10.2 Budgets and Optimal Consumption

The principle of diminishing marginal utility explains why most people eventually reach a limit, even at an all-you-can-eat buffet where the cost of another wing is measured only in future indigestion. Under ordinary circumstances, however, it costs some additional resources to consume more of a good, and consumers must take that cost into account when making choices.

What do we mean by cost? As always, the fundamental measure of cost is opportunity cost. Because the amount of money a consumer can spend is limited, a decision to consume more of one good is also a decision to consume less of some other good.

Budget Constraints and Budget Lines

Consider Sammy, whose appetite is exclusively for wings and potatoes (there’s no accounting for tastes). He has a weekly income of $20 and he spends all of it on wings and potatoes. We will assume that wings cost $4 per kilogram and potatoes cost $2 per kilogram. What are his possible choices?

Whatever Sammy chooses, we know that the cost of his consumption bundle cannot exceed his income, the amount of money he has to spend. That is:

A budget constraint requires that the cost of a consumer’s consumption bundle be no more than the consumer’s income.

Consumers always have limited income, which constrains how much they can consume. So the requirement illustrated by Equation 10-1—that a consumer must choose a consumption bundle that costs no more than his or her income—is known as the consumer’s budget constraint. It’s a simple way of saying that a consumer can’t spend more than the total amount of income available to him or her. In other words, consumption bundles are affordable when they obey the budget constraint. We call the set of all of Sammy’s affordable consumption bundles his consumption possibilities. In general, whether or not a particular consumption bundle is included in a consumer’s consumption possibilities depends on the consumer’s income and the prices of goods and services.

A consumer’s consumption possibilities is the set of all consumption bundles that can be consumed given the consumer’s income and prevailing prices.

Figure 10-2 shows Sammy’s consumption possibilities. The quantity of wings in his consumption bundle is measured on the horizontal axis and the quantity of potatoes on the vertical axis. The downward-sloping line connecting points A through F shows which consumption bundles are affordable and which are not. Every bundle on or inside this line (the shaded area) is affordable; every bundle outside this line is unaffordable.

Figure10-2The Budget Line The budget line represents all the possible combinations of quantities of potatoes and wings that Sammy can purchase if he spends all of his income. Also, it is the boundary between the set of affordable consumption bundles (the consumption possibilities) and unaffordable ones. Given that wings cost $4 per kilogram and potatoes cost $2 per kilogram, if Sammy spends all of his income on wings (bundle F), he can purchase 5 kilograms of wings; if he spends all of his income on potatoes (bundle A), he can purchase 10 kilograms of potatoes.

As an example of one of the points, let’s look at point C, representing 2 kilograms of wings and 6 kilograms of potatoes, and check whether it satisfies Sammy’s budget constraint. The cost of bundle C is 6 kilograms of potatoes × $2 per kilogram + 2 kilograms of wings × $4 per kilogram = $12 + $8 = $20. So bundle C does indeed satisfy Sammy’s budget constraint: it costs no more than his weekly income of $20. In fact, bundle C costs exactly as much as Sammy’s income. By doing the arithmetic, you can check that all the other points lying on the downward-sloping line are also bundles at which Sammy spends all of his income.

A consumer’s budget line shows the consumption bundles available to a consumer who spends all of his or her income.

The downward-sloping line has a special name, the budget line. It shows all the consumption bundles available to Sammy when he spends all of his income. It’s downward sloping because when Sammy is consuming all of his income, say consuming at point A on the budget line, then in order to consume more wings he must consume fewer potatoes—that is, he must move to a point like B. In other words, when Sammy chooses a consumption bundle that is on his budget line, the opportunity cost of consuming more wings is consuming fewer potatoes, and vice versa. As Figure 10-2 indicates, any consumption bundle that lies above the budget line is unaffordable.

