Business Economics

MBA(IB), 2020-22
LEC TURE 13

PAPIYA GHOSH
Budget Constraint
▪Consumers have limited income which restricts the quantities of
commodities they can buy. In economics, the limited amount of
income available to the consumers to spend on goods and services are
referred to as budget constraint.
▪To keep things simple, we consider the situation in which a consumer’s
income can be spent on only two goods X and Y where X and Y could
be anything like food and clothing or Pizza and Coke etc.
✓Although people buy thousands of different kinds of goods, assuming only two goods greatly simplifies the
problem without altering basic insights about consumer choice.

▪Suppose for example, the consumer’s income is Rs. 1000. Then how
much of each commodity he can buy depends on the price of 1 unit of
X and 1 unit of Y.
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 Budget line
▪Suppose the prices of X and Y are Rs. 2 and Rs. 120
10 respectively. Then, if he spends entire

Good Y
income on X, he could buy 500 units of X. On 100
the other hand, if he spends entire income on
Y, he could buy 100 units of Y. If he wished, he 80
could also buy some units of X and some units Slope= -1/5= -PX/PY
of Y. There are a large number of 60
combinations of X and Y that he could buy and
40
each such combination can be represented by
a point on a line, called the budget line. 20

0
0 200 400 600
Good X

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Budget Line
▪A consumer’s budget line shows all possible bundles, (x,y) that the consumer is able to buy at
given prices of X and Y if he spends all his income. It is therefore the consumption possibility
frontier of the consumer.
▪If we denote the prices of X and Y by PX and PY and the income of a consumer by M, then the
equation of the budget line is given by
PXx+PYy= M
where x is the amount of good X he buys and y is the amount of good Y.
▪Here note that PXx denotes the amount spent on good X and PYy denotes the amount spent on
good Y.
▪Hence the budget equation tells that the total amount spent on good X and Y equals the
consumer’s income.

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▪The budget line can be expressed as
Y= M/PY - (PX/PY)X
▪The slope of the budget line, -PX/PY, measures the rate at which the two goods can be exchanged or
substituted for each other without changing the total amount of money spent.
▪In other words, the slope reflects the trade-off the market is offering to the consumer or the
opportunity cost of X in terms of Y or the relative price of X w.r.t Y.
▪ In our example, since PX= 2 and PY= 10, the opportunity cost of X is 1/5 units of Y, i.e., 1/5 units of
good Y must be given up for 1 unit of good X.
▪ The vertical intercept represents the maximum amount of good Y that can be purchased with
income M and the horizontal intercept represents the maximum amount of good Y that can be
purchased with income M.

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Quick activity
Suppose Hari’s monthly income is Rs.1200
Prices: PF = Rs. 4 per banana, PM = Rs.1 per mango.
A. If Hari spends all his income on banana,
how many bananas does he buy?
B. If Hari spends all his income on mangos,
how many mangos does he buy?
C. If Hari buys 100 banana, how many mangos can he buy?
D. Draw Hari’s budget line.
E. Interpret the slope of the budget line.

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Effects of changes in Prices and Income
▪An increase in the price of good X, or decrease in the price of good Y, will make the budget line
pivot and become steeper.
▪A decrease in the price of good X, or increase in the price of good Y, will make the budget line
pivot and become flatter.
▪If the price of both goods change leaving the price ratio unchanged, the budget line shifts.
▪An increase in budget will move the budget line farther from the origin but will not change the
slope.
▪A decrease in budget will move the budget line closer to the origin but will not change the
slope.
▪If everything changes leaving the price ratio and the intercept unchanged, the budget line
remains unchanged.

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What does it tell about consumer’s purchasing
power?
▪Purchasing power of a consumer is determined not only by her income but also by the prices.
➢A consumer’s purchasing power can double either because her income
doubles or because the prices of all goods that she buys fall by half.
➢If income and all prices change by the same proportion, the consumer’s
purchasing power remains unchanged. (This can happen in inflationary
economy.)

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Quick activity
❑Show what happens to Hari’s budget constraint if:
A. His income falls to Rs. 800.
B. The price of mangos rises to PM = Rs. 2 per mango
❑Suppose the government has imposed the rationing constraint, such that the level of
consumption of one good is fixed to be no larger than some amount. Draw the
consumer’s budget line.

