Budget Line

Definition

The budget line is a graphical representation of the various combinations of two goods that an individual can purchase given their limited income and the prices of those goods. It shows the maximum amount of one good that can be consumed given the amount of the other good that is consumed.

5 Must Know Facts For Your Next Test

1. The budget line is determined by the individual's income and the prices of the two goods being considered.
2. The budget line has a negative slope, indicating that as more of one good is consumed, less of the other good can be consumed.
3. The slope of the budget line is equal to the negative of the ratio of the prices of the two goods, which represents the opportunity cost of consuming one good in terms of the other good.
4. The budget line represents all the possible combinations of the two goods that an individual can afford to consume given their limited income.
5. Movements along the budget line reflect changes in the consumption of the two goods, while shifts in the budget line reflect changes in income or prices.

Review Questions

• Explain how the budget line represents the budget constraint faced by an individual.
  • The budget line represents the budget constraint faced by an individual because it shows the maximum combinations of two goods that the individual can afford to purchase given their limited income and the prices of those goods. The slope of the budget line represents the opportunity cost of consuming one good in terms of the other good, and movements along the budget line reflect changes in the consumption of the two goods.
• Describe how changes in income or prices affect the budget line.
  • Changes in income or prices can cause shifts in the budget line. An increase in income will shift the budget line outward, allowing the individual to consume more of both goods. An increase in the price of one good will cause the budget line to rotate inward, reducing the amount of that good that can be purchased. Conversely, a decrease in the price of one good will cause the budget line to rotate outward, allowing the individual to consume more of that good.
• Analyze how the slope of the budget line is related to the opportunity cost of consuming one good in terms of the other good.
  • The slope of the budget line is equal to the negative of the ratio of the prices of the two goods, which represents the opportunity cost of consuming one good in terms of the other good. This means that as an individual consumes more of one good, they must give up a certain amount of the other good, and the slope of the budget line reflects the rate at which this trade-off occurs. Understanding the relationship between the slope of the budget line and the opportunity cost is crucial for making optimal consumption decisions within the constraints of the individual's budget.

Related terms

Budget Constraint: The budget constraint represents the limits on an individual's consumption choices due to their limited income and the prices of goods.

Opportunity Cost: The opportunity cost of consuming one good is the amount of the other good that must be given up to consume the first good.

Slope of the Budget Line: The slope of the budget line is equal to the negative of the ratio of the prices of the two goods, and represents the opportunity cost of consuming one good in terms of the other good.