = \$80) L1L1 L3L3 (I = \$40) A decrease in income shifts the budget line inward

Food (units per week) Clothing (units per week) 8012016040 (P F = 1) L1L1 An increase in the price of food to \$2.00 changes the slope of the budget line and rotates it inward. L3L3 (P F = 2) (P F = 1/2) L2L2 A decrease in the price of food to \$0.50 changes the slope of the budget line and rotates it outward. Effect of a Change in Price

Effects of Changes in Prices Food (units per week) Clothing (units per week) 8012016040 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 P c = \$1, P F =\$0.5 L2L2 L2L2 L1L1 L3L3 P c = \$4, P F =\$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 P F = \$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 of water 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 of water 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.

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