CHAPTER 2

Budget Constraint

Copyright © 2019 Hal R. Varian

Consumer Theory
Consumers choose the best bundle of goods they can afford.

We will describe more precisely what we mean by “best” and what we mean by
“can afford”.

This chapter examines how to describe what a consumer can afford.

Copyright © 2019 Hal R. Varian

Consumption Choice Sets
A consumption choice set is the collection of all consumption choices available
to the consumer.
What constrains consumption choice?
• Budgetary, time, and other resource limitations.

Copyright © 2019 Hal R. Varian

Budget Constraints – 1
A consumption bundle containing x1 units of commodity 1, x2 units of
commodity 2, and so on up to xn units of commodity n is denoted by the vector
(x1, x2, . . . , xn).
• For two goods, the consumption bundle is (x1, x2).
• Example: if an individual consumes only two goods (apples and oranges),
a bundle could be (40, 30).

Commodity prices are denoted by the vector (p1, p2, . . . , pn).

• For two goods, the price vector is (p1, p2).

Copyright © 2019 Hal R. Varian

Budget Constraints – 2
When is a bundle (x1, . . . , xn) affordable at prices (p1, . . . , pn)?
• When

where m is the consumer’s (disposable) income.

• For 2 goods,
• Example: if the individual only has 100 dollars in the pocket to buy
apples and oranges, what is the budget constraint of this individual?
• Example cont’d: what if the price of an apple is 2 dollar, and the price of
an orange is 1 dollar?

Copyright © 2019 Hal R. Varian

Budget Constraints – 3
The bundles that are only just affordable form the consumer’s budget
constraint. This is the set
and

Copyright © 2019 Hal R. Varian

Budget Constraints – 4
The consumer’s budget set is the set of all affordable bundles;
and

The budget constraint is the upper boundary of the budget set.

Copyright © 2019 Hal R. Varian

Budget Set and Constraint for Two Commodities – 1

Copyright © 2019 Hal R. Varian

Budget Set and Constraint for Two Commodities – 2

Copyright © 2019 Hal R. Varian

Budget Set and Constraint for Two Commodities – 3

x2
Budget constraint is
m/p2
p1x1 + p2x2 = m (slope is -p1 /p2).

The collection of
all affordable bundles

m/p1 x1

Copyright © 2019 Hal R. Varian

Budget Constraints – 5
If there are THREE goods, what do the budget constraint and the budget set
look like?

Copyright © 2019 Hal R. Varian

Budget Constraint for Three Commodities

Copyright © 2019 Hal R. Varian

Budget Set for Three Commodities

Copyright © 2019 Hal R. Varian

Budget Constraints – 6
For n = 2 and x1 on the horizontal axis, the constraint’s slope is –p1/p2. What
does it mean?
p1 m
x2 = − x1 +
p2 p2

• Increasing x1 by 1 must reduce x2 by p1/p2.

• The opportunity cost of an extra unit of commodity 1 is p1/p2 units
foregone of commodity 2.

Copyright © 2019 Hal R. Varian

Budget Constraints – 7

Copyright © 2019 Hal R. Varian

Budget Constraints – 8
The intercepts are meaningful. Why?

The slope is also meaningful.

• It measures the rate at which the market is willing to “substitute” good 1
for good 2.
• Sometimes economists say the slope measures the opportunity cost of
consuming good 1.

Copyright © 2019 Hal R. Varian

Budget Sets & Constraints: Income and Price Changes
The budget constraint and budget set depend upon prices and income.
Ø What happens as prices or income change?
Ø Let us first consider changes in income.
Ø Then we talk about changes in prices.

Copyright © 2019 Hal R. Varian

How Do the Budget Set & Constraint Change as Income m
Changes?

Copyright © 2019 Hal R. Varian

Higher Income Gives More Choice

Copyright © 2019 Hal R. Varian

Lower Income Shrinks the Budget Set

Copyright © 2019 Hal R. Varian

Budget Constraints: Income Changes – 1
• Increases in income m shift the constraint outward in a parallel manner,
thereby enlarging the budget set and improving choice.
• Decreases in income m shift the constraint inward in a parallel manner,
thereby shrinking the budget set and reducing choice.

Copyright © 2019 Hal R. Varian

Budget Constraints: Income Changes – 2
• No original choice is lost and new choices are added when income
increases, so higher income cannot make a consumer worse off.
• An income decrease may (typically will) make the consumer worse off.

Copyright © 2019 Hal R. Varian

Budget Constraints: Price Changes – 1
What happens if just one price decreases?
Suppose p1 decreases.

Copyright © 2019 Hal R. Varian

How Do the Budget Set & Constraint Change as p1 Decreases
from p1ʹ to p1ʺ? – 1

Copyright © 2019 Hal R. Varian

How Do the Budget Set & Constraint Change as p1 Decreases
from p1ʹ to p1ʺ? – 2

Copyright © 2019 Hal R. Varian

Budget Constraints: Price Changes – 2
• Reducing the price of one commodity pivots the constraint outward. No old
choice is lost and new choices are added, so reducing one price cannot
make the consumer worse off.
• Similarly, increasing one price pivots the constraint inward, reduces choice
and may (typically will) make the consumer worse off.

Copyright © 2019 Hal R. Varian

Uniform Ad Valorem Sales Taxes – 1
• An ad valorem sales tax levied at a rate of 5% increases all prices by 5%,
from p to (1 + 0.05)p = 1.05p.
• An ad valorem sales tax levied at a rate of t increases all prices by tp from p
to (1+ t)p.
• A uniform sales tax is applied uniformly to all commodities.

