Budget line shows us the combination of two specified goods at the certain income and the prices of those goods. It is presented as a graphic line with possibility to determine the amount of the particular goods when the whole budget is used, by using the mathematical formula. Artur Pollok defines the budget line as “set of all quantitative combinations of two goods or service, which household can acquire, using specific income, at specified prices for those goods and services”. There are 3 main sites on the budget line:
- 1) points over the line, which are unavailable for the consumer,
- 2) points beneath the line give us the possibility to increase consumption of at least one the goods we have
- 3) points that lie on the line which exhaust the whole budget of the consumer.
Budget line is shown in a form of the chart. Line has two main points, on both shoulders of the chart. Those points tell us, on which of the goods consumer spend more of his income. And that is said, when point is on the chart shoulder it means that all of the income is spend on the goods that this shoulder refers to. Budget line also based on the Consumer’s Choice Theory. It says, that the consumer must constantly making choices between services and goods that will satisfy his need, but also as well taking in consideration his current budget when making decisions. The basic budget line has two main assumptions. Consumer must use his whole budget and the prices of the goods shall remain the same and not change.
The budget line also depends on the customer's behavior. This is a maximization problem. This means that people try to make the most of their limited resources in order to enhance our utility. Consumer is insatiable and as his utility functions grows equally with quantity of goods, his consumption is limited only by his own budget.
Application of the budget line
Budget line is mostly used when comparing two goods and current consumers budget at the same time. Consumer has limited quantity of both goods that he can buy, because of his current income. Increasing amount one of the goods, amount of the second good is inversely proportional. For example, to show the usage of the budget line we will take into consideration a student and goods that are connected with him. Student have to choose between two goods like bottle of water( cost of €1) and a sandwich (cost of €2) and he has a budget of €10. Budget line here will give us some information of what kind of combinations of that two goods student can afford. Of course this will happen when he can spend all the money and the prices of the goods are stable and are not changing over the time. When student will not buy any bottles of water, he will be able to buy 5 sandwiches, and the opposite way, when he will not buy any sandwiches, he will be able to get 10 bottles of water. Between those specific points There are many more combinations of different amounts of bottles of water and sandwiches. The amount of one of them directly depend on the other. The budget line basically shows the maximum amount of sandwiches, when buying a specific amount of bottles of water. By using budget line we can easily make the exact calculation of two goods that we want to buy considering the income we have.There is a possibility to use this when considering many goods (more than two), but this makes a graphical presentation much harder to prepare.
Change of budget line’s slope
The main definition of budget line says that budget line happens when we have the whole budget and the prices are not changing, so in other words every single variable of this chart is constant. But this is a simple version. In fact prices of the good changes and have an impact on the budget line. This occurs, when the budget is still and the prices are changing. Firstly, when the price of one of the goods rises and the second stay still, consumer cannot afford to buy the same amount of that and the line on the side of the good is turning to the left. The second situation happen, when the price of one good stay still and price of the second one falls down, the budget line will move to the right, making that the consumer can afford to buy more goods. It closely depends on the prices.
This is a situation that occurs when the prices of the goods stay on the same level, but the income is changing. This situation makes that when the income increase we can afford to buy more things (if they are the same price) and the budget line move parallel to the original one to the top side. And on the other side, this is completely inversely. The budget is lower, the line goes parallel to the bottom side. That means that the income do not affect the slope of the budget line. It always stays the same, it is just changing its place. As we can see the budget line closely depends on the market conditions. The prices always depends on the market as well as our income.
The budget line also depends on the customer behavior. This is a maximization problem. This means that people try to make the most of their limited resources in order to enhance our utility. Consumer is insatiable and as his utility functions grows equally with quantity of goods, his consumption is limited only by his own budget.
Examples of Budget line
- One example of a budget line is a household budget. A household budget is a visual representation of a household's income and expenses. This budget line shows how much money is available to spend on different items such as food, housing, transportation, clothing and other necessities. The budget line allows the household to determine how much of each item they can afford based on their income and the prices of the items.
- Another example of a budget line is a business budget. A business budget is a visual representation of a company's income and expenses. This budget line shows how much money is available to spend on different items such as payroll, rent, utilities, marketing, and other business expenses. The budget line allows the business to determine how much of each item they can afford based on their income and the prices of the items.
- A third example of a budget line is an investment portfolio. An investment portfolio is a visual representation of an investor's investments and expected returns. This budget line shows how much money is available to invest in different items such as stocks, bonds, mutual funds, and other investments. The budget line allows the investor to determine how much of each item they can afford based on their expected returns and the prices of the items.
Advantages of Budget line
Budget line is a useful tool to visualize how certain spending pattern can be achieved when given certain income and price of the goods. It helps to understand the opportunity cost of the goods and how to allocate the income in the most effective way. The following are the advantages of budget line:
- It provides a clear and simple visualization of the budget and spending pattern. It shows the maximum attainable combinations of two goods that can be purchased at a given income and prices of the goods.
- It helps to understand the concept of opportunity cost and trade-off between the two goods. It also shows the effect of changes in prices and income on the budget line.
- It helps to identify the most efficient combination of two goods. It also helps to understand how to allocate the limited resources in the most effective way.
- It helps to understand the concept of consumer equilibrium, which is the point on the budget line where the consumer’s preferences are met.
Limitations of Budget line
Budget line has several limitations. These include:
- The budget line assumes that consumer's income and prices of two goods remain constant. However, in real life situation, fluctuation in income and prices of goods are unavoidable.
- The budget line does not account for the consumer's preferences. It does not show the consumer's optimal combination of goods that maximizes his/her satisfaction.
- The budget line does not account for the consumer's ability to substitute one good for another.
- The budget line does not consider the consumer's tastes, or the quality of the goods.
- The budget line also assumes that the consumer is able to purchase the goods in unlimited quantities, but in reality, the consumer may have limited resources and may not be able to purchase all the goods.
To complement the budget line, there are several other approaches used to analyze budget constraints. These include:
- The indifference curve approach, which allows the consumer to determine the combination of two goods that will maximize their satisfaction or utility. This approach relies on the assumption that the consumer has an indifference curve, which is a line that shows the combinations of two goods that make the consumer equally happy, regardless of the combination.
- The Engel curve approach, which examines the relationship between income and expenditure on a particular commodity. This approach looks at how the expenditure on a particular commodity changes as the consumer's income changes.
- The expenditure minimization approach, which is used to analyze the least-cost combination of two goods that the consumer can purchase given their budget constraint. This approach looks at the budget constraint and determines the combination of two goods that would achieve the least-cost solution.
In conclusion, the budget line is an important tool used to analyze budget constraints, but there are several other approaches that can be used to complement it. These include the indifference curve approach, the Engel curve approach, and the expenditure minimization approach.
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Author: Paulina Pisarek