
In
economics
Economics () is a behavioral science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services.
Economics focuses on the behaviour and interac ...
, a budget constraint represents all the combinations of goods and services that a consumer may purchase given current prices within their given income.
Consumer theory uses the concepts of a
budget
A budget is a calculation plan, usually but not always financial plan, financial, for a defined accounting period, period, often one year or a month. A budget may include anticipated sales volumes and revenues, resource quantities including tim ...
constraint and a
preference map as tools to examine the
parameters of
consumer choices . Both concepts have a ready
graphical representation in the two-good case. The consumer can only purchase as much as their income will allow, hence they are constrained by their budget.
The equation of a budget constraint is
where
is the price of good , and
is the price of good , and is income.
Soft budget constraint
The concept of soft budget constraint is commonly applied to centrally planned economies, later
economies
An economy is an area of the production, distribution and trade, as well as consumption of goods and services. In general, it is defined as a social domain that emphasize the practices, discourses, and material expressions associated with ...
in transition. This theory was originally proposed by
János Kornai in 1979. It was used to explain the "economic behavior in socialist economies marked by shortage”. In the socialist transition economy there are soft budget constraint on firms because of
subsidies
A subsidy, subvention or government incentive is a type of government expenditure for individuals and households, as well as businesses with the aim of stabilizing the economy. It ensures that individuals and households are viable by having acce ...
, credit and price support. This theory implies that the survival of a firm depends on financial assistance, especially in a socialist country. The soft budget constraint
syndrome
A syndrome is a set of medical signs and symptoms which are correlated with each other and often associated with a particular disease or disorder. The word derives from the Greek language, Greek σύνδρομον, meaning "concurrence". When a sy ...
usually occurs in the
paternalistic role of the State in economic organizations, such as public and private companies and non-profit organizations.
János Kornai also highlighted that there are five dimensions to evaluate the post-socialist transition, including fiscal
subsidy
A subsidy, subvention or government incentive is a type of government expenditure for individuals and households, as well as businesses with the aim of stabilizing the economy. It ensures that individuals and households are viable by having acc ...
, soft
tax
A tax is a mandatory financial charge or levy imposed on an individual or legal entity by a governmental organization to support government spending and public expenditures collectively or to regulate and reduce negative externalities. Tax co ...
ation, soft
bank credit (non-performing loans), soft
trade credit (the accumulate rears between firms) and
wage arrears.
According to the point of view by Cllower
965 budget constraints are a rational planning assumption with two main attributes. The first is that budget constraints refer to the decision makers' behavioural characteristics --- selling output or acquiring asset income to compensate for spending. This means that adjustment limitation on financial resources are obvious. The second is to impose constraints on prior variables, such as constraints on current actual demand based on expectations of future financial conditions.
The reason for the soft budget constraints is that the excess of
expenditure
An expense is an item requiring an outflow of money, or any form of fortune in general, to another person or group as payment for an item, service, or other category of costs. For a tenant, rent is an expense. For students or parents, tuition i ...
over income will be paid by additional organizations (the State). In addition, the decision maker expects such external financial assistance to be highly probable based on his actions. The further explanation is the more excess spending is covered by external aid, the budget constraints will be more softer.
Bank
Bank
supervision refers to the supervision on the
capital adequacy ratio
Capital Adequacy Ratio (CAR) also known as Capital to Risk (Weighted) Assets Ratio (CRAR), is the ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies ...
of banks. When the bank's capital is difficult to finance due to the default of a large number of loans, it can prevent the bank from going bankrupt with the aid of the government, then it will occurs the soft budget constraint of the bank.
Dewatripont and Maskin(1995) point out the presence of
sunk costs in existing loans may lead to soft budget constraints when banks need additional financial assistance. The
internalization of external options can expand the model by allowing banks to allocate funds between new loans and refinancing old loans. Through investment screening and monitoring technology, banks can improve the relative profitability of new loans, thus breaking the equilibrium of soft budget constraints.
Uses
Individual choice
Consumer behaviour
Consumer behaviour is the study of individuals, groups, or organisations and all activities associated with the Purchasing, purchase, Utility, use and disposal of goods and services. It encompasses how the consumer's emotions, Attitude (psy ...
is a
maximization problem. It means making the most of our limited resources to maximize our
utility
In economics, utility is a measure of a certain person's satisfaction from a certain state of the world. Over time, the term has been used with at least two meanings.
* In a normative context, utility refers to a goal or objective that we wish ...
. As consumers are insatiable, and utility functions grow with quantity, the only thing that limits our consumption is our own budget.
