BASIC MICROECONOMICS │japor

Module 10: The Budget Constraint

Overview
As people pursue happiness, they are constrained by a budget that defines what they can
afford. Sometimes it is possible to get a loan that allows you to spend money before you earn it.
But sooner or later, those who spend more than they can afford run into serious problems. For
example, they may be forced to sell their home or car. They may also reach the state of financial
ruin called bankruptcy, which means they cannot pay their debts and will have great difficulty
getting any sort of loan or credit card for many years. In this module we’ll discuss approaches to
money management that will help you avoid that fate. If you get into the habit of creating and
following a budget, you will find it much easier to manage your money and meet your financial
goals.

Objectives
At the end of this module, you are expected
• To understand the consumption choices.
• To explain the concept and importance of budget constraint, total utility, and marginal
utility.

Introduction to Consumer Choices

Microeconomics seeks to understand the behavior of individual economic agents such as

individuals and businesses. Economists believe that individuals’ decisions, such as what goods
and services to buy, can be analyzed as choices made within certain budget constraints. Generally,
consumers are trying to get the most for their limited budget. In economic terms they are trying
to maximize total utility, or satisfaction, given their budget constraint.

Everyone has their own personal tastes and preferences. The French say: Chacun à son
goût, or “Each to his own taste.” An old Latin saying states, De gustibus non est disputandum or
“There’s no disputing about taste.” If people’s decisions are based on their own tastes and
personal preferences, however, then how can economists hope to analyze the choices consumers
make?

An economic explanation for why people make different choices begins with accepting
the proverbial wisdom that tastes are a matter of personal preference. But economists also
believe that the choices people make are influenced by their incomes, by the prices of goods and
services they consume, and by factors like where they live. This chapter introduces the economic
theory of how consumers make choices about what to buy, how much to work, and how much to
save.

The analysis in this module will build on the three budget constraints: consumption
choice budget constraint, the labor-leisure budget constraint, and the intertemporal budget
constraint. This module will also illustrate how economic theory provides a tool to systematically
look at the full range of possible consumption choices to predict how consumption responds to
changes in prices or incomes.

Total Utility and Diminishing Marginal Utility

To understand how a household will make its choices, economists look at what consumers
can afford, as shown in a budget constraint line, and the total utility or satisfaction derived from
those choices. In a budget constraint line, the quantity of one good is measured on the horizontal
axis and the quantity of the other good is measured on the vertical axis. The budget constraint
line shows the various combinations of two goods that are affordable given consumer income.

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Consider the situation of Jennifer, shown in Figure 10.1. Jennifer likes to collect blouses and watch
movies.

In Figure 10.1, the quantity of blouses is shown on the horizontal axis, while the quantity
of movies is shown on the vertical axis. If Jennifer had unlimited income or goods were free, then
he could consume without limit. But Jennifer, like all of us, faces a budget constraint. She has a
total of ₱2,800 to spend. The price of blouse is ₱700 and the price of movies is ₱350. Notice that
the vertical intercept of the budget constraint line is at eight movies and zero blouse
(₱2,800/₱350=8). The horizontal intercept of the budget constraint is four, where Jennifer
spends of all of his money on blouses and no movies (₱2,800/₱700=4). The slope of the budget
constraint line is rise/run or –8/4=–2. The specific choices along the budget constraint line show
the combinations of blouses and movies that are affordable.

Figure 10.1. A Choice between Consumption Goods. Jennifer has income of ₱2,800. Movies cost ₱350
and blouses cost ₱700. The points on the budget constraint line show the combinations of movies
and blouses that are affordable.

