Budget Set and Budget Line

 

Learning Contents:                                                            

·         Concept of Budget Set

·         Concept of Budget line &Budget Equation

·         Assumptions of Budget Line and Budget Equation

·         Budget line and Attainable and Non-attainable combinations

Introduction:

As studied earlier, a consumer prefers to be on a higher indifference curve than the lower ones as the former gives him more satisfaction than the latter. In the real-world, consumers’ spending decisions are bounded by the given income or budget. A rational consumer is one who spends his money on different goods and services in such a way that he can maximize his satisfaction with the limited income. A consumer usually performs expenditure out of the income he receives in a given period of time. A consumer's spending can be done in different ways like his current income, savings, and borrowings. When a consumer cannot save or borrow money, he performs the expenditure through his current income. A consumer can also save money today for consuming it later in life at the time of retirement, uncertainty, etc. Also if he borrows money to perform consumption today, can repay back later in his life. For simplicity, we assume that each consumer has a fixed amount of money to spend now, so we can use the terms budget and income interchangeably.

Budget Set

A budget set or opportunity set refers to all possible consumption bundles that the consumer can afford given the prices of goods and his income. In other words, the Budget set represents consumption possibilities that a consumer can afford given the prices of goods and income

To understand the budget set simply, suppose a consumer has ₹60 that he wants to spend on two goods say A and B. We also assume that the price of Good-A is ₹2 per unit and the price of Good-B is ₹1 per unit. Accordingly, we find the following consumption possibilities available to a consumer.

                  Table 1: Budget Set of the consumer

Units of Good-A	Units of Good-B
0	60
10	40
20	20
30	0

Explanation:

Looking at the above table we understand that, if a consumer spends his entire income on Good-B, then he can buy 60 units of it. On the other hand, if he spends his entire income on Good-A, then he can buy 30 units of it. The other spending possibilities can be spending on both of the goods like he can buy 10 units of Good-A and 40 units of Good-B. Also, he can buy 20 units of Good-A and 20 units of Good-B. Likewise, there can be various combinations or possibilities of Good-A and Good-B that a consumer can buy with the given income and price of Good-A & Good-B.

Budget Line:

A budget line is a straight line that slopes downwards indicates all the possible combinations of the two goods that a consumer can buy at a given market price by allocating all his/her income. Anywhere on the budget line, a consumer is spending his entire income either on Good-1 or on Good-2 or on both Good-1 and Good-2

The two essential components of a budget line are:

·         Consumer’s purchasing power, i.e. his/her income;

·         The market price of both commodities.

Budget Equation:

The Budget line can better be understood by the budget equation explained below.

 P₁X₁+P₂X₂≤Y

Here, P₁= Price of Good-1

X₁=Quantity of Good-1

P₂=Price of Good-2

X₂=Quantity of Good-2

Y=Income of the Consumer or maximum budget a consumer can spend.

Continuing the above example, wherein the price of Good-A is ₹2 per unit and the price of Good-B is ₹1 per unit and the income of the consumer is ₹60. A consumer finds different possible combinations of goods are shown below

Budget Schedule
Combinations	Units of Good-A	Units of Good-B	Budget Allocation
A	0	60	2*0+1*60=60
B	10	40	10*2+1*40=60
C	20	20	20*2+1*20=60
D	30	0	2*30+0*60=60

The above budget schedule can be plotted graphically to form a budget line that shows all the combinations namely A, B, C, and D lying on the Budget line indicates the combinations of Good-A and Good-B which a consumer can buy with his given income, and given the price of Good-1 and Good-2.

Assumptions of Budget Line and Budget Equation

·         Income of the Consumer is Known:

  The consumer’s income given and limited which can be spent on buying only two commodities.

·         

       Two Commodities

  It is believed that the consumer will spend all his/her income on purchasing only two goods.

·         

        Market Price is Known

   The market price of both the goods are known to the consumer.

·         

        Expenditure is equal to the Income

   It is  assumed that the consumer spends all his/her income.

·         

        Consumer is Rational

   A consumer always strives to maximise his utility or satisfaction.

BUDGET LINE AND ATTAINABLE AND NON-ATTAINABLE COMBINATIONS

1. Attainable combination is any combination of two products that may be purchased using the given income. All the combination lying on or within the budget line is called an attainable or feasible combination. Further, if the combinations lying on the budget line indicate all income is spent on the purchase of both goods and the combinations below the budget line indicates some income is unspent for the purchase of goods.

2. Non-attainable combination is any combination of two products that is impossible to purchase using the given income. Any combination lying outside or above the budget line is called a non-attainable or non-feasible combination.

Test Yourself

Choose the Correct Answer

1. Given the money income and the price, the line which shows all different combinations of two goods that a consumer can buy by spending all his income is called:

a. production line

b. budget line

c. iso-cost line

d. none of these

2. All attainable combinations of Good-1 and Good-2 are shown

a. below the budget line

b. on the budget line

c. above the budget line

d. Both a and b

3. A consumption point inside the budget line

a. is unaffordable.

b. shows that the consumer spends income on only one of the goods.

c. is affordable and because it is inside the budget line means that all the person's budget

has been spent.

d. is possible to afford but has some unspent income.

e. shows that the consumer has chosen to spend all of his or her income on both products.

4.  If your budget is ₹100, the price of a cup of coffee is ₹5, and the price of pizza is ₹10, can you afford to buy 10 cups of coffee and 6 pizzas? 

a. Yes

b. No

5. A consumer's budget constraint describes:

a. The combinations of goods that a consumer is able (can afford) to buy.

b. Past consumer buying behaviour.

c. The combinations of goods that the consumer prefers to buy, but cannot because of the income constraint.

d. Goods outside of the consumer's consumption bundles

e. The amount of each good that the consumer is willing to buy.

6. If in a two-good model, the quantities of goods 1 and 2 are denoted by X₁ and X₂ and their prices are denoted by P₁ and P₂, then total expenditure can be expressed as:

a. P₁X₁+P₂X₂

b. P₂X₁+P₁X₂

c. P₁X₁/P₂X₂

d. P₁X₁-P₂X₂

Answers:

1. b 2.d 3.d 4.b 5.c 6.a