Budget Line: Concept & Explanation

2 years ago

Atiqur Rahman

6 minutes

We have seen that Indifference Curve is a tool through which a consumer can measure his utility of consuming goods. But in real life, a consumer is always constrained by two things in order to maximize his utility. One is his limited money income, and the other is the price of the commodities.

Both limited money income and prices of the goods act as a constraint to the utility-maximizing behaviour of the consumer. This is known as a budgetary constraint.

Symbolically:

Px*X + Py*Y ≤ M …………………………… (a)

This equation is known as the budget line of a consumer, where Px and Py are the prices of the two goods X and Y. X and Y are the respective quantities of X and Y, which a consumer consumes given his money income M and prices of these goods.

Hence according to this budget line, a consumer always decides about how much quantity of goods to be consumed based on his money income and the prices of the consumer. Then from this set of goods, he tries to choose which combination would give him the maximum utility.

Now if we adjust the above budget line equation for X, then we get: X = M/Px – Y*Py/Px

Here this –Py/Px is also known as the slope of the budget line. Now if X=0, then Y= M/Py and if Y=0, then X= M/Px.

Plotting these points on a graph, we get the following curve as the budget line:

Hence as per the budget line, all the points which come inside or on the budget line represent a feasible area as given the income of the consumer and prices of the goods the consumer can consume any combination. But if the combination costs more than his given income, then that will fall outside the budget line, which is represented by an infeasible area in the above graph.

Thus, the budget line is drawn based on the money income of the consumer and the prices of the goods. Therefore, if any of these factors change, then the budget line will also change.

If the money income of the consumer changes, then the budget line will shift either outside or inside as follows:

Shift in Budget Line due to change in Income of the Consumer

As it can be clearly seen from the above diagram if the money income of the consumer changes from M to M’, the budget line moves upward as now, with more of his income, he can consume more of both the goods and vice versa.

Now if the prices of the goods change, then it will pivot the budget line as follows:

Shift in Budget Line due to change in Price of Commodity X

As it can be clearly seen from the above graph that if the price of X increases from Px to Px’, then given his money income M, he will reduce the consumption of X as now X has become expensive. However, he will continue consuming the same quantity of Y. Hence the budget line will pivot inward to BL₂.

Similarly, if the price of X reduces from Px to Px’’, then he can increase his consumption of X as now, given his money income M, X has become relatively cheaper. Hence the budget line will pivot outward to BL₁.

Budget Line: Concept & Explanation

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