CHAPTER 2 H

BUDGET
CONSTRAINT

The economic theory of the consumer is very simple: economists assume

that consumers choose the best bundle of goods they can afford. To give
content to this theory, we have to describe more precisely what we mean by
"best" and what we mean by "can afford." In this chapter we will examine
how to describe what a consumer can afford; the next chapter will focus on
the concept of how the consumer determines what is best. We will then be
able to undertake a detailed study of the implications of this simple model
of consumer behavior.

2.1 The Budget Constraint

We begin by examining the concept of the budget constraint. Suppose

that there is some set of goods from which the consumer can choose. In
real life there are many goods to consume, but for our purposes it is conve-
nient to consider only the case of two goods, since we can then
depict the
consumer's choice behavior graphically.
We will indicate the consumer's consumption bundle by
(T1, T2). This
is simply a list of two numbers that tells us how much the consumer is
choos-
ing to consume of good 1, T1, and how much the consumer is choosing to
 21
TWO GOODS ARE OFTEN ENOUGH

T2. Sometimes it is convenient to denote the consumer's

consume of good 2,
a single symbol like X, where X is simply an abbreviation
for
bundle by
two numbers (z1, t2).
the list of
We suppose that we can observe the prices of the two goods, (P1,P2),
and the amount of money the cons1umer has to spend, m. Then the budget
constraint of the consumer can be written as

P11 P2T2 m . (2.1)

Here Piti is the amount ot money the consumer is spending on gooa l

and p202 is the amount of money the consumer is spending on good 2.

The budget constraint of the consumer requires that the amount ot money
spent on the two goods be no more than the total amount the consumer has
to spend. The consumer's affordable consumption bundles are those that
don't cost any more than m. We call this set of affordable consumption
bundles at prices (Pi, P2) and income m the budget set of the consumer.

2.2 Two Goods Are Often Enough

The two-good assumption is more general than you might think at first,
since we can often interpret one of the goods as representing everything
else the consumer might want to consume.
For example, if we are interested in studying a consumer's demand for
milk, we might let aj measure his or her consumption of milk in quarts per
month. We can then let c2 stand for everything else the consumer might
ne want to consumne.
ve When we adopt this interpretation, it is convenient to think of good 2

by as being the dollars that the consumer can use to spend on other goods.
ne Under this interpretation the price of good 2 will automatically be 1, since
on the price of one dollar is one dollar. Thus the budget constraint will take
be the formn
del P1T1 +T2 m . (2.2)
This expression simply says that the amount of money spent on good 1,,

P1T1, the amount of money spent on all other goods, T2, must be
plus
no

more than the total amount of money the consumer has to spend, m.
We say that good 2 represents a composite good that stands for ev-
Dse erything else that the consumer might want to consume other than good
In 1. Such a composite good is invariably measured in dollars to be spent
on goods other than good 1. As tar as the algebraic form of the budget
he constraint is concerned, equation (2.2) is just a special case of the formula
given in equation (2.1), with p2 = 1, So everything that we have to say
his about the budget constraint in general will hold under the composite-good
0S-
interpretation.
to
 (Ch. 2)
2 BUDGET CONSTRAINI

.3 Properties of the Budget Set

he budget line is the set of bundles that cost exactly m

(2.3)

hese are the bundles of goonds that just exhaust the consumer's ineone
Thebudget set is depicted in Figure 2.1 The heavy ine is the budget
ne the bundles that cost exactly m and the bunlles below this line are
hose that cost strictly less than m.

Vertical
intercept
mp Budget line;
slope =- P/P2

Horizontal intercept = mp;

The budget set. The budget set consists of all bundles that
are affordable at the given prices and income.

We can rearrange the budget line in equation (2.3) to give us the formula

(2.4)
P2 P2

This is the formula for a straight line with a vertical intercept of

m/p2
and a slope of -Pi/P2. The forimula tells us how many units of good 2 the
consumer needs to consume in order to just satisfy the budget constraint
if she is consuming t1 units of good 1.
 BUDGET SET
23
PROPERTIES OF THE

