Budget Constraints

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To get a better understanding
of how we make choices,

we first need to understand
the elements

that go into making a decision.

And not all of them
are within our control.

The world is constantly,
invisibly determining the prices

of goods and services.

Take the price of a cup of coffee.

It depends on so many variables.

Think culture, demographics,
the cost of beans, the weather,

the supply and demand for oil,

even the high rent at your hip
neighborhood coffee shop.

You get the idea.

All of this economic activity
is magically being simplified

into a price for a cup of coffee.

How about your salary -- the price
of one hour of your labor?

It depends on you, of course,
on your skills and effort,

but it also depends on many factors
outside of your control --

for example,
the demand for your services,

nearby competition,
even how fun your job is.

Every day you make decision
after decision about what to buy,

comparing hundreds
of different goods and services.

There are so many choices.

To simplify things, let's think
about what you would do

if you had a weekly budget of $50
to spend on just two goods:

coffee and pizza.

Coffee costs $5,
and pizza costs $10.

So pizza is twice
as expensive as coffee.

There are several different
combinations of coffee and pizza

you could buy with this money.

Let's plot a few
of your options on a graph.

On the x-axis, we have the number
of pizzas per week.

And on the y-axis, we have
the cups of coffee per week.

You could buy two cups of coffee
and four pizzas,

four cups of coffee
and three pizzas,

five pizzas but no coffee,

or 10 cups of coffee but no pizza.

When you connect
to different options that represent

the ways you can spend your $50,
you get a straight line.

This is your budget constraint.

And it represents all possible
combinations of coffee and pizza

you can buy, given your budget
and the prices of coffee and pizza.

This budget line also separates
what you can afford

from what you cannot afford.

Maybe you wish you could buy
two cups of coffee and six pizzas,

or four cups of coffee
and 10 pizzas.

But these are not in your budget.

Sorry.

All these different combinations
cost more than you have.

So they're unaffordable,

given your budget
and the prices of these two goods.

Combinations of coffee and pizza
below the budget line,

on the other hand,
are within your means.

So they're affordable,

and you could buy them
if you wanted.

The budget constraint also reflects
how the market substitutes

between the two goods.

Remember, pizzas are twice
as expensive as coffee.

And this simply means
that the relative price

of one pizza is two cups of coffee.

You see this on the slope
of the budget constraint,

which is 2.

Well, actually it's -2,
but we're less concerned

about the sign.

Although, it does remind us that
having more of one good requires

giving up some of the other.

When coffee costs $5,
and pizzas cost $10,

if you want an additional pizza,

you have to give up
two cups of coffee.

If this made you think
about opportunity cost,

you're right!

The slope of the budget constraint
is the opportunity cost of pizza.

Will this tradeoff change
if your budget increases --

say, if you find a $20 bill
in the pocket of your winter jacket

and now have $70 to spend
on these two goods?

No -- the tradeoff is given
by the market's prices.

So changes in your income
do not affect

the relative price of goods.

Sure -- you'll be able
to afford and choose

between all of the consumption
combinations that total $70.

And you can see how this makes
your budget constraint

shift outward.

But, the two cups of coffee

for one pizza tradeoff
remains the same.

And that is because the market
still values these two goods

relative to one another
just like it did before.

This tradeoff does change

if the relative price
of the two goods changes.

Think of what will happen if,

maybe because
of unusually good weather,

the price of coffee falls
from $5 to $2.50.

Does the market tradeoff
remain the same?

No.

Pizza's just became four times
more expensive than coffee.

So you're able to buy
four cups of coffee

when you give up eating one pizza.

This will make your budget
constraint rotate outward.

Notice how because nothing
happened to the price of pizza,

the number of pizzas you can buy

when you don't buy coffee
hasn't changed.

You can still only buy five pizzas.

But, if you spend
all of your budget on coffee,

just look at how many more
cups of coffee you can buy.

You can now buy
20 cups of coffee per week.

That's a lot of coffee.

You see -- the new higher
relative price of pizza,

in terms of coffee,

in the slope
of the new budget constraint,

which is now 4.

We make choices every day.

The reality of what we can afford,

given by our incomes and the prices
of goods and services,

are all very important elements
that affect our decisions.

But there are other elements
equally important,

and those are our preferences.

We'll examine these next.

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