❑Suppose instead of imposing rationing constraint, the government imposes a tax t on

all consumption of one good, if it exceeds a certain fixed level. Draw the consumer’s
budget line.

❑Suppose that a consumer can force the price of good 1 to rise by purchasing more of
good 1. Discuss the shape of the consumer’s budget line.

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Analyzing Consumer behaviour using Cardinal
Approach

▪Total Utility: It is a measure of total satisfaction obtained from consumption of a good.

▪Marginal Utility: It is a measure of the additional satisfaction obtained from consuming one
additional unit of a good.
▪For example, suppose when Hari consumes one slice of sandwich, his utility is 10. When he
consumes the second slice his utility increases to 18 and after he eats the third slice his utility is 24.
Therefore the marginal utility from the second slice is 8 and from the third is 6.
▪In the above example you can see that although the total utility is increasing with increase in
consumption, it is increasing at a decreasing rate.
▪This is true in general.
▪As more and more of a good is consumed, consuming additional units will yield smaller and smaller
additions to utility. This is called the Law of Diminishing Marginal Utility.

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 Total and Marginal Utility
The relationship between consuming additional 40 Total utility
unit during a period of time, total utility and the 30
marginal utility received from consuming each 20
additional unit. 10
No. Of pizza Hari’s Total Hari’s Marginal 0
slices Utility Utility 0 2 4 6 8
No. of pizza slices
0 0 0
1 10 10 Marginal Utility
15
2 18 8
10
3 24 6
5
4 28 4
5 30 2 0
0 2 4 6 8
6 29 -1 -5 No. of Pizza Slices

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▪Imagine, for example, the consumption of television. Marginal utility might fall
after the second or third hour and could become very small after the fifth or sixth
hour of viewing.
▪We can relate the concept of marginal utility to the utility maximization problem.
▪The principle of diminishing marginal utility helps us to understand how
consumers can best spend their limited incomes on the products available to them.
▪Utility maximization is achieved when the budget is allocated so that marginal
utility per rupee spent of the expenditure is the same for each good. This is called
the Law of Equi- marginal utility per rupee.
▪In other words, what this rule says is that The consumer’s money income should
be allocated so that the last rupee spent on each product yields the same amount
of extra (marginal) utility.
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Example # 1
▪Now consider Hari’s utility schedule.
▪If Hari does not have a budget constraint, he would buy 5 slices of pizza and 4 coke
bottles, because that will give him a total utility of 62 (30 + 32), which is the maximum
he can achieve.
▪But unfortunately he has a limited budget of Rs.10 to spend on refreshments.
Suppose pizza is selling for Rs 2 per slice and Coke is selling for Rs.1 a bottle.
No. Of pizza Hari’s Total Utility Hari’s Marginal No. Of Hari’s Total Utility Hari’s Marginal
slices from Pizza Utility from Pizza Coke from Coke Utility from Coke

0 0 0 0 0 0
1 10 10 1 13 13
2 18 8 2 23 10
3 24 6 3 29 6
4 28 4 4 32 3
5 30 2 5 31 -1
6 29 -1 6 28 -3
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▪With his limited budget Hari will not be able to afford 5 pizza slices and 4
Coke bottles.
▪Given the constraint, which bundle would then maximize his utility?
▪The two conditions for maximizing Hari’s utility are as follows:
1. MUPizza / PPizza = MUCoke / PCoke
2. Spending on pizza + Spending on Coke = Amount available to be
spent.
▪To see why the first condition must hold, suppose Hari gets more utility
from spending an additional rupee on pizza than on Coke. In this case, his
utility will be increased by spending more on pizza.

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▪As long as the marginal utility of spending more on pizza exceeds the
marginal utility of spending an extra rupee on Coke, he can increase her
utility by shifting his budget toward pizza and away from Coke.
▪Eventually the marginal utility of pizza will decrease (because there is
diminishing marginal utility) and the marginal utility of Coke will increase.
Only when he has satisfied the Equi-Marginal Principle will he have
maximized the utility.
▪The second condition just says that Hari stays on the budget line because
otherwise some of his budget remains unspent which he can allocate
among the two goods and get higher utility.