income
to draw budget line given prices
a (p1, P2) and
Here is
an casy way could buy if she
how much of good2 the c o n s u m e r
J u s t ask
yourselt m/p2. T h e n
o n good 2. The a n s w e r is, of course,
of her money of her
nent all
spe c o n s u n e r could buy if
she spent all
of good I the
ask how much and vertical
1. The a n s w e r is m/p1. Thus the horizontal
on good of her
money
how much the c o n s u m e r
could if she spent all
get.
the budget line
measure
intercepts
goods l and 2, respectively. In order to depict connect
of the graph and
on
money
on the appropriate a x e s
plot these two points
iust
a straight
line.
them with It mea-
economic interpretation.
the budget line has a ice
The slope of 1 for
at which the market is willing to "substitute" good
rate
sures the
hner
tor example that the c o n s u m e r
is going to increase
Suppose
good 2. consumption of good
of good 1 by Aci. How much will her
consumption Let us use Az2
in order t0 satisfy her budget constraint?
2 have to change 2.
her change in the consumption of good and atter
to indicate constraint before
she satisfies her budget
Now note that if
must satisfy
making the change she
m
P1Tit P2T2
=

and
+ P2(T2 + Ar2)
= m.
Pi(T+Ar1)
from the second gives
Subtracting the first equation
0.
P1Ar + P2At2
must be
value of the change in her consumption
total
This says that the 2 can be
substituted
the rate at which good
zero. Solving
for Ar2/Ar1,
constraint, gives
while still satisfying the budget
for goodl

A P2
there since
of the budget line. The negative sign is
This is just the slope signs. f you
consume more
of
have opposite
Ar and Atz must always 2 and vice versa if you continue
have to consume less of good
good 1, you
constraint.
to satisfy the budget of the budget line
measures

sometimes say slope

that the
Economists more of
1. In order to
consume

cost of consuming good

the opportunity consumption of good 2. Giving up the
some

good 1 you have to give up economic cost of more good 1

consume good 2 is the true
opportunity to the budget line
that cost is
measured by the slope of
consumption; and

denotes the
"del-ta." The notation Ari
delta, is pronounced
1The Greek letter A, the Mathematical
see
and rates of changes,
in good 1. For m o r e o n changes
change
Appendix.
 BUDGETCONSTRAINT (Ch.
2)
24

Budget Line Changes

2.4 How the can
consumer

of goods that
a
change, the
set
When prices and
incomes
budget set?
How do these
changes affect the
wrll from equation
afford changes as to s e e
onsiier changes in income. t is easy and not
let us first increase the vertical int.ercept
that an increase in i1ncomewill incone will
result in a par-
(2.4) increase in
Thus an decrease
affect the slope of the line. in Figure 2.2. Similarly,
a

the budget line

as

allel shaft ontuard of inward.

will cause a parallel shift
income
in

mP
Budgetlines

mP2

Slope-PP2

an
mp m'p pr
int
Increasing income. An increase in income causes a parallel
Figure lin
2.2 shift outward of the budget line.
Jus

What about changes in prices? Let us first consider increasing price

I while holding price 2 and income fixed. According to equation (2.4), No
change the vertical intercept, but it will make the pric
increasing pi will not
budget line steeper since p1/p2 will become larger.
Another way to see how the budget line changes is to use the trick de-
But
scribed earier for drawing the budget line. If you are spending all of
your money on good 2, then increasing the price of good l does1't change
the maximum amount of good 2 you could buy thus the vertical inter-
cept of the budget line doesn't change. But if you are spending all of Thu
your money on good 1, and good 1 becomes more expensive, then your incc
 HOW THE BUDGET LINE CHANGES 25

consumption of good l must decrease. Thus the horizontal intercept of

the budget
line must shift inward, resulting in the tilt depicted in Fig-
ure 2.3.

mp
Budget lines

SlopePi/P Slope P2

mp
Figure
Increasing price I good 1 becomes:more, expensiye, 2.3
budgetline becomes stecper

1
What happens to the budget line when we change the prices of good
the
2 at the same time? for
Suppose example that we double
and good both the horizontal and
vertical
of both goods 1 and 2. In this case
prices and therefore the budget
a factor of one-half,
intercepts shift inward by two is
one-half as well. Multiplying both prices by
line shifts inward by
just like dividing
income by 2. line is
this algebraically. Suppose our original budget
We can also s e e

m.
P1T1 +p2T2
=

both
both prices become t times as large. Multiplying
Now suppose that
prices by t yields m.
tp1T1 + tp2T2
=

same as
is the
But this equation
m
P1T tP2T2
t

by a c o n s t a n t amount t is just like dividing

both prices
Thus multiplying tollows that it we multiply both prices
constant t. It
income by the same
26 BUDGET CONSTRAINT (Ch. 2)

