The Budget Constraint: What a Consumer Can Afford

As we know most people want to consume more quantity or quality of goods,

right? Ex: to take longer vacations, drive fancier cars, or eat at better restaurants.
But people consume less than they desire because their spending is constrained,
or limited, by their income. And we call it the budget constraint, it is the …
The slope of the budget constraint: measures the rate at which the consumer can
trade one good for the other. It equals the relative price of the two goods-the
price of one good compared to the price of the other
Table 1: Also an example
Explain: The first row in the table shows that if the consumer spends all her
income on pizza, she can eat 100 pizzas during the month, but she would not be
able to buy any Pepsi at all. The second row shows another possible consumption
bundle: 90 pizzas and 50 liters of Pepsi. And so on. Each consumption bundle in
the table costs exactly $1,000.
 We can see that because her budget is limited so if she spent more on Pizza,
then she would have to spend less on Pepsi and vice versa.
Figure 1: Three points are marked on this figure. At point A, the consumer buys
no Pepsi and consumes 100 pizzas. At point B, the consumer buys no pizza and
consumes 500 liters of Pepsi. At point C, the consumer buys 50 pizzas and 250
liters of Pepsi. Point C, which is exactly at the middle of the line from A to B, is the
point at which the consumer spends an equal amount ($500) on pizza and Pepsi.
These are only three of the many combinations of pizza and Pepsi that the
consumer can choose. All the points on the line from A to B are possible.
Shifts in the Consumer’s Budget Constraint
Why does this happen? So if consumer's income or the prices change, the budget
constraint shifts. Let's consider three examples of how such a shift might occur.
Figure 2
- Suppose first that the consumer's income increases from $1,000 to $2,000 while
prices remain the same, with higher income consumer can afford more both on
pizza and Pepsi, therefore, shifts the budget constraint outward, as in Panel (a)
- Now suppose that the price of Pepsi falls from $2 to $1 and the consumer’s
income remain the same ($1000). If you only buy pizza, you can get 100 pizzas,
this doesn’t change even if Pepsi gets cheaper. But, if you buy some Pepsi too,
now you can get more Pepsi for the same amount of money because it’s cheaper.
Panel (b)
Ex: Budget $1000
Initial New
60 pizzas ($600) 70 pizzas ($700)
200L of Pepsi ($400) 300L of Pepsi ($300)
 With a lower price of Pepsi, the consumer can now trade a pizza for 10 liters of
Pepsi rather than 5. As a result, the new budget constraint is steeper.
- For our third example, suppose that the price of pizza falls from $10 to $5 while
the consumer's income remains at $1,000 and the price of Pepsi remains at $2.
Once again, the lower price expands the consumer's buying demand and leads to
an outward shift in the budget constraint. Now, with a lower price of pizza, the
consumer can now trade a pizza for 2.5 liters of Pepsi rather than 5, and so the
budget constraint becomes flatter.
Indifference curve: shows the various bundles of consumption that make the
consumer equally happy.
- If the two bundles suit the consumer’s tastes equally well, we say that the
consumer is indifferent between the two bundles.
Slope of indifference curve
- Marginal rate of substitution, MRS: on slide
- The marginal rate of substitution is not the same at all points, the rate at which
a consumer is willing to trade one good for the other changes depending on how
much of each you already have. The more you have of one good, the less you’re
willing to trade it for the other. In other words, the rate at which a consumer is
willing to trade pizza for Pepsi depends on whether she is hungrier or thirstier.
(Think of it like this: If you have a lot of pizza but only a little Pepsi, you might be
more willing to trade some of your pizza for more Pepsi. But if you already have a
lot of Pepsi and only a little pizza, you might not want to trade any more pizza for
Pepsi.)
Figure 3
- We can see that the consumer is indifferent among combinations A, B, and C
because they are all on the same curve. Not surprisingly, if the consumer
consumes less pizza, from point A to point B, consumption of Pepsi must increase
to keep her equally happy. From point B to point C, she continues to consume less
pizza, so the amount of Pepsi consumed must increase yet again
- Because the consumer prefers more of a good, points (D) on a higher
indifference curve (L2) are preferred to points on a lower indifference curve (L 1).
- The marginal rate of substitution (MRS) shows the rate at which the consumer is
willing to trade Pepsi for pizza. It measures the quantity of Pepsi the consumer
must receive in exchange for 1 pizza.
Four properties of indifference curves
- Higher indifference curves are preferred to lower ones. People usually prefer to
consume more rather than less. Higher indifference curves represent larger
quantities of goods than lower indifference curves.
- Indifference curves slope downward, why does it slope downward? The
indifference curve slopes downward because as you consume more of one good,
you need to consume less of another good to maintain the same level of overall
satisfaction. In other words, you’re willing to give up some amount of one good
(e.g., Pepsi) to get more of another good (e.g., pizza) while staying equally happy.
This trade-off creates a downward slope, reflecting that as you increase
consumption of one good, you must decrease consumption of the other to stay
on the same indifference curve of satisfaction.
- Indifference curves do not cross (Figure 4): A situation like this can never
happen. Because point A is on the same indifference curve as point B, the two
points would make the consumer equally happy. In addition, because point B is on
the same indifference curve as point C, these two points would make the
consumer equally happy. According to these indifference curves, the consumer
would be equally satisfied at points A, B, and C, even though point C has more of
both goods than point A.
- Indifference curves are bowed inward toward the graph’s origin: Because
people are more willing to give up things they have a lot of, but less willing to give
up things they have little of. Because of this, the indifference curves (which show
combinations of goods that give equal satisfaction) bend inward. It means they’re
curved, not straight, reflecting that trade-offs change depending on how much of
each good you have. The more you have of one good, the less you want to give it
up, causing the curve to bow inward toward the graph’s origin.
Figure 5: At point A, the consumer has little pizza and much Pepsi, so she requires
a lot of extra Pepsi to induce her to give up one of the pizzas: The MRS is 6 liters
of Pepsi per pizza. At point B, the consumer has much pizza and little Pepsi, so she
requires only a little extra Pepsi to induce her to give up one of the pizzas: The
MRS is 1 Liter of Pepsi per pizza.
Perfect substitutes: two goods are perfect substitutes when the indifference
curves are straight lines and the marginal rate of substitution is constant.
(are goods that can be easily replaced by one another. If you have two items that
serve the exact same purpose and you don’t care which one you use, they’re
perfect substitutes.)
- Example: Nickels and dimes can be perfect substitutes in this case. If someone
offers you 10 nickels or 5 dimes (10 đồng năm xu hoặc 5 đồng mười xu), you’d
probably be indifferent because both bundles equal the same amount of money
(50 cents), you would always be willing to trade 2 nickels for 1 dime, so the
MRS=2. You don’t prefer one over the other since they serve the same purpose of
giving you the same total value.
It’s like having two different brands of bottled water that taste exactly the same
to you. You don’t mind which one you get because they’re identical in your eyes.
Perfect Complements: Two goods with right-angle indifference curves, we say
that the two goods are perfect complements.
- Example: If someone gave you a bunch of left shoes and right shoes, you’d care
about how many complete pairs you can make. Now if you have 5 left shoes and 7
right shoes, you can only make 5 pairs. The extra 2 right shoes don't help because
they have no matching left shoes.
In simpler terms, the value of each bundle depends on how many complete pairs
you can form, not just the total number of shoes.
Figure 6
Panel (a): When two goods are perfectly substitutable, such as nickels and dimes
trade 2 nickels for 1 dime, so the MRS=2 (1 dime vs 2 nickels, 2 dime vs 4 nickels)
 So the indifference curves are straight lines, as shown in panel (a).
Panel (b): left and right shoes are perfect complements because you need one of
each to form a useful pair.
 A bundle of 5 left shoes and 5 right shoes gives you 5 pairs.
 A bundle of 5 left shoes and 7 right shoes still gives you only 5 pairs (the
extra right shoes are useless without matching left shoes).
 Similarly, a bundle of 7 left shoes and 5 right shoes also gives you just 5
pairs (the extra left shoes are useless without matching right shoes).
Because you value only the number of pairs you can form, the indifference curves
for these goods are right angles (vuông góc). You can't increase your satisfaction
without having an equal number of both left and right shoes.

