|
|
|
|
In chapter 2, we drew a production possibilities curve that showed all of the possible combinations of goods that could be produced by an economy given limited resources. Below, a similar model is developed to show all the possible combinations of goods that could be purchased by an individual, given limited income and wealth. In this example, we will assume that your income is fixed at $100 and there are only two goods in the economy, books and movies. The quantity of books is on the vertical axis and the quantity of movies is on the horizontal axis. The line drawn represents the combinations of books and movies that could be consumed if you spent all of your money. Let us say that books cost $5 and movies cost $10. If we spent all of our money on books, we could consume at point A shown below. Since we have $100 and books cost $5 each, we could afford to buy 20 books.
The problem is that you could not afford to buy 20 books and see any movies. In order to see two movies, which cost a total of $20, you will only have $80 to spend on books, allowing you to buy a maximum of 16 books. This combination is point B below.
If you were to spend all of your money going to the movies, you could see 10 movies. This point is labeled C below. The combination of these points makes up the budget constraint. The budget constraint is the maximum combination of goods that one could consume given a set of prices, income, and wealth.
Like the production possibility frontier, the points below the budget constraint represent combinations of books and movies that could be bought without spending all of the available income. For example, we could afford to see 5 movies and buy 5 books. This point is below the budget constraint, meaning that this consumption choice will cost (5 x $10) + (5 x $5) = $75, with money left over. All the points under (and including) the budget constraint are called the opportunity set or choice set. This set is all of the possible consumption combinations that are affordable. Household demand is constrained by the ability to buy things. The budget constraint is a specific graph that represents the ability of a consumer to purchase things. It shows from the above budget constraint that 10 movies and 10 books is an impossible consumption choice. Similarly, the U.S. Government operates with a budget constraint. If the price of the books or movies were to go down, consumption of 10 movies and 10 books might be possible. If the price of a movie drops to $5, then the new budget constraint is shown below. The choice set has become larger, since the price of movies has fallen. To more practice using the budget contraint, try the following active graph exercise:
|