for each
and multiply
by
al.
we income by t, then the budget. line won't change at about
How
We also consider price and income
can
changes together. What happeis the viev
if both prices go up and imcome goes down?
Think about what happens O
the horizontal and vertical intercepts. If m
decreases and pi and p2 bO quantity
increase, then the intercepts m/p1 and m/p2 must both decrease. This from pF
means that the budget line will sBhift inward. must g e
What about the slope O
the budget line? If price 2 increases more than price 1, so that Anotl,
decreases (in absolute value), then the budget. line will be flatter; if -P1/P2
price 2 on the v
increases less than price 1, the budget line will be a goorl. f
stceper.
in the U
is price
2.5 The Numeraire ad val
If goc
The budget line is defined by two prices and one income, but one of these the act
variables is redundant. We could peg one of the prices, or the income, to payPi
some fixed value, and adjust the other variables so as to describe exactly so t.he t
the same budget set. Thus the budget line A suk
the gov
amount
P1t1 tP2T2=m
were su

is exactly the same budget line as Consum

the sub

P +2 viewpo
P2 P2 therefor
Simi
Or
good b
P1+
Tn m
2=1, you do
at a rat
since the first budget line results from dividing everything by P2, and the
second budget line results from dividing everything by m. In the first case subject
facing t
we have pegged p2 = 1, and in the second case, we have pegged m = 1.
Pegging the price of one of the goods or income to 1 and adjusting the
You
way exX
other price and income appropriately doesn't change the budget set at all.
and a s
When we set one of the prices to 1, as we did above, we often refer to that
the numeraire price. The numeraire price is the price relative to
Anot
price as
sum tai
which we are measuring the other price and income. It will occasionally be
takes a
convenient to think of one of the goods as being a numeraire good, since
havior.
there will then be one less price to worry about.
will shi
lump-si
taxes a,
2.6 Taxes, Subsidies, and Rationing
Economic policy often uses tools that affect a consumer's budget constraint, 2 The

such taxes. For

as if the government imposes a quantity tax, this
example, 3 The
means that the consumer has to pay a certain anmount to the government
 TAXES esDNES
12pe. p p
in the L S . ior
purchases.
unit of
the zod he taz Fro
zaiire
for+ach terleTal crITDer
a
zalkn
as of a
line Thun2s a
a t f e r t the toiget
15 cents
about tar
like a higher
prie
quantity ZO
the t a r is just
a
How does c o n S T n e r t h e price
of the changes ES
the
viewpoint
dollars per
urit of zrd 1 sirnply the d g e t
thar
inplies
quantity
tax of seen
a t r e . this
t As we
v tar

I frorn p1 to pi inplies
this s 2

nust get sterper.

As the
nane ot
of t a x i s
a value tax
the q u a n t i t y
purchaset
kind rather than
Another
p r i c e - o f a good, terS. M SIA
v a l u e - the percestage tnat
on
the expressed i n then a go
t a x is usually
value is 6 percent.
A
a good. If the sales tax
k i o A Ts
also
have sales t a x s . t a r e s are
U.S. (Value
in the sell for $i.06.
i l l actually
a t S1 rate t h e n
is priced tar at rate
ad valorem taxes.) a saes
but is subjert to has t o
price of P:
consuner

has a The
I fgod1 is (1 )P:
t h e zood
facing the vnit of
consumer

actual price for each

the the g o v e r n m e n t
andi Tp1 t o
to the suPplier
pay pi consurner is 1 - p : the subsidy.
total cost good to of the c a s e of a
quantity
So the tax. In the onre
of a
is the opposite thar depends
A subsidy a n o u n t to
the consurner

oi niik

government
an
ives exarnple. the
consunption
the Ií, for money t o
eacn2
arnount of the good purchased. sorne arnount
oi
would pay 1i
subsidized, the
government purchased.
were that consumer

on the amount
then from
the
consuner
of milk depending of good 1.
dollars per unit of consumption This woud
is s
would be pi - s .
the subsidy i
the price of good
the c o n s u m e r ,
viewpoint of fiatter.
therefore make
the budget line based on the price
of the
is a subsidy
valorem subsidy S2
Similarly a n ad gives you
back $1 for every
subsidized. If the government subsidized
good being then your
charity a r e being
donations to
donate to charity, and good 1 is
you if the price of good 1 is pi
In general, 1
at a rate of 50 percent.
at rate a, then
the actual price of good
ad valorem subsidy
subject to a n
facing the consuiner is (1-)P1
and subsidies prices in exactly
affect
the same

You see that taxes

increases the price to the
can consumer.

a tax
for the algebraic sign:
way except
decreases it.
and a subsidy use is a luinp-
tax or subsidy that the governrnent inigit
Another kind of
m e a n s that the government
or subsidy. In
the case oi a tax, this
sum tax ir:dividua!'s be-
some fixed of money, regardless of the
amount
takes away
that the budget line of a consurner

havior. Thus a lump-sum tax m e a n s

his money income has been
reduced. Similarly. a
will shift inward because
means that the budget line will shift out ward. Quantit:
lump-sun subsidy
taxes and value taxes tilt the budget line one way or the other depending

"wow"
T h e Greek letter 7, tau, rhymnEs with

3The Crcek letter o is pronounCed "sig-ma.

