BUDGET LINE
Introduction
Budget line is a graphical representation of all possible combinations of two
goods which can be purchased with given income and prices, such that the
cost of each of these combinations is equal to the money income of the
consumer.
Explanation of Budget Line
Example:
Assume that a consumer has a total budget of ₹40, with which he can buy
various combinations of Good X and Good Y. The cost of one unit of Good X
is ₹8 and the cost of one unit of Good Y is ₹4 respectively. Now, the potential
set of combinations that can be purchased by the consumer are:
Combinations Good X Good Y Money Spent =
(₹8 per unit) (₹4 per unit) Individual Income
E 5 0 (5 x 8) + (0 x 4) = 40
F 4 2 (4 x 8) + (2 x 4) = 40
G 3 4 (3 x 8) + (4 x 4) = 40
H 2 6 (2 x 8) + (6 x 4) = 40
I 1 8 (1 x 8) + (8 x 4) = 40
J 0 10 (0 x 8) + (10 x 4) = 40
In the given graph, Good X is represented on the X-axis and Good Y is
represented on the Y-axis. Point J represents one extreme where income is
spent only on Good Y. Similarly, point E represents another extreme where
income is spent only on Good X. Between these two we get other points
representing other combinations (Point I, H, G and F) in which all income is
spent on both commodities. Joining these gives us a straight line, also known
as the Budget Line.
From this graph we can also see points D and C which do not lie on the
budget line. Point D lies below the budget line which indicates a combination
where full income has not been spent. Point C lies beyond the budget line
which indicates an unattainable combination, which means this combination
cannot be achieved with the consumer’s current income.
Budget Set
Budget Set is the set of all possible combinations of the two goods which a
consumer can afford given his income and prices in the market.
Algebraic Expression of Budget Line
M = (PA x QA) + (PB x QB)
Where:
M = money income of the consumer
PA = price of Good A
QA = quantity of Good A
PB = price of Good B
QB = quantity of Good B
Slope of Budget Line
Slope of Budget Line is denoted by Market Rate of Exchange (MRE). MRE is
the rate at which one good is sacrificed to gain an additional unit of the other
good. It is equal to the price ratio of two goods.
Properties of Budget Line
1. Negative Slope: Budget line is downward sloping, i.e, when units of one
good are decreased, more units of the other good can be bought.
2. Straight Line: Slope of Budget Line is represented by price ratio, which
is always constant.
Assumptions of Budget Line
➢ Consumer’s Income remains constant
➢ Prices of the goods remain constant
➢ Consumer spends his entire income
➢ Income is spent only on two goods
Shift in Budget Line
Budget line shifts when there is a change in either price of the goods or
income of the consumer.
➢ Effect of Change in Income of Consumer
● When the income of the consumer increases, the budget line
shifts rightwards, i.e, the budget line shifts from AB to A1B1.
● When the income of the consumer decreases, the budget line
shifts leftwards, i,e, budget line shifts from AB to A2B2.
➢ Effect of Change in Price of Goods
● When the prices of both goods rise, the budget line shifts
leftwards, i.e, the budget line shifts from AB to A2B2.
● When the price of both goods fall, the budget line shifts
rightwards, i.e, the budget line shifts from AB to A1B1.
Rotation of Budget Line
Budget line rotates when the price of either good changes.
➢ Change in Price of the Commodity on X-axis
● When the price of good X rises, the budget line rotates left from
AB to A2B.
● When the price of good X falls, the budget line rotates right from
AB to A1B.
➢ Change in Price of the Commodity on Y-axis
● When the price of good Y rises, the budget line rotates left from
AB to AB2.
● When the price of good X falls, the budget line rotates right from
AB to AB1.
Reasons why we use Budget Lines
1. They help businesses analyse how consumers are likely to spend their
money on items.
2. They are used with indifference curves to determine consumer
equilibrium.
3. They allow us to evaluate how changes in the economic conditions
reflect on the choices of the consumer. (eg: change in price, change in
income, etc.)
Merits of Budget Line
1. A budget line is a simple and easy-to-understand visual representation
of the consumer's budget constraint.
2. A budget line helps to identify the consumer's optimal consumption
bundle, which is the point where the budget line is tangent to the
indifference curve.
3. A budget line helps to identify the range of choices available to the
consumer given their income and the prices of goods.
Demerits of Budget Line
1. A budget line assumes that the consumer only has two goods to choose
from, which may not be realistic
2. A budget line assumes that the consumer only has a fixed amount of
money to spend, which may not be realistic in some situations.
3. A budget line assumes that the consumer's marginal utility of the goods
is constant, which may not be the case in some situations.
Conclusion
Budget lines help us analyse consumer choices based on how they spend
their income between two given commodities. We have understood how to
calculate and graph budget lines with given income and prices of
commodities. Budget line can change based on the change in income of the
consumer and prices of goods. There are many reasons why we use budget
lines to represent the budget constraints in a graphical format and we have
identified some merits and demerits of budget lines as well.
Methodology
Source of the information in this synopsis: Secondary sources.
Bibliography
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Sandeep Garg - Introductory Microeconomics
