ECO2201 – Microeconomics

Chapter 21: The Theory of

Consumer Choice

Individual’s Budget Constraint

Lesson 2.1
Road Map
1. Overview
2. Budget Constraint
– What Does the Budget Constraint Tell Us?
– Tradeoffs and Opportunity Costs
– Shift of the Budget Constraint
– Change in the Slope of the Budget Constraint
– Budget Constraint Limitation

Review & Exercises

2
1. Overview
• Individuals (households) face tradeoffs.
– Buying more of one good leaves less income to buy other goods
– Working more hours means more income and more consumption,
but less leisure time
– Reducing saving allows more consumption today but reduces
future consumption
• This lesson explores how consumers make choices like these.

3
2. The Budget Constraint
• Budget constraint:
– a schedule or curve that shows (the greatest) combinations of two
products can be purchased with given product prices and income.
• That is, the limit on the consumption combinations that a consumer
can afford
• For simplicity, we assume that there are two products.

4
 Example 1: Budget Constraint
• Suppose an individual has $120 budget. A T-shirt costs $20 each,
whereas a burger costs $10 each.
T-shirt Burger
($20) ($10)

Quantity of T-shirts
6 A
A 6 0 B
B 5 2 4 C
C 4 4 D
E
D 3 6 2
F
E 2 8 G
F 1 10 2 4 6 8 10 12
G 0 12 Quantity of Burgers

5
 2. The Budget Constraint:
Constructing a Budget Constraint

Income = $120
• Focus on the two points where
=6
Quantity of T-shirts

PT-shirt = $20 all money is spent one good

6
(and none on the other good).
Income = $120
4 = 12 → the horizontal and vertical
PBurger = $10

2
intercepts.

• Then, draw a straight line to

4 8 12
Quantity of Burgers connect the two points.

6
2.1. What does the budget constraint tell us?
Points on the budget constraint tell us

• Maximum combinations of
Quantity of T-shirts

6 Max combination goods one can buy given income

of goods and product prices.
4 • all income is spent on the
goods.
2

4 8 12
Quantity of Burgers

7
2.1. What does the budget constraint tell us?
Attainable Combinations: Points inside the budget constraint

• Attainable combinations of goods

Quantity of T-shirts

6
one can buy given income and
4 product prices.
• But, not all the income is spent on
2
the goods.
Attainable
4 8 12
Quantity of Burgers

9
2.1. What does the budget constraint tell us?
Unattainable Combinations: Points outside the budget constraint

• Unattainable combinations of
Quantity of T-shirts

6
Unattainable goods one can buy given income
4
and product prices.
2 • Not enough money to buy the
combinations of goods.
4 8 12
Quantity of Burgers

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2.1. What does the budget constraint tell us?
Tradeoffs and Opportunity Costs

• The budget constraint is always downward

sloping (having a negative slope).
Quantity of T-shirts

6
• For example:
4 – To buy more burger, one needs to give up
T-shirt (as our income is limited).
2 – That is, consumers must make tradeoffs in
their consumption decisions.
4 8 12
Quantity of Burgers

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 2.1. What does the budget constraint tell us?
Tradeoffs and Opportunity Costs
• The magnitude of the slope reflects the
Quantity of T-shirts

Slope = -2/4 opportunity cost of one more unit of a good

6
under analysis.
4 – Recall: slope =∆Y/∆X → mean that if X
increases by one, how much Y will change
2
• The opportunity cost remains the same

4 8 12 regardless of how many units of good the

Quantity of Burgers consumer purchase (as slope is constant).

13
Example 2: Opportunity cost
• What is the opportunity cost of the first burger?
• What is the opportunity cost of the first T-shirt?
T-Shirts Burgers
($20) ($10)

Quantity of T-shirts
6
6 0
5 2
4
4 4
3 6 2
2 8
1 10 4 8 12
Quantity of Burgers
0 12

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 Example 2: Opportunity cost
What is the opportunity cost of the first burger?
oThe opportunity cost of the first burger is how many T-shirts individual has
to give up to purchase the first burger.
T-Shirts ($20) Burgers ($10)
6 0
• The opportunity cost of the first
-1 +2
5 2 two burgers is one T-shirt.
4 4
– i.e., the opportunity cost of the
3 6
2 8 first burger is 0.5 T-shirt.
1 10
0 12

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 Example 2: Opportunity cost
What is the opportunity cost of T-shirt?
oThe opportunity cost of the first T-shirt is how many burgers the person has
to give up to purchase the first T-shirt.
T-Shirts ($20) Burgers ($10)
6 0 • Opportunity cost of the first T-shirt
5 2 is how many burgers the person
4 4 has to give up to purchase the first
3 6 T-shirt, and it is 2 burgers.
2 8
1 10
+1 -2
0 12

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 2.2. What if income changes?