 28 BUDGET CONSTRAINT (Ch. 2)

line
which is being taxed, but. a lump-sum tax shifts the budget
on good
inward.
This means
Governments also sometimesimpose 7atoning constraints.
that the level of consumption of s o m e good is fixed t.o be no
larger than
some amount.. For example, during World War I the U.S. governmment
rationed certain foods like but.ter and neat
no more
than
Suppose, for example, that good l were rationed so that
Then the budget set ot the
T1 COuld be consumed by a given consumer.
consumer would look like that depicted in igure 2.4: it. would be the old

budget set with a piece lopped off. The lopped-off piece consists of all th
consumption bundles that are affordable but have t1 1 .

X2

Budget line

EXAN

Since=
a sub
adju=
of th
B
allo-
Budget set,with rationing. If good l is rationed, the section at r
Figure
2.4 of the budget set beyond the rationed quantity will be lopped
off. the

inc
S8

Sometimes taxes, subsidies, and rationing are combined. For example, ha-
we could consider a situation where a consumer could consume goodT
at a price ot pi up to some level Ti, and then had to pay a tax t on all T
consumption in eXcess of T1. The budget set for this consumer is depicted
inFigure 2.5. Here the budget line has a slope of -p/pg the lett oi
and a slope of - (P1+ t)/p2 to the
to D1
right of T.
 RATIONING 29
AXES, SUBSIDIES, AND

tline
neans
than
ment Budget line

than Slope - PVP2

f the
he old
l the

Slope = - (Pi + tVP2

X1
this budget set Figure
Taxing consumption greater than T1. In of good 2.5
the consumer must pay a tax only on the consumption
steeper to
1 that is in excess of T1, so the budget line becomes
the right of T1.

EXAMPLE: The Food Stamp Program

has provided
1964 the U.S. federal government
Since the Food Stamp Act of have been
food for poor people. The details of this program
a subsidy on
of one
describe the economic effects
adjusted several times. Here we will
of these adjustments. requirements were
who met certain eligibility
Before 1979, households food
food stamps, which could then be used to purchase
allowed to purchase four could receive
In January 1975, for example, a family of
at retail outlets.
participating in
allotment of S153 in food coupons by
a maximum monthly
the program. the household
the household depended
on
of these coupons to
The price income of $300 paid
with adjusted monthly
A family of four
an
income. If family a of four had
allotment of food stamps.
$83 for the full monthly allotment would
the cost for the full monthly
a monthly income of $100,
have been $25.1 valorem subsidy on food.
was an ad
ple, The pre-1979 Food
Stamp program
the household
income.
d 1 food was subsidized depended on

The rate at which

all
ted
Food Stamps and
Nutrition, Ameri-
from Kenneth Clarkson,
4These figures are taken
1975.
can Enterprise Institute,
 30 BUDGET CONSTRAINI (Ch. 2)
househol
householc
to
The family of four that was charged 883 for their allotmont paid o
Suppost
receive $184 worth of food (181 equals 153 divided by 83). Similarly,
6.12 month. "
household that paid $25 wns paying 81 to reccive $6.12 worth of food per niont
cquals 153 divided by 25).
The way that the Food Stamp program affected the budget set o
implies t
housebold is depicted in Figure 2.6A. IHere we have measured the ano
will not
of money spent on toocd on the horizontal axis and expenditures on all otn
other thi
goods on the vertical axis. Since we arc neasuring cach good in terns o maxiinui
and tne Food Sta
the money spent on it, the "price" of cach good is automatically 1, that the
budget line will therefore have a slope of - 1. this
then
If the household is allowed to buy $153 of food stamps for $25,
represents roughly an 84 percent (= 1-25/153) subsidy of food purchasCS,
until the
2.7 Budti
so the budget line will have a slope of roughly -.16 (= 25/153)
household has spent S153 on food. Each dollar that the household
spends
about
In the ne
on food up to $153 would
reduce its consumption of other goods by
cosimpte
the budget line facings
16 cents. After the household spends $153 on food, SOme obs
it would again have a slope of -1. movemen

First,
multiply
the c o n s t

OTHER lyzing th,

OTHER GOODS Budget line
COODS a perfect
with food
Budget line at the sa
stamps
with food Budget
Budget line
change al
stamps
line without Secondi
without food can be at
food stamps
stamps increases

parallel s
was cosi
income.

