Budget Constraints

ECO61
Udayan Roy
Fall 2008
 Prices, quantities, and expenditures
• PX is the price of good X
– It is measured in dollars per unit of good X
– The consumer pays this price no matter what quantity
she buys.
– That is, there are no quantity discounts and there is
no rationing
• X is also the quantity of good X that is purchased
by the consumer
– It is measured in units of good X per unit of time
• PX  X = PXX is the consumer’s expenditure on
good X
 Budget constraint
• Assume a world with only two consumer
goods, X and Y
• Total expenditure = PXX + PYY
• M is the consumer’s income or budget
• The consumer cannot spend more than her
budget allows
• PXX + PYY ≤ M is the consumer’s budget
constraint
 “More-is-better” implies budget
exhaustion
• A rational consumer will spend every penny
available.
• PXX + PYY ≤ M becomes PXX + PYY = M
• Here’s an example:
 Saving
• The budget constraint PXX + PYY = M does not
imply that saving is being ignored.
• We saw earlier that, to an economist, “food
delivered now” and “food delivered in the
future” are different goods
• The former could be our good X and the latter
could be good Y
• Then PYY would represent saving for the
future.
 Saving
• You may pay today for something that will be
delivered at some date in the future.
– For example, you may pay Long Island University
today for courses you plan to take in 2015
– You may pay today to reserve hotel rooms in
London for the 2012 Olympics
– You may pay today for the future delivery of the
National Geographic magazine
• These purchases are the same as saving for
the future.
Budget constraint algebra
PX X  PY Y M
PY Y M  PX X
M  PX X
Y
PY
M PX
Y  X
PY PY
 Budget constraint algebra
• If X = 0, then Y = M/PY M PX
Y  X
– This is the maximum amount of PY PY
good Y that the consumer can buy
• Similarly, the maximum amount
of good X that the consumer can
buy is M/PX
• If the consumer’s income (M)
increases, both maximums will
increase by the same proportion
 Budget Constraint: Graph
• PSS + PBB = M is the budget constraint
• It can be graphed into the budget line:
 Budget constraint algebra
• If X increases by one unit, then M PX
Y  X
Y must decrease by PX/PY units PY PY
– This is at the heart of the
consumer’s tradeoff
– PX/PY is also called the relative
price of good X (in units of good
Y)
 Budget Constraint
• Consider Lisa, who buys only burritos (B) and pizza (Z)
M  PZ Z M PZ
B   Z
PB PB PB
– If pZ = $1, pB = $2, and M = $50, then:

$50  ($1Z )
B 25  0.25Z
$2
Possible Allocations of Lisa’s Budget Between
Burritos and Pizza

Lisa’s budget is $50. Burritos are $2 each and pizzas are $1 each.
 Budget Constraint: graph
Amount of Burritos  From previous slide we have
consumed if all income that if:
is allocated for – pZ = $1, pB = $2, and M = $50,
B, Burritos per semester

Burritos.
then the budget constraint, L1,
a is:
25 = M/pB
b $50  ($1Z )
20
B 25  0.25Z
$2
L1
Amount of Pizza
c consumed if all income
10
Opportunity set is allocated for Pizza.

d
0 10 30 50 = M/pZ
Z, Pizzas per semester
 The Slope of the Budget Constraint

• We have seen that the budget constraint for Lisa is given by

the following equation:

M PZ
B  Z
PB PB
Slope = B/Z

– The slope of the budget line is the rate at which Lisa can trade burritos for
pizza in the marketplace
Changes in the Budget Constraint: An increase in the
Price of Pizzas.
M PZ = $1$2
Slope = -$1/$2 = -0.5 B= - Z
PB PB
B, Burritos per semester

25 If the price of Pizza doubles,

(increases from $1 to $2) the
slope of the budget line
pZ = $1 increases

Loss
This area represents
pZ = $2 the bundles she can
no longer afford
0 25 50
Slope = -$2/$2 = -1 Z, Pizzas per semester
How taxes affect the budget constraint
• A tax of TZ dollars per pizza has the effect of
raising the price paid by the buyer from PZ to
PZ + TZ.
• Therefore, the effect is essentially the same as
in the previous slide
Changes in the Budget Constraint: Increase in
Income (M)
$100
$50 PZ
B= - Z
PB PB
B, Burritos per semester

If Lisa’s income increases by

50 $50 the budget line shifts to
the right (with the same
M = $100 slope!)

25
This area represents
Gain
the new consumption
M = $50 bundles she can now
afford
0 50 100
Z, Pizzas per semester
 Solved Problem
• A government rations water, setting a quota
on how much a consumer can purchase.
• If a consumer can afford to buy 12 thousand
gallons a month but the government restricts
purchases to no more than 10 thousand
gallons a month, how does the consumer’s
opportunity set change?
Solved Problem
 Income in the budget constraint
• We have seen that the consumer’s budget is
affected by her income (M)
• Therefore, the consumer’s choices (of X and Y)
are affected by her income
• But it has been implied that income (M) is not
affected by the consumer’s choices (of X and
Y)
• This is not always true: the consumer’s
choices (of X and Y) may affect her income (M)
 Income in the budget constraint
• It is also implicit in my discussion of the
budget constraint that income (M) is not
affected by prices (of X and Y)
• This is not always true: the prices of goods (PX
and PY) may affect income (M)
 Leisure and consumption
• The price of leisure (N) is
(24w + M*) /PY
the wage (w) that is lost
Y, Goods per d ay

Time constraint
PY Y wH  M *
Slope = -w/PY PY Y w (24  N )  M *
When w/PY decreases,
the budget constraint
rotates down
PY Y 24 w  wN  M *
PY Y  wN 24 w  M *

Consumption with non-

labor income (M*/PY)

0 N1 N2 24 N, Leisure hours per d ay

24 H1 H2 0 H, Work hours per d ay
Leisure and consumption II: M = 0 *

• The price of leisure (N) is

the wage (w) that is lost
24w /PY PY Y wH
Y, Goods per d ay

PY Y w (24  N )
PY Y 24 w  wN
Slope = -w/PY PY Y  wN 24 w
When w/PY decreases,
the budget constraint
rotates down

24w/w = 24

0 N1 N2 24 N, Leisure hours per d ay

24 H1 H2 0 H, Work hours per d ay
 Progressive income tax
• Now we
have a 20%
Y, Goods per d ay

24w  (1-0.20) /PY

Slope = -w  (1-0.20)/PY
income tax,
but only on
Y0 income in
Slope = -w/PY excess of Y0.
24w/w = 24

0 N1 N2 24 N, Leisure hours per d ay

24 H1 H2 0 H, Work hours per d ay
 Income is affected by choices
• Other examples where consumers’ choices
affect their incomes
– How much we save today will affect our future
interest income
– How much we spend today on which asset
(stocks, bonds, college courses) will affect our
future incomes