Budget Constraint: Intermediate Microeconomics I ECON 2301

CHAPTER 2
BUDGET
CONSTRAINT
Intermediate Microeconomics I
ECON 2301
1. The Budget Constraint
Budget Constraint:
• Suppose that there is some set of goods from which the
consumer can choose.
• Convenient to consider only the case of two goods
• indicate the consumer’s consumption bundle by (x1,

x2): list of two numbers that tells us how much the
consumer is choosing to consume of good 1, x1, and how
much the consumer is choosing to consume of good 2, x2
• observe the prices of the two goods, (p1, p2) and the amount of
money the consumer has to spend, m.
• Then the budget constraint or budget set of the consumer can

be written as
p1x1 + p2x2 ≤ m
• Here p1x1 is the amount of money the consumer is spending on

good 1,
• and p2x2 is the amount of money the consumer is spending on
good 2.
• The budget constraint of the consumer requires that the amount

of money spent on the two goods be no more than the total
amount the consumer has to spend
2. Two Goods Are Often Enough
• let x1 measure his or her consumption of rice in kg per
month.
• We can then let x2 stand for everything else the consumer
might want to consume.
• it is convenient to think of good 2 as being the dollars

that the consumer can use to spend on other goods.
• Under this interpretation the price of good 2 will

automatically be 1
• Thus the budget constraint will take the form

p1x1 + x2 ≤ m.
• good 2 represents a composite good that stands for everything
else that the consumer might want to consume other than good
1.
•
• Such a composite good is invariably measured in dollars to be
spent on goods other than good 1.
• Second equation is just a special case of the formula given in

first equation with p2 = 1,
3. Properties of the Budget Set
• The budget line is the set of bundles that cost exactly m:
p1x1 + p2x2 = m.
• This is the formula for a straight line with a vertical intercept

of m/p2 and a slope of −p1/p2.
• The formula tells us how many units of good 2 the consumer

needs to consume in order to just satisfy the budget constraint
if she is consuming x1 units of good 1.
• The slope of the budget line: measures the rate at which the
market is willing to “substitute” good 1 for good
• Suppose for example that the consumer is going to increase her

consumption of good 1 by Δx1.1 How much will her
consumption of good 2 have to change in order to satisfy her
budget constraint?
• This says that the total value of the change in her consumption
must be zero
• This is just the slope of the budget line. The negative sign is
there since Δx1 and Δx2 must always have opposite signs
• the slope of the budget line measures the opportunity cost of

consuming good 1. In order to consume more of good 1 you
have to give up some consumption of good 2.
4. How the Budget Line Changes
When prices and incomes change, the set of goods that a

consumer can afford changes as well. How do these
changes affect the budget set?
CHANGES IN INCOME:
• an increase in income will increase the vertical intercept and not
affect the slope of the line.
• Thus an increase in income will result in a parallel shift
outward of the budget line.
• Similarly, a decrease in income will cause a parallel shift
inward.
CHANGES IN PRICES
• First consider increasing price 1 while holding price 2 and

income fixed.
• According to equation increasing p1 will not change the vertical
intercept, but it will make the budget line steeper since p1/p2
will become larger.
• Vertical intercept of the budget line does not change
• Horizontal intercept of the budget line shifts inwards

What happens to the budget line when we change the prices of
good 1 and good 2 at the same time?
• double the prices of both goods 1 and 2: both the horizontal and
vertical intercepts shift inward by a factor of one-half, and
therefore the budget line shifts inward by one-half as well
• Thus multiplying both prices by a constant amount t is just like

dividing income by the same constant t.
CHANGES IN PRICES AND INCOME
What happens if both prices go up and income goes down?
• the horizontal and vertical intercepts: If m decreases and p1

and p2 both increase, then the intercepts m/p1 and m/p2 must
both decrease: the budget line will shift inward.
• slope of the budget line: If price 2 increases more than price 1,

so that −p1/p2 decreases (in absolute value), then the budget
line will be flatter; if price 2 increases less than price 1, the
budget line will be steeper.
5. The Numeraire
• peg one of the prices, or the income, to some fixed value,
and adjust the other variables so as to describe exactly the
same budget set
• In the first case, we have pegged p2 = 1, and in the second case,
we have pegged m = 1.
• Numeraire price: set one of the prices to 1
• The numeraire price is the price relative to which we are

measuring the other price and income
6. Taxes, Subsidies and Rationing
Economic policy tools that affect a consumer’s budget
constraint: taxes, subsidies and rationing
• quantity tax: the consumer has to pay a certain amount to the
government for each unit of the good he purchases
• How does a quantity tax affect the budget line of a

consumer?
• tax is just like a higher price.
• Thus a quantity tax of t dollars per unit of good 1 simply

changes the price of good 1 from p1 to p1 + t.
• this implies that the budget line must get steeper

