Decisions within a budget constraint

Posted 2023-04-19 19:48:00

Key points

The budget constraint is the boundary of the opportunity set—all possible combinations of consumption that someone can afford given the prices of goods and the individual’s income.
Opportunity cost measures cost in terms of what must be given up in exchange.
Marginal analysis is the process of comparing the benefits and costs of choosing a little more or a little less of a certain good.
The law of diminishing marginal utility indicates that as a person receives more of a good, the additional—or marginal—utility from each additional unit of the good declines.
Sunk costs are costs that occurred in the past and cannot be recovered; they should be disregarded in making current decisions.
Utility is the satisfaction, usefulness, or value one obtains from consuming goods and services.

Introduction

Most consumers have a limited amount of income to spend on the things they need and want. Alphonso, for example, has $10 in spending money each week that he can use to buy bus tickets for getting to work and the burgers that he eats for lunch. Burgers cost $2 each, and bus tickets are 50 cents each.

There are a lot of combinations of burgers and bus tickets that Alphonso could buy.

The figure above shows Alphonso’s budget constraint—the outer boundary of his opportunity set. The opportunity set identifies all the opportunities for spending within his budget—in this case, bus tickets and burgers. The budget constraint indicates all the combinations of burgers and bus tickets Alphonso can afford before he exhausts his budget, given the prices of the two goods.

The vertical axis in the figure shows burger purchases, and the horizontal axis shows bus ticket purchases. If Alphonso spends all his money on burgers, he can afford five per week—$10 per week divided by $2 per burger equals five burgers per week. But if Alphonso uses all his money on burgers, he will not be able to afford any bus tickets. This choice—zero bus tickets and five burgers—is shown by point A in the figure.

Alternatively, if Alphonso spends all his money on bus tickets, he can afford 20 per week—$10 per week divided by $0.50 per bus ticket equals 20 bus tickets per week. If he does this, however, he will not be able to afford any burgers. This choice—20 bus tickets and zero burgers—is shown by point F.

If Alphonso is like most people, he will choose some combination that includes both bus tickets and burgers. That is, he will choose some combination on the budget constraint that connects points A and F. Every point on or inside the constraint shows a combination of burgers and bus tickets that Alphonso can afford. Any point outside the constraint is not affordable because it would cost more money than Alphonso has in his budget.

The budget constraint shows the tradeoff Alphonso faces in choosing between burgers and bus tickets. Suppose he is currently at point D, where he chooses to buy 12 bus tickets and two burgers. What would it cost Alphonso for one more burger? It would be natural to answer $2, but that’s not the way economists think. Economists think about the true cost of a burger—the number of bus tickets Alphonso will have to sacrifice.