The concept of budget lines and consumer constraints

A budget line represents the different combinations of two products that a consumer can afford with their available money and the current prices of those products. Consumers are limited by their disposable income and by the prices of the goods they wish to buy.

Constructing a budget line

For example, suppose a consumer has £100 to spend on books and drinks:

• Books cost £20 each, so maximum books = 5 (if no drinks are bought).
• Drinks cost £4 each, so maximum drinks = 25 (if no books are bought).

Worked example - Calculating points on a budget line

A student has £180 to spend on notebooks and pens. Notebooks cost £20 each, and pens cost £5 each. Calculate the maximum number of each item if all money is spent on one, and find a combination in between.

Step 1: Identify the values

• Total budget = £180
• Price of notebooks = £20
• Price of pens = £5

Step 2: Calculate maximum notebooks

Maximum notebooks = £180 ÷ £20 = 9 notebooks (with 0 pens)

Step 3: Calculate maximum pens

Maximum pens = £180 ÷ £5 = 36 pens (with 0 notebooks)

Step 4: Find a midpoint combination

For 5 notebooks: Cost = 5 × £20 = £100

Remaining for pens = £180 - £100 = £80

Pens affordable = £80 ÷ £5 = 16 pens

How changes in prices affect budget lines

When the price of one good alters while income stays the same, the budget line pivots around the intercept of the unchanged good.

Effects of price changes

• Price decreases - If the price of one good falls, the budget line pivots outward from the axis of the other good.
• Price increases - If the price of one good rises, the budget line pivots inward from the axis of the other good.

Substitution and income effects

Price changes influence consumer behaviour through two main effects, encouraging adjustments in purchasing decisions.

The substitution effect

When one good becomes cheaper relative to another, consumers tend to buy more of the cheaper good and less of the more expensive one.

The income effect

A price reduction increases the consumer's real purchasing power, effectively giving them more income to spend. This can lead to buying even more of the good whose price fell.

Optimal consumption point and types of goods

The optimal consumption point is where the budget line just touches the highest possible indifference curve. Goods can be classified based on how consumption changes with income.

Normal goods

These are goods where demand rises as income increases. For example, with higher income, consumers might buy more high-quality clothing or electronics.

Inferior goods

These are goods where demand falls as income rises. Conversely, if income falls, demand for inferior goods increases.

Effects of income changes on consumption

Changes in income cause the budget line to shift parallel to its original position, altering the affordable combinations of goods.

Impact of income changes

• Income increases - The budget line shifts outward, parallel to the original. This enables consumers to reach a higher indifference curve, typically leading to increased consumption of normal goods.
• Income decreases - The budget line shifts inward, parallel to the original. This restricts choices, often resulting in reduced consumption of normal goods but increased consumption of inferior goods.

For normal goods, the new optimal point after an income rise shows higher quantities of both goods being purchased.