FOOD incomme aE
:FOOD $200 able as b
$153
A stay the :

is affected by the Food Servation-

the budget line
Figure Food stamps. How and part
Part A shows the pre-1979
progran

2.6 Stamp program.

B the post-1979 program. Summa

. The
House- afford a
of "kink" depicted in Figure 2.6.
These effects lead
to the kind
allotment of food only tw
to more for their
incomes had pay
as house-
holds with higher line would become steeper 2 The
the slope of the budget
stamps. Thus a verti1C
hold income increased.
Instead of requiring
that
was modified.
program
In 1979 the Food Stamp
 SUMMARY 31

to qualinea
households purchns food stamps, they a r e now sirmply yiven
households. F'isgure 2.63 shows how this afects the bucdyet set.
Suppose that a hosehod now receives a grant of 8200 of food stainps
$200 more food
month. Then this n e a n s that the household can c o n s u n e
of how much it is spending on other gOods, whien
per month, regardless
$200. The slope
inplies that the budget line will shift to the right by
will not change:$I less spent on food would n e a n
$1 n o r e to spend o n
other things. But since the household cannot legally sell food starnps, the
The
maximun amou1t that it, can spend o n other goods does not, change.
Food Stamp program is effectively a lump-sum subeidy, e%cept for tne 122

that the food stamps can't be sold.

2.7 Budget Line Changes

chooses an optirnal
In the next chapter we will analyze how the
consuner
state
But we can alrcady
consumption bundle from his or her budget set.
learned about the
some observations
here that follow from what we have
movements of the budget line.
when w e
set doesn't change
First, we can observe that since the budget choice of
number, the optinal
multiply all prices and income by a positive
either. Without even
ana-

the c o n s u n e r from the budget set can't change conclusion:

we have derived an inportant
lyzing the choice process itself, and all incomes rise
a perfectly
balanced inflation-one in which all prices
cannot
budget set, and thus
at the rate- doesn't change anybody's
same
choice.
change anybody's optimal about how well-off the c o n s u m e r
make some statements
Second, we can
consumer's income
can be at different prices
and incomes. Suppose that the
the s a m e . We know that this
represents a
increases and all prices remain
Thus every bundle the
consumer

shift outward of the budget line.

parallel also a possible choice at
the higher
was consuming
at the lower income is
c o n s u m e r must be at
least as well-off at the higher
income. But then the
income-since he or she has
the s a m e choices avail-
income as at the lower others
s o m e more. Similarly,
if one price declines and all
able as before plus well-off. This simple ob-
the consuner must be at least as
stay the same,
considerable use later on.
Servation will be of

Summaryy
can
of goods that the consuner

set consists of
all bundles
1. The budget typicaliy assume that there are
and income. We will
afford at given prices general than it seems.
is more
two goods, but this assumption
only
= m. It has a slope of -Pi/P2
written as p1t1 4+ P2#2
2. The budget line is intercept of m/p1
a horizontal
of m/p2, and
a vertical intercept
32 BUDGET CONSTRAINT (Ch. 2)

3. Increasing income shifts the budget

line outward. Increasing the price
the price of good 2
of good 1 makes the budget line steeper. Increasing
makes the budget line flatter.

4. Taxes, subsidies, and rationing change the slope and position of the
line by changing the prices paid by the consumer.
budget

REVIEW QUESTIONS

1. Originally the consumer faces the budget line PiE1 + p22 = m. Then

the price of good 1 doubles, the price of good 2 becomes 8 times larger,
and income becomes 4 times larger. Write down an equation for the new
budget line in terms of the original prices and income.

2. What happens to the budget line if the price of good 2 increases, but
the price of good 1 and income remain constant?

3. If the price of good 1 doubles and the price of good 2 triples, does the
budget line become flatter or steeper?

4. What is the definition of numeraire

a
good?
5. Suppose that the government
puts a tax of 15 cents a gallon on gasoline
and then later decides to put a subsidy on gasoline at a rate of 7 cents a
gallon. What net tax is this combination equivalent to?

6. Suppose that a budget equation is given by P1T1 + P2T2 = m. The

government decides to impose a lump-sum tax of u, a quantity tax on
good 1 of t, and a quantity subsidy on good 2 of s. What is the formula
for the new budget line?

7. If the income of the consumer increases and oné of

the prices decreases
at the same time, will the consumer
necessarily be at least as well-off?