Budget Constraints

To get a better understanding of how we make choices, we first need to understand the elements that go into making a decision. And not all of them are within our control. The world is constantly, invisibly determining the prices of goods and services. Take the price of a cup of coffee. It depends on so many variables. Think culture, demographics, the cost of beans, the weather, the supply and demand for oil, even the high rent at your hip neighborhood coffee shop. You get the idea. All of this economic activity is magically being simplified into a price for a cup of coffee.

How about your salary -- the price of one hour of your labor? It depends on you, of course -- on your skills and effort. But it also depends on many factors outside of your control. For example -- the demand for your services, nearby competition, even how fun your job is. Every day you make decision after decision about what to buy, comparing hundreds of different goods and services. There are so many choices.

To simplify things, let's think about what you would do if you had a weekly budget of $50 to spend on just two goods: coffee and pizza. Coffee costs $5, and pizza costs $10. So pizza is twice as expensive as coffee. There are several different combinations of coffee and pizza you could buy with this money. Let's plot a few of your options on a graph. On the x-axis, we have the number of pizzas per week. And on the y-axis, we have the cups of coffee per week. You could buy two cups of coffee and four pizzas, four cups of coffee and three pizzas, five pizzas but no coffee, or 10 cups of coffee but no pizza. When you connect the different options that represent the ways you can spend your $50, you get a straight line. This is your budget constraint. And it represents all possible combinations of coffee and pizza you can buy given your budget and the prices of coffee and pizza.

This budget line also separates what you can afford from what you cannot afford. Maybe you wish you could buy two cups of coffee and six pizzas, or four cups of coffee and 10 pizzas. But these are not in your budget. Sorry. All these different combinations cost more than you have. So they're unaffordable, given your budget and the prices of these two goods. Combinations of coffee and pizza below the budget line, on the other hand, are within your means. So they're affordable, and you could buy them if you wanted.

The budget constraint also reflects how the market substitutes between the two goods. Remember, pizzas are twice as expensive as coffee. And this simply means that the relative price of one pizza is two cups of coffee. You see this on the slope of the budget constraint, which is 2. Well, actually it's -2, but we're less concerned about the sign. Although, it does remind us that having more of one good requires giving up some of the other. When coffee costs $5, and pizzas cost $10, if you want an additional pizza, you have to give up two cups of coffee. If this made you think about opportunity cost, you're right! The slope of the budget constraint is the opportunity cost of pizza.

Will this tradeoff change if your budget increases -- say, if you find a $20 bill in the pocket of your winter jacket and now have $70 to spend on these two goods? No -- the tradeoff is given by the market's prices. So changes in your income do not affect the relative price of goods. Sure, you'll be able to afford and choose between all of the consumption combinations that total $70. And you can see how this makes your budget constraint shift outward. But, the two cups of coffee for one pizza tradeoff remains the same. And that is because the market still values these two goods relative to one another just like it did before.

This tradeoff does change if the relative price of the two goods changes. Think of what will happen if, maybe because of unusually good weather, the price of coffee falls from $5 to $2.50. Does the market tradeoff remain the same? No. Pizzas just became four times more expensive than coffee. So you're able to buy four cups of coffee when you give up eating one pizza. This will make your budget constraint rotate outward.

Notice how, because nothing happened to the price of pizza, the number of pizzas you can buy when you don't buy coffee hasn't changed. You can still only buy five pizzas. But, if you spend all of your budget on coffee, just look at how many more cups of coffee you can buy. You can now buy 20 cups of coffee per week. That's a lot of coffee! You see the new higher relative price of pizza, in terms of coffee, in the slope of the new budget constraint, which is now 4.

We make choices every day. The reality of what we can afford, given by our incomes and the prices of goods and services, are all very important elements that affect our decisions. But there are other elements equally important, and those are our preferences. We'll examine these next.