Jennifer wishes to choose the combination that will provide her with the greatest utility, which is
the term economists use to describe a person’s level of satisfaction or happiness with her choices.
Let’s begin with an assumption, which will be discussed in more detail later, that Jennifer can
measure her own utility with something called utils. Table 10.2 shows how Jennifer’s utility is
connected with his consumption of blouses or movies. The first column of the table shows the
quantity of blouses consumed. The second column shows the total utility, or total amount of
satisfaction, that Jennifer receives from consuming that number of blouses. The most common
pattern of total utility, as shown here, is that consuming additional goods leads to greater total
utility, but at a decreasing rate. The third column shows marginal utility, which is the additional
utility provided by one additional unit of consumption. This equation for marginal utility is:

𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦

𝑀𝑈 =
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦

Notice that marginal utility diminishes as additional units are consumed, which means
that each subsequent unit of a good consumed provides less additional utility. For example, the
first blouse Jennifer picks is her favorite and it gives her an addition of 22 utils. The fourth blouse
is just to something to wear when all her other clothes are in the wash and yields only 18
additional utils. This is an example of the law of diminishing marginal utility, which holds that
the additional utility decreases with each unit added.

The rest of Table 10.2 shows the quantity of movies that Jennifer attends, and her total
and marginal utility from seeing each movie. Total utility follows the expected pattern: it
increases as the number of movies seen rises. Marginal utility also follows the expected pattern:

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each additional movie brings a smaller gain in utility than the previous one. The first movie
Jennifer attends is the one she wanted to see the most, and thus provides her with the highest
level of utility or satisfaction. The fifth movie she attends is just to kill time. Notice that total utility
is also the sum of the marginal utilities.

Table 10.2. Total and Marginal Utility

Blouses Marginal Movies Marginal

Total Utility Total Utility
(Quantity) Utility (Quantity) Utility
1 22 22 1 16 16
2 43 21 2 31 15
3 63 20 3 45 14
4 81 18 4 58 13
5 97 16 5 70 12
6 111 14 6 81 11
7 123 12 7 91 10
8 133 10 8 100 9

Calculating Total Utility

Let’s look at how Jennifer makes her decision in more detail.

Step 1. Observe that, at point Q (for example), she consumes three blouses and two
movies.

Step 2. Look at Table 10.2. You can see from the fourth row/second column that three
blouses are worth 63 utils. Similarly, the second row/fifth column shows that two
movies are worth 31 utils.

Step 3. From this information, you can calculate that point Q has a total utility of 94 (63 +
31).

Step 4. You can repeat the same calculations for each point on Table 10, in which the total
utility numbers
Table 10.3 are shown
looks in the
at each last column.
point on the budget constraint in Figure 6.2, and adds up
Jennifer’s total utility for five possible combinations of blouses and movies.

Table 10.3. Finding the Choice with the Highest Utility

Point Blouses Movies Total Utility

P 4 0 81 + 0 = 81
Q 3 2 63 + 31 = 94
R 2 4 43 + 58 = 101
S 1 6 21 + 83 = 103
T 0 8 0 + 100 = 100

For Jennifer, the highest total utility for all possible combinations of goods occurs at point
S, with a total utility of 103 from consuming one blouse and six movies.

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Choosing with Marginal Utility

Most people approach their utility-maximizing combination of choices in a step-by-step

way. This step-by-step approach is based on looking at the tradeoffs, measured in terms of
marginal utility, of consuming less of one good and more of another.

For example, say that Jennifer starts off thinking about spending all his money on blouses
and choosing point P, which corresponds to four blouses and no movies, as illustrated in Figure
10.2. Jennifer chooses this starting point randomly; she has to start somewhere. Then she
considers giving up the last blouse, the one that provides her the least marginal utility, and using
the money she saves to buy two movies instead. Table 10.4 tracks the step-by-step series of
decisions Jennifer needs to make (Key: blouses are ₱700, movies are ₱350, and income is ₱2800).

