Can you purchase those goods and services that cost more than the money you have in your pocket? It’s a strong ‘No’ and this is the basic concept of budget constraint in economics. If you are searching for its meaning, properties, and budget line changes, you are in right place. I have tried to incorporate complete information about it as much as possible. If you have any doubt feel free to comment below. Let’s start.
Budget Constraint
In the study of consumer behavior, economists believe that consumers tend to select the best and affordable bundle of goods. ‘What is the best’ is a matter of the preference or Indifference curve, but what is affordable is a matter of budget constraint.
Budget constraint implies that the amount of money spent on goods is no more than the total amount the consumer has to spend.
Let’s take an example: Suppose there are two goods X and Y (we took only two goods for convenience). The price of goods X is P and the price of Y is Q. The total amount available is M. Then the budget constraints are given by,
PX+QY≤M……….. Budget constraint (1)
Where PX is the amount spent on goods X and QY is the amount spent on goods Y. The amount spent on both goods should be less than or equal to the available amount (M). In other words, those consumption bundles that do not exceed the budget are affordable.
Let’s simplify this example by using some values. Suppose you have $12 as the total budget. The price of Goods X is $2 per unit and the Price of Goods Y is $3 per unit.
If you want to consume 2 units of Goods X and 2 units of Goods Y it means a consumption bundle of (2,2). Then place the value in the above constraint. 2*2+3*2≤12 or, 10≤12. This inequality is satisfied. That means this consumption bundle is affordable.
If you want to consume 2 units of Goods X and 3 units of Goods Y or a consumption bundle of (2,3). Then we get 2*2+3*3≤12 or, 13≤12 which is not satisfied. That means this consumption bundle is not affordable.
Consumption bundles that satisfy the budget constraint are affordable.
Budget Line
The budget line is the set of consumption bundles that cost equal to the available budget. From the above (1), we can write the budget line as below,
PX+QY=M
Graphically,
For your exercise, please try following consumption bundles in the following budget line.
Budget Line: 2X+3Y=12, consumption bundles: (3,2), (0,4), (6,0). I hope that it will satisfy the budget line. Here we have to understand that those consumption bundles that satisfy the budget line equation lie in the same budget line.
How does the Budget Line Change?
The budget line can be changed due to two possible reasons. The first one is due to a change in the price of any goods, and due to a change in income. For easy understanding, it can be classified into the following characteristics
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Swings in Budget Line
It happens due to a change in the price of any one product. Suppose the price of goods X increases from P to P’ then you can purchase fewer goods than before. Similarly, if the price decreases to P” you can purchase more goods than before. It happens the same for the goods Y also. Here, if the price of goods X increases the slope of the budget line gets stripper, and if the price of goods X decreases the slope of the budget line gets flatter. Remember: if the price of Goods X changes the Price of Goods Y remains the same and hence the quantity of Goods Y also remains the same.
Graphically,
P1=Price of X, P2=Price of Y
Shift in Budget Line
It happens because of the change in income. The change in income does not affect the price of the product or the slope of the line (because slope = -p1/p2). That is why it shifts parallel to the initial budget line. If the income of the consumer increases, the budget line shifts away from the origin or toward the right side. Similarly, if income decreases, it shifts toward the origin or left side.
Graphically,
P1=Price of X, P2=Price of Y
In the figure, we can see that the income of consumers increases from M to M’. In such case, if he spends all income on goods X he can buy more goods X than before and if he spends all income on goods Y he can buy more goods Y than before. It means the quantity of both products increases.
On the other hand, if the income of the consumer decreases from M to M”, the quantity of both products decreases. Hence the budget line is shifted toward the origin.
Hence, a change in budget line can be caused by a change in the price of one product and a change in income. Change in price causes swings and changes in income cause shifts.
Budget Line changes in Tax and Subsidy
What will happen to the budget line equation if there is Tax and Subsidy? To answer this question let’s learn about different types of taxes and its effect together.
Quantity Tax
This kind of tax is imposed according to the quantity bought by the consumers. For example $1 for 1 unit and $2 for 2 units like this. In this case, the budget line changes as follows:
Initial budget line: PX+QY=M
New Budget line: P(1+t)X+QY=M (We assumed that tax applies to goods X only). Where t=tax
If there is a subsidy the new budget line is P(1-t)X+QY=M
Value Tax
This tax is imposed on the total transaction value. It is generally represented in percentages. In the presence of value tax, the budget line will be changed to (1+t) PX+QY=M. ( Here also we assumed that tax applies to goods X only)
In the case of subsidy, (1-t) PX+QY=M will be the new budget line.
Lump-sum tax/Income Tax
This is imposed on the disposable income of consumers which reduces the income of consumers. In this case, the new budget line will be PX+QY=M-t
If there is an income tax subsidy it will be PX+QY=M+t
FAQ
What will happen to the budget line when we double the price of goods X and Goods Y at the same time?
The answer is that the budget line will shift toward the origin by one-half. For example, the initial budget line: PX+QY=M. After doubling the price. 2PX+2QY=M, or 2(PX+QY)=M or PX+QY=M/2. That means the budget line will shift inward as it shifts due to a decrease in income by one-half.
What is the budget constraint also known as?
Budget constraint is also knows as budget line, but constraints always refers to the inequality and line refers to the equation. Therefore if we replace less than or equals to symbol of budget constraint to the equal symbol, it becomes budget line.
What does the budget constraint line represent?
Budget constraint line represents the the set of consumption bundles that can be just affordable by the consumer at given income.
Disclaimer: For the complete information please consider “Hal R. Varian Intermediate Microeconomics book“.