Do we need to consider the other bundles in Sammy’s consumption possibilities, the ones that lie within the shaded region in Figure 10-2 bounded by the budget line? The answer is, for all practical situations, no: as long as Sammy continues to get positive marginal utility from consuming either good (in other words, Sammy doesn’t get satiated)—and he doesn’t get any utility from saving income rather than spending it, then he will always choose to consume a bundle that lies on his budget line and not within the shaded area. This assumption is sometimes simply stated as “more is preferred to less” or “more is better than less.”

Given his $20 per week budget, which point on his budget line will Sammy choose?

Optimal Consumption Choice

Because Sammy has a budget constraint, which means that he will consume a consumption bundle on the budget line, a choice to consume a given quantity of wings also determines his potato consumption, and vice versa. We want to find the consumption bundle—the point on the budget line—that maximizes Sammy’s total utility. This bundle is Sammy’s optimal consumption bundle, the consumption bundle that maximizes his total utility given the budget constraint.

A consumer’s optimal consumption bundle is the consumption bundle that maximizes the consumer’s total utility given his or her budget constraint.

Table 10-1 shows how much utility Sammy gets from different levels of consumption of wings and potatoes, respectively. According to the table, Sammy has a healthy appetite; the more of either good he consumes, the higher his utility.

TABLE10-1 Sammy’s Utility from Wing and Potato Consumption

But because he has a limited budget, he must make a trade-off: the more kilograms of wings he consumes, the fewer kilograms of potatoes, and vice versa. That is, he must choose a point on his budget line.

Table 10-2 shows how his total utility varies for the different consumption bundles along his budget line. Each of six possible consumption bundles, A through F from Figure 10-2, is given in the first column. The second column shows the level of wing consumption corresponding to each choice. The third column shows the utility Sammy gets from consuming those wings. The fourth column shows the quantity of potatoes Sammy can afford given the level of wing consumption; this quantity goes down as his wing consumption goes up, because he is sliding down the budget line. The fifth column shows the utility he gets from consuming those potatoes. And the final column shows his total utility. In this example, Sammy’s total utility is the sum of the utility he gets from wings and the utility he gets from potatoes.

TABLE10-2 Sammy’s Budget and Total Utility

Figure 10-3 gives a visual representation of the data shown in Table 10-2. Panel (a) shows Sammy’s budget line, to remind us that when he decides to consume more wings he is also deciding to consume fewer potatoes. Panel (b) then shows how his total utility depends on that choice. The horizontal axis in panel (b) has two sets of labels: it shows both the quantity of wings, increasing from left to right, and the quantity of potatoes, increasing from right to left. The reason we can use the same axis to represent consumption of both goods is, of course, the budget line: the more kilograms of wings Sammy consumes, the fewer kilograms of potatoes he can afford, and vice versa.

Figure10-3Optimal Consumption Bundle Panel (a) shows Sammy’s budget line and his six possible consumption bundles. If we assume that these goods, potatoes and wings, are perfectly divisible, then Sammy can buy fractions of kilograms. This implies that points in between the consumption bundles (A to F), but still on the budget line, are also attainable.
Panel (b) shows how Sammy’s total utility is affected by his consumption bundle, which must lie on his budget line. The quantity of wings is measured from left to right on the horizontal axis, and the quantity of potatoes is measured from right to left. His total utility is maximized at bundle C, the highest point on his utility function, where he consumes 2 kilograms of wings and 6 kilograms of potatoes. This is Sammy’s optimal consumption bundle.

Clearly, the consumption bundle that makes the best of the trade-off between wing consumption and potato consumption, the optimal consumption bundle, is the one that maximizes Sammy’s total utility. That is, Sammy’s optimal consumption bundle puts him at the highest point of the total utility curve.

As always, we can find the highest point of the curve by direct ob servation. We can see from Figure 10-3 that Sammy’s total utility is maximized at point C—that his optimal consumption bundle contains 2 kilograms of wings and 6 kilograms of potatoes. But we know that we usually gain more insight into “how much” problems when we use marginal analysis. So in the next section we turn to representing and solving the optimal consumption choice problem with marginal analysis.

FOOD FOR THOUGHT ON BUDGET CONSTRAINTS

Budget constraints aren’t just about money. In fact, there are many other budget constraints affecting our lives. You face a budget constraint if you have a limited amount of closet space for your clothes or limited storage on your phone. All of us face a budget constraint on time: there are only so many hours in the day.