Copyright © 2019 Hal R. Varian

Uniform Ad Valorem Sales Taxes – 2
A uniform sales tax levied at rate t changes the constraint from

to

Or equivalently,

Copyright © 2019 Hal R. Varian

Uniform Ad Valorem Sales Taxes – 3

Copyright © 2019 Hal R. Varian

Uniform Ad Valorem Sales Taxes – 4

Copyright © 2019 Hal R. Varian

The Food Stamp Program – 1
• Food stamps are coupons that can be legally exchanged only for food.
• How does a commodity-specific gift such as a food stamp alter a family’s
budget constraint?

Copyright © 2019 Hal R. Varian

The Food Stamp Program – 2
Suppose and the price of “other goods” is
Ø The budget constraint is then

Copyright © 2019 Hal R. Varian

The Food Stamp Program – 3

Copyright © 2019 Hal R. Varian

The Food Stamp Program – 4

Copyright © 2019 Hal R. Varian

Budget Constraints: Relative Prices – 1
• “Numeraire” means “unit of account.”
• Suppose prices and income are measured in dollars.
Ø Say
Ø Then the constraint is:

Copyright © 2019 Hal R. Varian

Budget Constraints: Relative Prices – 2
If prices and income are measured in cents, then
and the constraint is the same as
Ø Changing the numeraire changes neither the budget constraint nor
the budget set.

Copyright © 2019 Hal R. Varian

Budget Constraints: Relative Prices – 3
The constraint for p1 = 2, p2 = 3, m = 12

is also

the constraint for p1 = 1, p2 = 3/2, m = 6. Setting p1 = 1 makes commodity 1

the numeraire and defines all prices relative to p1. E.g., 3/2 is the price of
commodity 2 relative to the price of commodity 1.

Copyright © 2019 Hal R. Varian

Budget Constraints: Relative Prices – 4
Any commodity can be chosen as the numeraire without changing the budget
set or the budget constraint.

It will occasionally be convenient to think of one of the goods as being a

numeraire good.

Copyright © 2019 Hal R. Varian

Budget Constraints: Relative Prices – 5
Suppose p1 = 2, p2 = 3, and p3 = 6.
Ø Price of commodity 2 relative to commodity 1 is 3/2,
Ø price of commodity 3 relative to commodity 1 is 3.
Ø Relative prices are the rates of exchange of commodities 2 and 3 for
units of commodity 1.

Copyright © 2019 Hal R. Varian

Shapes of Budget Constraints – 1
What makes a budget constraint a straight line?
Ø A straight line has a constant slope and the constraint is

So, if prices are constants then a constraint is a straight line.

Copyright © 2019 Hal R. Varian

Shapes of Budget Constraints – 2
But what if prices are not constants?
Ø For example, bulk buying discounts, or price penalties for buying “too
much.”
Ø Then constraints will be curved.

Copyright © 2019 Hal R. Varian

Shapes of Budget Constraints: Quantity Discounts
Suppose p2 is constant at $1 but that p1 = $2 for 0 ≤ x1 ≤ 20 and p1 = $1 for x1 >
20. Then the constraint’s slope is: for and
for

Copyright © 2019 Hal R. Varian

Shapes of Budget Constraints with a Quantity Discount – 1

Copyright © 2019 Hal R. Varian

Shapes of Budget Constraints with a Quantity Discount – 2

Copyright © 2019 Hal R. Varian

Shapes of Budget Constraints with a Quantity Penalty

Copyright © 2019 Hal R. Varian

Shapes of Budget Constraints: One Price Negative – 1
Commodity 1 is stinky garbage. You are paid $2 per unit to accept it; i.e.,
Income, other than from accepting commodity 1,is

Then the constraint is or

Copyright © 2019 Hal R. Varian

Shapes of Budget Constraints: One Price Negative – 2

Copyright © 2019 Hal R. Varian

Shapes of Budget Constraints: One Price Negative – 3

Copyright © 2019 Hal R. Varian

More General Choice Sets
Choices are usually constrained by more than a budget; e.g. time
constraints and other resources constraints.
A bundle is available only if it meets every constraint.
More General Choice Sets
Other Stuff

At least 10 units of food

must be eaten to survive

10 Food
More General Choice Sets
Other Stuff
Choice is also budget
constrained.

Budget Set

10 Food
More General Choice Sets
Other Stuff
Choice is further restricted by
a time constraint.

10 Food
More General Choice Sets

So what is the choice set?

More General Choice Sets
Other Stuff

10 Food
More General Choice Sets
Other Stuff

10 Food
More General Choice Sets
Other Stuff

The choice set is the

intersection of all of
the constraint sets.

10 Food
Exercises
Your budget is such that if you spend your entire income, you can afford either
4 units of good x and 6 goods of y or 12 units of x and 2 units of y.

(a) Mark these two consumption bundles and draw the budget line.
(b) What is the ratio of the price of x to the price of y?
(c) If you spend all of your income on x, how much x could you buy?
(d) If you spend all of your income on y, how much y could you buy?
(e) Write a budget constraint that gives you this budget line, where the price of
x is 1.
(f) Write another budget equation that gives you the same budget line, but
where the price of x is 3.
Credits
This concludes the Lecture PowerPoint presentation for Chapter 2 of Intermediate Microeconomics, 9e.
For more resources, please visit http://digital.wwnorton.com/intermicro9media.

Copyright © 2019 Hal R. Varian