Scribd
Upload
97 views15 pages

Budget Line

The document discusses consumer equilibrium using indifference curves and budget constraints. It defines a budget line as combinations of goods that can be purchased given prices and income. Rita's budget line and possible combinations of goods X and Y, given prices of Rs. 2 and Rs. 4 respectively and income of Rs. 80, are shown in a schedule. The budget line graphically shows Rita's constraint set. Consumer equilibrium occurs at the tangency point of the highest indifference curve and budget line, where marginal rate of substitution equals the price ratio and maximum satisfaction is achieved given prices and income.

Uploaded by

Abinash Pokharel
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
97 views15 pages

Budget Line

The document discusses consumer equilibrium using indifference curves and budget constraints. It defines a budget line as combinations of goods that can be purchased given prices and income. Rita's budget line and possible combinations of goods X and Y, given prices of Rs. 2 and Rs. 4 respectively and income of Rs. 80, are shown in a schedule. The budget line graphically shows Rita's constraint set. Consumer equilibrium occurs at the tangency point of the highest indifference curve and budget line, where marginal rate of substitution equals the price ratio and maximum satisfaction is achieved given prices and income.

Uploaded by

Abinash Pokharel
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 15

BUDGET LINE

After showing consumer’s preferences on


indifference curves, we should also
understand how consumers make decisions
when they have limited income or budget. We
use a special concept named budget line to
understand what consumers can afford. To do
this, we must chart the consumer’s budget
constraint. In a budget constraint, the quantity
of one good is measured on the horizontal axis
and the quantity of the other good is
measured on the vertical axis.
Definition
- The budget line shows various combinations of any two
goods that the consumer can afford at given prices
within the income. Suppose that Rita has a total of Rs.
80 and she is allocating this sum to two hypothetical
goods X and Y. The given prices of X and Y are Rs 2 and
Rs. 4. Now, based on the given information Rita’s
allocation of the budget can be shown in the following
formula
Where, PX × QX + PY × QY ≤ M
Px is the price of goods X;
Qx is the quantity of goods X;
Py is the price of goods Y; Budget Equation
Qy is the quantity of goods Y; Quantities of good X
M is the income of the consumer.
Given
Px = Rs. 2 ;
Py = Rs. 4
The Budget equation states that the consumer’s
expenditure on commodity X and Y cannot
exceed his money income (M). Thus, the
quantities of commodities X and Y that a
consumer can buy from his income (M) at
given prices Px and Py can be calculated
through the budget equation
Budget Schedule
Combination X at PX = Rs. 2 Y at PY = Rs. 4 M = PX *X + PY *Y
A 0 20 2 × 0 + 4 × 20 = 80
B 10 15 80
C 20 10 80
D 30 5 80
E 40 0 80

Rita’s budget allocations has been presented in the


above budget schedule. When her money income (M)
is Rs. 80 and prices of good X and good Y are given
respectively at Rs. 2 and Rs. 4, she can buy 5
possible combinations of X and Y. If she spent whole
money on good Y, 20 units of good Y could be bought.
On the other hand , 40 units of good X could be
bought when total money was spent on X.
Y

PX × QX + PY × QY ≤ M
Quantities of good Y
Budget line
A
20

15 B

F
10 C

G D
5
E
0 X
5 10 15 20 25 30 35 40
Quantities of good X
• The figure shows Rita’s budget constraint
when prices of X and Y are given at Rs. 2 and
Rs. 4 respectively. We know that Rita must
purchase at some point on the budget. Three
things should be noted as
1. All points on the budget line( A,B,C,D and E)
are optimal
2. Any point within the budget line is feasible,
such as G
3. Any point beyond the budget line is not
feasible , such as point F
Rita can spend her entire income on any
combinations from A to E. Since all points lie
on the budget line, the consumer can
efficiently use the income on purchase of
those combinations.
Slope of the budget line (How many of good Y
Rita has to give up to afford one more X)
It’s called price ratio which can be found as
• This means the slope of the curve is the
relative price of the good on the x-axis in
terms of the good on the y-axis. The price
ratio of 2 means that Rita must give up 2 units
of good Y for every unit of good X.
Consumer Equilibrium

• Use of the indifference curve and the budget


line
• Based on the ordinal utility approach (utiility
or satisfaction can only be ranked in such way
as 1st, 2nd and 3rd)
• Explains how a rational consumer attains
maximum satisfaction
Definition
• A situation in which the rational consumer spends
the entire income on the purchase of goods and
services in such way that gives the consumer
maximum satisfaction and there is no tendency of
such
• Consumer equilibrium refers to a situation, in
which a consumer derives maximum satisfaction,
with no intention to change it and subject to given
prices and his given income. The point of
maximum satisfaction is achieved by studying
indifference map and budget line together.
Assumptions
• The consumer is rational and seeks to maximize
his satisfaction through the purchase of goods.
• The consumer consumes only two goods (X and
Y).
• The goods are homogenous and perfectly
divisible.
• Prices of the goods and income of the consumer
are constant.
• The indifference map for goods X and Y are
given. The indifference map is based on the
consumer’s preferences for the goods.
• The preference or habit of the consumer does
not change throughout the analysis.
• The income of consumer is given and
constant.
Conditions of consumer equilibrium

(1) The Budget line should be Tangent to the


Indifference Curve, i.e.
When marginal rate of substation is equal to
ratio of prices of two goods i.e., MRSxy = Px/Py.
(2) The indifference curve must be convex at the
point of tangency
Consumer equilibrium in figure

You might also like