INTRODUCTION

A budget line is a straight line that slopes downwards and consists of all the possible
combinations of the two goods which a consumer can buy at a given market price by allocating
all his/her income. It is an entirely different concept from that of an indifference curve, though
they are both are essential for consumer equilibrium.
The budget line is an elementary concept that most consumers understand intuitively
without a need for graphs and equations -- it's the household budget, for example.

Taken informally, the budget line describes the boundary of affordability for a given
budget and specific goods. Given a limited amount of money, a consumer can only spend that
same amount buying goods. If the consumer has X amount of money and wants to buy two
goods A and B, she can only purchase goods totaling X. If the consumer needs an amount of A
costing 0.75 X, she can then spend only .25 X, the amount remaining, on her purchase of B. 

This seems almost too obvious to bother writing or reading about. As it turns out,
however, this same concept -- one that most consumers make many times each day with
reflecting on it -- is the basis of the more formal budget line concept in economics.
Lines in a Budget

Before turning to the economics definition of "budget line," consider another concept: the
line-item budget. This is effectively a map of future expenditures, with all the constituent
expenditures individually noted and quantified. There's nothing very complicated about this; in
this usage, a budget line is one of the lines in the budget, with the service or good to be
purchased named and the cost quantified.

The Budget Line as an Economics Concept 

One of the interesting ways the study of economics relates to human behavior generally is
that a lot of economic theory is the formalization of the kind of simple concept outlined above --
a consumer's informal understanding of the amount she has to spend and what that amount will
buy. In the process of formalization, the concept can be expressed as a mathematical equation
that can be applied generally.

Equation of Budget Line

The concept of the budget line is precisely explained through the following equation

Where,
Px is the price of goods X;
Qx is the quantity of goods X;
Py is the price of goods Y;
Qy is the quantity of goods Y;
M is the income of the consumer.

Example: A person has 50/- for buying pens. He/She has the following options for allocating
his/her amount such that he/she derives the maximum utility from limited income:
The above Budget schedule can be plotted on a graph to obtain the appropriate budget line for
this instance;

Budget Set: Budget set defines all such combinations of the two goods lying within the
affordability limit of a consumer.

Market Rate of Exchange (MRE)

The market rate of exchange refers to the ratio of units sacrificed of Y to acquire specific units of
X at a given market price. It indicates the slope of a budget line.

Price Ratio

The price ratio can be understood as the relationship between the prices of the two goods say X
and Y, where both the products are inversely related to each other. It is constant throughout a
budget line.

Equation:

Where,
Px is the price of Goods X; and
Py is the price of Goods Y.

Properties of Budget Line

It has specific characteristics which distinguish it from other economic tools.

Some of these features are discussed below:

 Negative Slope: It slopes downward showing an inverse relationship between the buying
of the two goods.
 Straight Line: It is a straight line which denotes the constant market rate of exchange at
each combination.
 Real Income Line: It functions on the principle of income and the spending capacity of a
consumer.
 Tangent to Indifference Curve: The indifference curve touches the budget line at a
point, and this point is known as the consumer’s equilibrium.

Assumptions of a Budget Line

As we know that economics is mostly based on assumptions, so goes for the budget line.

To make the results and analysis more clear and easy to understand, the economist assumes the
following in respect of a budget line:
  Two Commodities: It is believed that the consumer will spend all his/her income on
purchasing only two goods.
 Income of the Consumer is Known: The consumer’s income is limited and is known,
even the revenue is wholly allocated for buying only two commodities.
 Market Price is Known: The market price of both the goods are known to the consumer.
 Expenditure is equal to the Income: We assume that the consumer spends all his/her
income.

STATEMENT OF THE PROBLEM

1. How does change of price and income affect the budget line?
2. Why does a budget line slope downward?

CONCLUSIONS AND RECOMMENDATIONS

A budget line is that part of the budget set, which highlights all possible combinations of
two commodities and focuses on the expenditure of total income. It works on the principle of
sacrificing one commodity to acquire more of the other goods within a limited income and at a
specified market price.

The slope of a budget line is downward because as we know that the consumer has a
fixed income, he/she has to let go of some quantity of Goods Y to get an additional unit of Goods
X. This inverse relationship between both commodities leads to a declining slope. When more
and more units of one good can be bought, it leads to decrease some units of other good with the
given income that is why the slope is downward.

A budget line consists of consumer’s income, the price of the goods and the quantity in
which they are purchased. Here, the volume of products is a controllable agent while the other
two may vary with time. Therefore, it shifts from its original position due to the following two
primary reasons:

Shift due to Change in Price: The price of a commodity is volatile in nature and change from
time to time. The market price of the goods will either decrease or increase.

If the other factors like income and price of goods Y remain constant and the price of one
commodity say X decreases; the buying capacity of the consumer for goods X will automatically
increase.

If the other factors remain constant, and the price of goods X increases, the buying capacity of
the consumer for goods X will automatically decrease.

Shift due to Change in Income: Income is another vital agent that leads to a shift in the budget
line.

An increase in the consumer’s income means expansion of his/her purchasing power and vice-
versa, thus leading to a shift in budget line too.
 The budget constraint framework suggest that when income or price changes, a range of
responses are possible. When income rises, households will demand a higher quantity of normal
goods, but a lower quantity of inferior goods. When the price of a good rises, households will
typically demand less of that good—but whether they will demand a much lower quantity or
only a slightly lower quantity will depend on personal preferences. Also, a higher price for one
good can lead to more or less of the other good being demanded.

References:
https://theinvestorsbook.com/budget-line.html
Moffatt, Mike. "Understand the Economic Concept of a Budget Line." ThoughtCo, Feb. 11,
2020, thoughtco.com/definition-of-budget-line-1146040.
https://pressbooks.bccampus.ca/uvicecon103/chapter/6-1-consumption-choices/
https://byjus.com/commerce/budget-line/
http://www.economicsdiscussion.net/indifference-curves/concept-of-budget-line-with-diagram-
consumers-equilibrium-economics/27539
https://www.slideshare.net/FaHadHassanNooR/the-theory-of-consumer-choice-budget-line-
constraint
https://www.tutor2u.net/economics/reference/the-budget-line
https://www.geneseo.edu/~stone/perloff3.pdf
https://2012books.lardbucket.org/books/microeconomics-principles-v1.0/s10-03-indifference-
curve-analysis-an.html

University of Luzon
COLLEGE OF ACCOUNTANCY
Dagupan City

A Term Paper
on
BUDGET LINE
as a requirement for the subject
 ECO 22 Microeconomics,
a paper to be presented
to the faculty of University of Luzon