• VALUE TAX: a tax on the value—the price—of a good, rather
than the quantity purchased of a good
• If good 1 has a price of p1 but is subject to a sales tax at rate τ,

then the actual price facing the consumer is (1 + τ)p1
• The consumer has to pay p1 to the supplier and τp1 to the

government for each unit of the good so the total cost of the
good to the consumer is (1 + τ )p1.
SUBSIDY
• quantity subsidy: the government gives an amount to the
consumer that depends on the amount of the good purchased.
• If the subsidy is s dollars per unit of consumption of good 1,

then the price of good 1 would be p1−s.
• This would therefore make the budget line flatter.
• ad valorem subsidy: subsidy based on the price of the good

being subsidized
• if the price of good 1 is p1 and good 1 is subject to an ad

valorem subsidy at rate σ, then the actual price of good 1 facing
the consumer is (1 − σ)p1
LUMPSUM TAX OR SUBSIDY
• Lump-sum tax: this means that the government takes away
some fixed amount of money, regardless of the individual’s
behavior.
• Thus a lump-sum tax means that the budget line of a consumer

will shift inward because his money income has been reduced.
• lump-sum subsidy: means that the budget line will shift

outward.
• Quantity taxes and value taxes tilt the budget line one way or the
other depending on which good is being taxed, but a lump-sum
tax shifts the budget line inward.
• Rationing Constraints: the level of consumption of some good
is fixed to be no larger than some amount
• Suppose, for example, that good 1 were rationed so that no more

than x1 could be consumed by a given consumer it would be the
old budget set with a piece lopped off.
• The lopped-off piece consists of all the consumption bundles

that are affordable but have x1 > x1.
• Sometimes taxes, subsidies, and rationing are combined.
• For example, we could consider a situation where a consumer

could consume good 1 at a price of p1 up to some level x1, and
then had to pay a tax t on all consumption in excess of x1.
• Here the budget line has a slope of −p1/p2 to the left of x1, and
a slope of −(p1 + t)/p2 to the right of x1.

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CHAPTER 2

• Convenient to consider only the case of two goods

• indicate the consumer’s consumption bundle by (x1,

• Then the budget constraint or budget set of the consumer can

• Here p1x1 is the amount of money the consumer is spending on

• The budget constraint of the consumer requires that the amount

• it is convenient to think of good 2 as being the dollars

• Under this interpretation the price of good 2 will

• Thus the budget constraint will take the form

• Second equation is just a special case of the formula given in

• This is the formula for a straight line with a vertical intercept

• The formula tells us how many units of good 2 the consumer

• Suppose for example that the consumer is going to increase her

• the slope of the budget line measures the opportunity cost of

When prices and incomes change, the set of goods that a

• First consider increasing price 1 while holding price 2 and

• Vertical intercept of the budget line does not change

• Horizontal intercept of the budget line shifts inwards

• Thus multiplying both prices by a constant amount t is just like

What happens if both prices go up and income goes down?

• the horizontal and vertical intercepts: If m decreases and p1

• slope of the budget line: If price 2 increases more than price 1,

• Numeraire price: set one of the prices to 1

• The numeraire price is the price relative to which we are

• How does a quantity tax affect the budget line of a

• tax is just like a higher price.

• Thus a quantity tax of t dollars per unit of good 1 simply

• this implies that the budget line must get steeper

• If good 1 has a price of p1 but is subject to a sales tax at rate τ,

• The consumer has to pay p1 to the supplier and τp1 to the

• If the subsidy is s dollars per unit of consumption of good 1,

• This would therefore make the budget line flatter.

• ad valorem subsidy: subsidy based on the price of the good

• if the price of good 1 is p1 and good 1 is subject to an ad

• Thus a lump-sum tax means that the budget line of a consumer

• lump-sum subsidy: means that the budget line will shift

• Suppose, for example, that good 1 were rationed so that no more

• The lopped-off piece consists of all the consumption bundles

• For example, we could consider a situation where a consumer

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