1

The budget constraint

Consumers need income to buy goods and they must pay prices. These features limit

what the consumer can have.

2

Budget constraint or budget line

The budget constraint for an individual shows combinations of two goods, say goods x and y, that can be attained given a certain income and assuming prices must be paid for the goods.

The constraint will be a line, like in the graph below.

x

y

3

Budget constraint or budget line

If I = the consumer income in dollars Px = the price per unit of x Py = the price per unit of y x = the amount of x the consumer buys y = the amount of y the consumer buys, then the amount the consumer buys is

I = (Px)(x) + (Py)(y) or y = (I)/(Py) - [Px/Py](x)

Note if x = 0, y = I/Py and if

y = 0, x = I/Px and the slope of the line is - (Px)/(Py).

4

Budget constraint

y

x

(0, I/PY)

(I/Px, 0)

-Px/Py This is the slope – a negative number.

5

Budget constraint

y

x

The slope of the budget line is - Px/Py. Say x = a bag of chips and y = a can of pop. If Px = $1/bag and Py = .50/can, then

- Px/Py = -($1/bag)

($.50/can)

= - 2 cans/bag

2

1

The slope of the budget line indicates that if one bag of chips is given up, 2 cans of pop can be obtained in the market. This occurs at every point on the budget line when prices remain constant in relation to the amount bought.

6

slope

Note on the previous screen that the slope of the budget line is telling us about how much good x is valued in the market in relation to good y.

This implies that the slope of the budget is indicating the market rate of substitution of good x for good y.