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What Is Budget Line?
A budget line refers to a downward-sloping straight line consisting of every possible combination of two commodities that a consumer can purchase at a certain market price by using the entire income. It helps comprehend households’ decision-making. Moreover, it helps economists to determine what consumers can afford.
Any point outside this line represents the combinations not achievable for consumers considering their income. Two crucial components of this graphical representation are both commodities’ market price and the consumer’s purchasing power or income. Also known as the budget constraint line, it is based on specific assumptions and has certain properties, like the tangent to the indifferent curve.
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- The budget line refers to a straight line sloping downwards, indicating the different combinations of two goods available to a consumer considering the prices and his income.
- Twp properties of a price line are the real income line and negative slope.
- A key difference between budget lines and budget sets is that changes in the former occur due to alterations in the budget constraint or the prices of commodities. That said, a budget set alters with changes in the price line or the prices of commodities.
- The factors influencing a price line’s position are the consumer’s income and goods’ prices.
Budget Line Explained
The budget line refers to the graphical delineation of the possible combinations involving two goods that consumers can purchase, with each combination’s cost equal to their monetary income. This means consumers selecting a consumption bundle lying on the budget constraint line use their entire earnings. This graphical representation is a crucial component of consumer behavior analysis, and it helps people understand household decisions.
Note that the slope of the budget constraint line equals the ratio of the two commodities’ cost, and the market rate of exchange (MRE) denotes this line. The MRE refers to the rate at which a commodity is sacrificed in the market to obtain an extra unit of another good.
Let us look at the following budget line graph to understand the concept better.
In the above image, the red downward-sloping line is the budget line. The points (P, Q, R, etc.) on it represent the different combinations of the two commodities (A and B) available to the consumer considering the goods’ prices and the limited income. Any point outside the line will be an unachievable combination for the consumer.
Factors
A budget constraint line includes three factors — the price and quantity of goods and the consumer’s earnings. Here, the commodities’ volume is controllable. However, the two other agents can vary over time. Thus, a budget constraint line’s position actually depends on two factors — the consumer’s income and the goods’ prices.
If the two commodities' prices stay the same but income increases, the consumer’s budget constraint line shifts towards the right. Note that the new budget constraint line will be parallel to the initial one. Similarly, if the income decreases, this line will shift leftwards.
A shift in the budget constraint line also occurs if there is a change in the prices of the commodities. If both goods’ prices decrease, the line will shift towards the right. That said, if the two commodities prices increase, the budget constraint line will shift towards the left.
There are two more situations one must be aware of regarding the change in commodity prices.
#1 - When The Price Of The Good On The X-Axis (Good X) Changes
The budget or price line rotates towards the right if the price falls. This is because a consumer can buy more units of Good X. Note that the new budget constraint line will join the Y-axis at the exact point. On the other hand, if the price increases, the line will rotate in the opposite direction.
#2 - When The Price Of The Good On the Y-Axis (Good Y) Changes
If the price falls, the price line will rotate towards the right. This is because a consumer can buy more units of Good Y. The price line will meet the X-axis at the same point. On the contrary, if the price surges, the line will rotate towards the left as the consumer can buy fewer units of Good Y.
Properties
Some key properties of price lines are as follows:
- Real Income Line: The function of this line is based on the income principle and a consumer’s spending capacity.
- Tangent To The Indifference Curve: Note that the indifference curve joins the price line at a point called the consumer’s equilibrium.
- Negative Slope: A key characteristic of a price line is that it slopes downward, representing an inverse relation between the purchasing of the two commodities.
- Straight Line: This refers to the line denoting the constant MRE at every combination.
Equation
Let us look at the price line equation.
M = (Px x Qx) + (Py x Qy)
Where:
- Px is Commodity X’s price
- Qx is Commodity X’s quantity
- Qx is Commodity Y’s price
- Qy is Commodity Y’s quantity
- M is the income of the consumer
Examples
Let us look at a few budget constraint line examples to understand the concept better.
Example #1
Suppose Jack has $50 to purchase different beverages. He has multiple options concerning income allocation to maximize utility using his limited wages.
| Combination | Salted Chips ($5 per packet) | Peri Peri Chips ($10 per packet) | Budget Allocation ($) |
|---|---|---|---|
| U | 10 | 0 | = 50 |
| V | 8 | 1 | = 50 |
| W | 6 | 2 | = 50 |
| X | 4 | 3 | = 50 |
| Y | 2 | 4 | = 50 |
| Z | 5 | 0 | = 50 |
The above table shows the combinations Jack can choose with his limited income to get maximum utility. One can plot these combinations on a graph to draw the price line.
Example #2
Suppose Jim has $100 to spend on tea and coffee. He may allocate his earnings in multiple ways to get maximum utility.
| Combination | Tea ($10 per pack) | Coffee ($20 per pack) | Budget Allocation ($) |
|---|---|---|---|
| A | 10 | 0 | = 100 |
| B | 8 | 1 | = 100 |
| C | 6 | 2 | = 100 |
| D | 4 | 3 | = 100 |
| E | 2 | 4 | = 50 |
| F | 0 | 5 | = 100 |
The above table shows the possible combinations that Jim can choose with his limited income. Individuals can plot the combinations graphically to create the price line. Note that if any point lies outside the downward-sloping line, it represents an unachievable combination. Now, suppose Jim’s income increases, but the price of tea and coffee remains constant. In this case, the price line will shift towards the right.
Difference Between Budget Line And Indifference Curve
The differences between budget lines and indifferences curve are as follows:
- A price line represents the combinations of a couple of commodities a consumer can consume considering a budget constraint. On the other hand, an indifference curve shows the combinations of two commodities yielding equal satisfaction.
- Another key difference between budget lines and indifference curves is that the former’s slope remains constant, unlike the latter.
Difference Between Budget Line And Budget Set
The concepts of budget line and budget set often cause confusion among individuals new to the world of economics. It is vital for one to know how they differ. So, let us look at their distinct features to understand their meaning fully.
| Budget Line | Budget Set |
|---|---|
| It is a graphical representation of a downward-sloping straight line. | A budget set is an area under the price line represented on a graph. |
| This line shows the maximum quantity of a commodity a consumer can buy for a certain quantity of the other good. | It represents the various options for buying different amounts of the two commodities. |
| A price line depends on the utility and preferences of consumers. | It depends on the budget constraint, utility, and preferences of the consumer. |
| Price lines alter with the changes in the goods’ prices or budget constraints. | Budget sets change with the alterations in the goods’ prices or the price line. |
| A price line indicates the trade-off between both commodities that is possible within a certain budget. | It indicates different options for buying different combinations of both commodities within a particular budget. |
Frequently Asked Questions (FAQs)
The assumptions of a price line are as follows:
- Consumers will spend their entire income on two commodities.
- The consumer’s earnings are known as limited.
- A consumer knows both goods’ market prices.
- Consumers’ expenditure is equal to their income.
This is because the budget constraint line signifies the market exchange rate for each combination of the two commodities shown.
One can use the terms interchangeably as the price of a unit of a commodity, for example, Commodity A, is equivalent to the price of 2 units of another commodity (Commodity B). Thus, a price line represents the price ratio between two goods.
A price line is tangent to the indifference curve or IC as the consumers maximize utility.
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