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 Now consider the following table.
No. Of pizza Marginal Utility Mupizza/ Ppizza No. Of Coke Marginal Utility MUCoke/PCoke
slices from from Coke
Pizza(MUpizza) (MUCoke)
0 0 0 0 0 0
1 10 5 1 13 13
2 8 4 2 10 10
3 6 3 3 6 6
4 4 2 4 3 3
5 2 1 5 -1 -1
6 -1 - 6 -3 -3

There is only one combination of Pizza and Coke with Equal Marginal Utilities per Dollar,
that is 3 slices of pizza and 4 Coke bottles. At this combination the amount spent is also
equal to his budget. Hence his utility is maximized if he buys this bundle. 16
 Example # 2
▪Now suppose Kajal’s utility schedule is as follows.
▪Find her utility maximizing bundle (i) without budget constraint and (ii) with a budget of Rs. 10.

No. Of pizza slices Hari’s Total Utility from Pizza No. Of Coke Hari’s Total Utility from Coke

0 0
1 20
2 36
3 46
4 52
5 54
6 51
0 0
1 20
2 35
3 45
4 50
5 53
6 52

Without the budget constraint the utility maximizing bundle is 5 slices of pizza and 5
Coke bottles.
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 We can derive the following table for Kajal.
No. Of pizza Marginal Utility Mupizza/ Ppizza No. Of Coke Marginal Utility MUCoke/PCoke
slices from from Coke
Pizza(MUpizza) (MUCoke)
1 20 10 1 20 20
2 16 8 2 15 15
3 10 5 3 10 10
4 6 3 4 5 5
5 2 1 5 3 3
6 −3 -- 6 −1 --

There are three combinations of Pizza and Coke with Equal Marginal Utilities per
Dollar for Kajal.
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The Rule of Equal Marginal Utility per Rupee Spent

Marginal Utility
Combinations of Pizza per Dollar
and Coke with Equal (Marginal
Marginal Utilities per Dollar Utility/Price) Total Spending Total Utility
Rs.2 + Rs.3 =
1 Slice of Pizza and 3 Coke 10 Rs.5 20 + 45 = 65
Rs.6 + Rs.4 =
3 Slices of Pizza and 4 Coke 5 Rs.10 46 + 50 = 96
Rs.8 + Rs.5 =
4 Slices of Pizza and 5 Coke 3 Rs.13 52 + 53 = 105

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Marginal Utility and Law of Demand

Adjusting Optimal Consumption Assume that price of pizza has fallen to Rs.1.50
to a Lower Price of Pizza
per slice, other things remaining constant

Number Marginal Utility MUPizza/ Ppizza Marginal Utility

of Slices from Last Slice Number from Last Cup MUCoke/PCoke
of Pizza (MUPizza) of Coke (MUCoke)
1 20 13.33 1 20 20
2 16 10.67 2 15 15
3 10 6.67 3 10 10
4 6 4 4 5 5
5 2 1.33 5 3 3
6 −3 – 6 −1 –

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Marginal Utility and Law of Demand
▪Examining the table, we can see that the fall in the price of pizza will result in your eating 1 more
slice of pizza; so your optimal consumption now becomes 4 slices of pizza and 4 bottles of coke.

▪You will be spending entire Rs.10, and the last rupee spend on pizza will provide you with about the
same marginal utility per rupee as the last rupee you spend on coke.

▪You will not be receiving exactly the same marginal utility per rupee spend on the two products. But
this is as close as you can come to equalizing marginal utility per rupee for the two products, unless
you can buy a fraction of a slice of pizza or a fraction of a cup of Coke.

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 Marginal Utility and Law of Demand
▪ Max U; budget = Rs.10
▪ Qp = 3; Pp = Rs.2; one point on D curve
▪ (Qc = 4 ; Pc = Rs.1)
▪ Price of pizza drops to Rs.1.50, other things constant
▪ Max U; budget = Rs.10
▪ Qp = 4; Pp = Rs.1.5; second point on D curve
▪ (Qc = 4 ; Pc = Rs.1)

▪ Draw the demand curve on your own

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▪In the analysis of consumer behaviour so far, we made the assumption
that satisfaction, or utility, is measurable in utils.
▪Although this assumption made our analysis easier to understand, we can
do the same analysis by making much simpler (weaker) assumption which
is at the same time more realistic.
▪More precisely, it is actually sufficient to assume that consumers are able
to rank different combinations of goods and services in terms of how
much utility they provide.
▪In other words, a consumer is able to determine whether he prefers one
bundle over another, even if he is unsure about exactly how much utility
he or she would receive from consuming these goods.

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