The individual’s budget constraint

As individuals are utility maximisers, each person seeks to be on an indifference curve as far away from the origin as possible. The extent to which this is possible is limited by the individual’s budget constraint. The budget constraint states that expenditure cannot exceed income. Let m be money income, and Px and Py be the prices of goods x and y. These prices cannot be changed by an individual consumer. The budget constraint can be written as

and is represented diagramatically in Figure 3.5. If the prices of the goods x and y are Px1 and Py1 respectively, and available money income is m1 , the individual’s budget constraint is given by the shaded area. Given this set of prices and money income, it shows all combinations of the two goods that it is feasible for the consumer to purchase. For reasons that will be clear shortly, the individual will choose a combination of goods on the outer diagonal boundary of the budget constraint (the line denoted M1 ). From now on it is this line that we shall call “the budget constraint”.

The slope and position of the budget constraint depend on two factors

  • the relative prices of the two goods: that is the ratio Px : Py . Relative prices determine the slope of the budget constraint

  • the level of money income. This determines, for any given set of prices, how far the budget constraint is located away from the origin.

An individual’s budget constraint will change whenever there is a change in prices or money income. For example, the budget constraint shift from M1 to M2 in Figure 3.6 occurs when money income is increased from m1 to m2 but with prices remaining unchanged. On the other hand, the budget constraint shift from M1 to M3 if the price of good x falls to Px2 but money income and the price of y remain unchanged.