Table 10.4. A Step-by-Step Approach to Maximizing Utility

Marginal Gain and Loss of Utility,

Try Which Has Total Utility Conclusion
Compared with Previous Choice

Choice 4 blouses and 81 from 4 blouses +

- -
1: P 0 movie 0 from 0 movie = 81

63 from 3 blouses + Loss of 18 from 1 less blouse, but Q is

Choice 3 blouses and
31 from 0 movie = gain of 31 from 2 more movies, for a preferred
2: Q 2 movies
94 net utility gain of 13 over P

43 from 2 blouses + Loss of 20 from 1 less blouse, but R is

Choice 2 blouses and
58 from 4 movies = gain of 27 from two more movies for preferred
3: R 4 movies
101 a net utility gain of 7 over Q

22 from 1 blouse + Loss of 21 from 1 less blouse, but S is

Choice 1 blouse and 6
81 from 6 movies = gain of 23 from two more movies, preferred
4:S movies
103 for a net utility gain of 2 over R

Decision Making by Comparing Marginal Utility

Jennifer could use the following thought process (if he thought in utils) to make his
decision regarding how many blouses and movies to purchase:

Step 1. From Table 10.2, Jennifer can see that the marginal utility of the fourth blouse is
18. If she gives up the fourth blouse, then she loses 18 utils.

Step 2. Giving up the fourth blouse, however, frees up ₱750 (the price of a blouse),
allowing Jennifer to buy the first two movies (at ₱350 each).

Step 3. Jennifer knows that the marginal utility of the first movie is 16 and the marginal
utility of the second movie is 15. Thus, if she moves from point P to point Q, she gives up
18 utils (from the blouse), but gains 31 utils (from the movies).

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Step 4. Gaining 31 utils and losing 18 utils is a net gain of 13. This is just another way of
saying that the total utility at Q (94 according to the last column in Table 10.3) is 13 more
than the total utility at P (81).

Step 5. So, for Jennifer, it makes sense to give up the fourth blouse in order to buy two
movies.

Jennifer clearly prefers point Q to point P. Now repeat this step-by-step process of
decision making with marginal utilities. Jennifer thinks about giving up the third blouse and
surrendering a marginal utility of 20, in exchange for purchasing two more movies that promise
a combined marginal utility of 27. She prefers point R to point Q. What if she thinks about going
beyond R to point S? Giving up the second blouse means a marginal utility loss of 21, and the
marginal utility gain from the fifth and sixth movies would combine to make a marginal utility
gain of 23, so she prefers point S to R.

However, if she seeks to go beyond point S to point T, she finds that the loss of marginal
utility from giving up the first blouse is 22, while the marginal utility gain from the last two movies
is only a total of 19. If she was to choose point T, her utility would fall to 100. Through these stages
of thinking about marginal tradeoffs, she again concludes that S, with one T-shirt and six movies,
is the choice that will provide him with the highest level of total utility. This step-by-step approach
will reach the same conclusion regardless of her starting point.

Another way to look at this is by focusing on satisfaction per peso. Marginal utility per
peso is the amount of additional utility she receives given the price of the product. For her blouses
and movies, the marginal utility per peso is shown in Table 10.5.

𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦
𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑢𝑡𝑖𝑙𝑖𝑡𝑦 𝑝𝑒𝑟 𝑝𝑒𝑠𝑜 =
𝑝𝑟𝑖𝑐𝑒

Jennifer’s first purchase will be a movie. Why? Because it gives her the highest marginal
utility per peso and it is affordable. She will continue to purchase the good which gives her the
highest marginal utility per peso until she exhausts the budget. Jennifer will keep purchasing
movies because they give her a greater “bang or the buck” until the sixth movie is equivalent to a
blouse purchase. Jennifer can afford to purchase that blouse. So she will choose to purchase six
movies and one T-shirt.

Table 10.5. Marginal Utility per Peso

Quantity Quantity
Total Marginal Marginal Utility per Total Marginal Marginal Utility per
of of
Utility Utility Peso Utility Utility Peso
Blouses Movies
1 22 22 22/700 0.031 1 16 16 16/350 0.046
2 43 21 21/700 0.030 2 31 15 15/350 0.043
3 63 20 20/700 0.029 3 45 14 14/350 0.040
4 81 18 18/700 0.026 4 58 13 13/350 0.037
5 97 16 16/700 0.023 5 70 12 12/350 0.034
6 111 14 14/700 0.020 6 81 11 11/350 0.031
7 123 12 12/700 0.017 7 91 10 10/350 0.029