And people trying to lose weight on the Weight Watchers plan face a budget constraint on the foods they eat.

The Weight Watchers plan assigns each food a certain number of “points.” A 100-gram serving of ice cream gets 7 points, a slice of pizza 5 points, any serving of grapes zero points, a large fast-food hamburger 13 points.

You are allowed a maximum number of points each day but are free to choose which foods you eat. In other words, a dieter on the Weight Watchers plan is just like a consumer choosing a consumption bundle: points are the equivalent of prices, and the overall point limit is the equivalent of total income.

THE GREAT CONDIMENT CRAZE

Would you prefer the horseradish mayo or the smoky bacon mayo?

Those of us of a certain age remember when the only kind of mustard available in Canadian grocery stores was a runny, fluorescent yellow concoction packaged in plastic squeeze bottles. Ditto for ketchup and mayonnaise—what little selection there was, tasted the same. As for salsa—wasn’t that some sort of dance step?

No longer. Lately, Canadians have developed an intense liking for condiments—in a dizzying array of varieties. Who wants plain mustard when you can get mustard flavoured with roasted garlic, apricot, or even maple and bacon? Likewise, would you like saffron and garlic mayonnaise or wasabi mayonnaise on your club sandwich?

So what happened? Tastes changed and budgets changed. With budget-conscious consumers more likely to eat at home, but having been exposed to gourmet cooking and ethnic cuisine, specialty condiments have become an affordable way of spicing up home cooking. In 2012, the Canadian market for sauces, dressings, and condiments was valued at $2.9 billion and projected to grow to $3.1 billion by 2017, while stable overall demand is increasing for healthy options as well as for Asian, Indian, and spicy flavours.

The explosion of varieties stems from the fact that it’s fairly easy to make bottled condiments. This enables smaller companies to experiment with exotic flavours, finding the ones that appeal to consumers’ increasingly sophisticated tastes. Eventually, the flavours that attract a significant following are picked up by the larger companies such as Kraft. As one industry analyst put it, “People want cheaper, more specialized gourmet products. It’s like fashion.”

Although some analysts believe that the great condiment craze can continue indefinitely, others think that a limit will eventually be reached as food buyers’ zest for experimentation wanes.

Quick Review

  • The budget constraint requires that a consumer’s total expenditure be no more than his or her income. The set of consumption bundles that satisfy the budget constraint is the consumer’s consumption possibilities.

  • A consumer who spends all of his or her income chooses a point on his or her budget line. The budget line slopes downward because on the budget line a consumer must consume less of one good in order to consume more of another.

  • The consumption choice that maximizes total utility given the consumer’s budget constraint is the optimal consumption bundle. With economic goods, more is generally preferred to less, so the optimal consumption bundle must lie on the consumer’s budget line.

Check Your Understanding 10-2

CHECK YOUR UNDERSTANDING 10-2

Question 10.4

In the following two examples, find all the consumption bundles that lie on the consumer’s budget line. Illustrate these consumption possibilities in a diagram and draw the budget line through them.

  1. The consumption bundle consists of movie tickets and buckets of popcorn. The price of each ticket is $10.00, the price of each bucket of popcorn is $5.00, and the consumer’s income is $20.00. In your diagram, put movie tickets on the vertical axis and buckets of popcorn on the horizontal axis.

  2. The consumption bundle consists of underwear and socks. The price of each pair of underwear is $4.00, the price of each pair of socks is $2.00, and the consumer’s income is $12.00. In your diagram, put pairs of socks on the vertical axis and pairs of underwear on the horizontal axis.

  1. The accompanying table shows the consumer’s consumption possibilities, A through C. These consumption possibilities are plotted in the accompanying diagram, along with the consumer’s budget line, BL.

  2. The accompanying table shows the consumer’s consumption possibilities, A through D. These consumption possibilities are plotted in the accompanying diagram, along with the consumer’s budget line, BL.