• If income changes, the budget

8
Quantity of T-shirts

constraint will shift.

6 – When income decreases, we can buy
4
less burgers and T-shirts with the same
prices → BC shifts leftward
– When income increases, we can buy

8 12 16 more burgers and T-shirts with the

Quantity of Burgers
same prices. → BC shifts rightward

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 2.3. What if the price changes?

Price of burger increases • If the price changes, the slope will

to $15 or decreases to $8.
change.
Quantity of T-shirts

6
• If the price of burgers increases, we
4 can buy less burgers with the same
income. → BC pivots leftward
2
• If the price of burgers decreases, we
8 12 15 can buy more burgers with the same
Quantity of Burgers
income. → BC pivots rightward

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2.4. Budget constraint limitation

• The budget constraint does not indicate what a consumer will

choose.
• It only indicates what a consumer can choose.
• To find out what a consumer will choose, more information
about the consumer’s preference is required
– It will be discussed in lesson 2.2 on consumer decision.

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Review & Exercise
 Review
• A consumer’s budget constraint shows the possible
combinations of different goods she can buy given her

Unattainable income and the prices of the goods.

Quantity of T-shirts

6 • Downward sloping line reflects opportunity cost.

Max
• The slope of the budget constraint equals the
4
𝑷
relative price of the goods, - 𝑷𝒙 .
𝒚
2
Attainable • A change in income shifts the budget constraint
4 8 12 parallelly.
Quantity of Burgers • A change in the price of one of the goods pivots the
budget constraint.

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Exercise 1: Budget Constraint
• From Mankiw and McConnell et al.
• Suppose Hurley have a daily salary of $20 and he spends all
income on fish and mango. The price of fish is $4 per fish and
the price of mango is $1 per mango.
• Fill in the table below:

Goods A B C D E F
Fish
Mango

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Exercise 1: Budget Constraint
• Recall that income is $20. The price of fish is $4, and the price
of mango is $1
• Spending all the money on each good:
– Maximum amount of fish to buy is $20/$4 = 5 fish.
– Maximum amount of mangos to buy is $20/$1= 20 mangoes.
• Thus, we can fill in A and F.

Goods A B C D E F
Fish 5 0
Mango 0 20

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Exercise 1: Budget Constraint

• Then, we spread the units evenly for each good.

• That is, we fill in B to E from the information on A and F.

Goods A B C D E F
Fish 5 4 3 2 1 0
Mango 0 4 8 12 16 20

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Exercise 1: Budget Constraint

• Plot the data in your table as a budget constraint in a graph.

1. What is the slope of the budget constraint?
2. What is the opportunity cost of one more fish? Of one more
mango?
3. Do these opportunity costs rise, fall, or remain constant as
each additional unit of the product is purchased?

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Exercise 1: Budget Constraint
Fish

• Slope = -5/20 = - 0.25

Income = $20
=5
Pfish = $4 𝑃𝑚𝑎𝑛𝑔𝑜 1
• Slope = - =- = -0.25
5 𝑃𝑓𝑖𝑠ℎ 4
Income = $20
= 20 • Opportunity cost of 20 more
Pmango = $1
mangoes is 5 fish.
20 Mango
• Opportunity cost of 1 more
mango is 0.25 less fish.

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Exercise 1: Budget Constraint

• Opportunity cost of 5 more fish

Fish

Income = $20 is 20 mangoes.

=5
Pfish = $4 • Opportunity cost of 1 more fish
5
Income = $20 is 4 less mangoes.
= 20
Pmango = $1 • The opportunity costs remain
constant.
20 Mango

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Exercise 1: Budget Constraint
• Does the budget constraint tell us which of the available
combinations of fish and mangoes to buy?
• No! It only tells us which combinations are feasible.
– The budget constraint does not tell us which of the available
combinations of fish and mangoes to buy.
– We will need to use our preference relationship for fish and
mangoes to determine which combination to buy.

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Exercise 1: Budget Constraint

• Suppose that Hurley’s daily salary increases to $28.

• Show the $28 budget constraint in the diagram.
• Has the number of available combinations increased or
decreased?

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Exercise 1: Budget Constraint
Fish

• Given the higher income, the

Income = $28 =7
Pfish = $4 number of available
combinations will increase.
7
5 Income = $28 • The budget constraint shifts
= 28
Pmango = $1 outward.

20 28 Mango

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 Next Week Schedule
• Lecture session covers
– 2.2 Consumer Choice and Utility Maximization
• Discussion session covers
– 2.3* Discussion and Exercise of Topics 2.1 and 2.2