Optimization: to understand how a consumer makes choices

Optimum: is the point where indifference curve and budget constraint touch, it
represents the best combination of goods available to the consumer.
- At the optimum, the slope of the indifference curve equals the slope of the
budget constraint
- The consumer chooses the quantities of the two goods so that the marginal rate
of substitution equals the relative price
Figure 7:
- The point at which this indifference curve and the budget constraint touch is
called the optimum. At this point, the marginal rate of substitution equals the
relative price of the two goods
- The consumer would prefer point A, but she cannot afford that bundle of goods
because it lies above her budget constraint. Point B is affordable, but that bundle
of goods is on a lower indifference curve which provides the consumer less
satisfaction. The optimum represents the best bundle of pizza and Pepsi that the
consumer can afford.
Higher income: Now just suppose that you have higher income, would you spend
more money for both goods
- Consumer can afford more of both goods
- Which shifts the budget constraint outward  create new optimum
Normal good: As you may recall from Chapter 4, if a consumer wants more of a
good when her income rises, economists call it a normal good (good for which an
increase in income raises the quantity demanded)
The indifference curves in Figure 8 are drawn under the assumption that both
pizza and Pepsi are normal goods.
- When the consumer's income rises, her budget gets bigger so the budget
constraint shifts outward
- Pizza and Pepsi are both normal goods, the consumer responds to the increase
in income by buying more both of them.
Inferior good: is good for which an increase in income reduces the quantity
demanded
Ex: Figure 9: An increase in her income shift the budget constraint outward, but
she consumes less Pepsi which make Pepsi an inferior good. By contrast, her pizza
consumption increase making pizza a normal good
Price of one good falls: a change in the price of one of the goods changes the
consumer's choices.
- Rotates the budget constraint outward, making slope steeper and a change in
relative price
- Figure 10 shows how the fall in the price of Pepsi rotates the budget constraint
and thus changes the consumer's optimum.
- When the price of Pepsi falls, the consumer's budget constraint shifts outward
and changes slope. The consumer moves from the initial optimum to the new
optimum, which changes her purchases of both pizza and Pepsi. In this case, the
quantity of Pepsi consumed rises (Ex: from 50 to 100 because the price is
cheaper), and the quantity of pizza consumed falls.
(since Pepsi has become relatively cheaper, the consumer will allocate a larger
portion of their budget to Pepsi. As a result, the demand for pizza decreases.)
- The slope becomes steeper because the rate at which you can trade pizza for
Pepsi has changed—each pizza now equals 10 Pepsis instead of 5