Budget Constraint

Definition

A budget constraint refers to all the combination of goods and services that can be purchased by a consumer with his or her income at their given prices. The concepts of a preference map and a budget constraint is used by the consumer theory for analyzing consumer choices.

Uses

Individual choice

Consumer behavior is considered a maximization problem, which means that a consumer utilizes the most of his limited resources for maximizing his utility. Budget is the only thing that limits the consumption of a consumer as the demand of consumer is insatiable and with quantity the utility function grows.

An individual consumer should make the choice of consuming goods at the point in which the indifference curve which is most preferred on the preference map is tangent to the budget constraint. It means that the tangency of the indifference curve to the budget constraint shows the maximum utility that can be obtained by making use of the consumer’s entire budget. The point of tangency represents the combination of goods a consumer should purchase in order to utilize the budget fully to get maximum utility. A line that joins all tangent points between the indifference curve and budget constraint is known as expansion path.

Equation of budget constraint

P_xx + P_yY = m

Where, P_x = price of a specific good

P_y = price of all other goods

x = amount bought of a specific good

y = amount bought of all other goods

m = money income that is allocated for consumption

International economies

A production-possibility frontier which is a budget constraint is represented by the limitation of factors of production that are available. Under autarky, it is also the limitation of the individuals’ consumption in the country. However, the advantages of international trade are usually shown by allowing a shift in the consumption possibility frontiers of all the trade partners that gives access to a more attractive indifference curve.

In the international trade models of Hecksher-Ohlin and Krugman, an economy’s budget constraint is decided by the terms-of-trade as a downward sloping line whose slope is equal to that of the terms-of-trade of the economy.