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A Rule for Maximizing Utility

This process of decision making suggests a rule to follow when maximizing utility. Since
the price of blouses is twice as high as the price of movies, to maximize utility the last blouse
chosen needs to provide exactly twice the marginal utility (MU) of the last movie. If the last blouse
provides less than twice the marginal utility of the last movie, then the blouse is providing less
“bang for the buck” (i.e., marginal utility per peso spent) than if the same money were spent on
movies. If this is so, Jennifer should trade the blouse for more movies to increase her total utility.
Marginal utility per peso measures the additional utility that Jennifer will enjoy given what he has
to pay for the good.

If the last blouse provides more than twice the marginal utility of the last movie, then the
blouse is providing more “bang for the buck” or marginal utility per peso, than if the money were
spent on movies. As a result, she should buy more blouses. Notice that at Jennifer’s optimal choice
of point S, the marginal utility from the first blouse, of 22 is exactly twice the marginal utility of
the sixth movie, which is 11. At this choice, the marginal utility per peso is the same for both
goods. This is a tell-tale signal that she has found the point with highest total utility.

This argument can be written as a general rule: the utility-maximizing choice between
consumption goods occurs where the marginal utility per dollar is the same for both goods.

𝑀𝑈1 𝑀𝑈2
=
𝑃1 𝑃2

A sensible economizer will pay twice as much for something only if, in the marginal
comparison, the item confers twice as much utility. Notice that the formula for the table above is:

22 11
=
₱700 ₱350

0.031 = 0.031

Maximizing Utility

𝑀𝑈1 𝑀𝑈2
The general rule, = , means that the last peso spent on each good provides
𝑃1 𝑃2
exactly the same marginal utility. So:

Step 1. If we traded a peso more of movies for a peso more of T-shirts, the marginal
utility gained from pesos would exactly offset the marginal utility lost from fewer
movies. In other words, the net gain would be zero.

Step 2. Products, however, usually cost more than a peso, so we cannot trade a peso’s
worth of movies. The best we can do is trade two movies for another peso, since in this
example blouses cost twice what a movie does.

Step 3. If we trade two movies for one blouse, we would end up at point R (two T-shirts
and four movies).

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Step 4. Choice 4 in Table 6.4 shows that if we move to point S, we would lose 21 utils from
one less blouse, but gain 23 utils from two more movies, so we would end up with more
total utility at point S.

In short, the general rule shows us the utility-maximizing choice.

There is another, equivalent way to think about this. The general rule can also be
expressed as the ratio of the prices of the two goods should be equal to the ratio of the marginal
utilities. When the price of good 1 is divided by the price of good 2, at the utility-maximizing point
this will equal the marginal utility of good 1 divided by the marginal utility of good 2. This rule,
known as the consumer equilibrium, can be written in algebraic form:

𝑃1 𝑀𝑈1
=
𝑃2 𝑀𝑈2

Along the budget constraint, the total price of the two goods remains the same, so the
ratio of the prices does not change. However, the marginal utility of the two goods changes with
the quantities consumed. At the optimal choice of one blouse and six movies, point S, the ratio of
marginal utility to price for movies (22:14) matches the ratio of marginal utility to price for
movies (of 11:7).

Check this out!

Here are some video clips that you may view for easy understanding of the concept and
calculation of Budget Constraint Line, Total Utility, and Marginal Utility:

https://www.youtube.com/watch?v=LpB-2tlU-rU
https://www.youtube.com/watch?v=JlS5K1AxjT4

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References:

Books:

Greenlaw, S. & Taylor, T. (2014) Principles of Microeconomics. Houston, Texas, USA: Rice University
Krueger, A.B. & Anderson, D.A. (2014) Explorations in Economics. New York, USA: BFW Worth
Publishers

Electronic:

https://www.youtube.com/watch?v=LpB-2tlU-rU
https://www.youtube.com/watch?v=JlS5K1AxjT4

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