In general, the budget set (all bundle choices that are on or below the budget line) represents all possible bundles of goods an individual can afford given their income and the prices of goods. A common assumption underlying consumer theory is the concept of well-behaved preferences, and as such, the direction of an individual's preferences will point 45 degrees from the origin. When behaving rationally, an individual
consumer
A consumer is a person or a group who intends to order, or use purchased goods, products, or services primarily for personal, social, family, household and similar needs, who is not directly related to entrepreneurial or business activities. ...
should choose to consume goods at the point where the most preferred available
indifference curve
In economics, an indifference curve connects points on a graph representing different quantities of two goods, points between which a consumer is ''indifferent''. That is, any combinations of two products indicated by the curve will provide the c ...
on their
preference map is
tangent
In geometry, the tangent line (or simply tangent) to a plane curve at a given point is, intuitively, the straight line that "just touches" the curve at that point. Leibniz defined it as the line through a pair of infinitely close points o ...
to their budget constraint. The tangent point (the xy coordinate) represents the amount of goods x and y the consumer should purchase to fully utilize their budget to obtain maximum utility. It is important to note that the optimal consumption bundle will not always be an interior solution. If the solution to the optimality condition leads to a bundle that is not feasible, the consumer's optimal bundle will be a
corner solution which suggests the goods or inputs are perfect substitutes. A line connecting all points of tangency between the indifference curve and the budget constraint is called the
expansion path.
[Salvatore, Dominick (1989). ''Schaum's outline of theory and problems of managerial economics,'' McGraw-Hill, ]
All two dimensional budget constraints are generalized into the equation:
Where:
*
money income allocated to consumption (after saving and borrowing)
*
the price of a specific good
*
the price of all other goods
*
amount purchased of a specific good
*
amount purchased of all other goods
The equation can be rearranged to represent the shape of the curve on a graph:
, where
is the y-intercept and
is the slope, representing a downward sloping budget line.
The factors that can shift the budget line are a change in income (m), a change in the price of a specific good (
), or a change in the price of all other goods (
).
International economics

A
production-possibility frontier is a constraint in some ways analogous to a budget constraint, showing limitations on a country's production of multiple goods based on the limitation of available
factors of production
In economics, factors of production, resources, or inputs are what is used in the production process to produce output—that is, goods and services. The utilised amounts of the various inputs determine the quantity of output according to the rela ...
. Under
autarky
Autarky is the characteristic of self-sufficiency, usually applied to societies, communities, states, and their economic systems.
Autarky as an ideology or economic approach has been attempted by a range of political ideologies and movement ...
this is also the limitation of consumption by individuals in the country. However, the benefits of
international trade
International trade is the exchange of capital, goods, and services across international borders or territories because there is a need or want of goods or services. (See: World economy.)
In most countries, such trade represents a significan ...
are generally demonstrated through allowance of a shift in the
consumption-possibility frontiers of each trade partner which allows access to a more appealing indifference curve.
In the "toolbox" Hecksher-Ohlin and Krugman models of international trade, the budget constraint of the economy (its CPF) is determined by the terms-of-trade (TOT) as a downward-sloped line with slope equal to those TOTs of the economy. (The TOTs are given by the price ratio Px/Py, where x is the exportable commodity and y is the importable).
Many goods
While low-level demonstrations of budget constraints are often limited to less than two good situations which provide easy graphical representation, it is possible to demonstrate the relationship between multiple goods through a budget constraint.
There are 2 requirements for this case. The first one is that the constraint is not affected if the prices are multiplied by any positive scalar. The second one is that all commodities are desirable and the constraint will always be binding.
In such a case, assuming there are
goods, called
for
, that the price of good
is denoted by
, and if
is the total amount that may be spent, then the budget constraint is:
:
Further, if the consumer spends his income entirely, the budget constraint binds:
:
In this case, the consumer cannot obtain an additional unit of good
without giving up some other good. For example, he could purchase an additional unit of good
by giving up
units of good
Borrowing and lending
Budget constraints can be expanded outward or contracted inward through borrowing and lending. By borrowing money in a period, usually at an interest rate
''r'', a consumer can choose to forgo consumption in future periods for extra consumption in the borrowing period. Choosing to borrow would expand the budget constraint in this period and contract budget constraints in future periods. Alternatively, consumers can choose to lend their money in the current period, usually at a lending rate
''l''. Lending contracts the budget constraint in the current period but expands budget constraints in future periods.
[Allingham, Michael (1987). ''Wealth Constraint,'' The New Palgrave: A Dictionary of Economics, ] According to behavioral economics, choices on borrowing and lending may also be affected by
Present bias. In economics, there are two groups of present biased individuals, sophisticated individuals who are aware of their present bias, and naive individuals who are not aware of their present bias.
[O'Donoghue, Ted, and Matthew Rabin. 2015. "Present Bias: Lessons Learned and to Be Learned." American Economic Review, 105 (5): 273-79.]
See also
*
Choice modelling
*
Contingent valuation
*
Guns versus butter model
*
Heckscher–Ohlin theorem on country level budget constraints called resource endowments
*
Intertemporal budget constraint
*
Isoquant
*
Opportunity cost
In microeconomic theory, the opportunity cost of a choice is the value of the best alternative forgone where, given limited resources, a choice needs to be made between several mutually exclusive alternatives. Assuming the best choice is made, ...
*
Scarcity
*
Trade-off
*
Paternalism
Notes
References
*
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{{DEFAULTSORT:Budget Constraint
Consumer theory
Constraint
Economics curves