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What is a Budget Constraint?

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  • Written By: Justin Riche
  • Edited By: A. Joseph
  • Last Modified Date: 29 August 2016
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Budget constraint is a concept from what is known as the consumer theory in economics, which shows how a consumer's spending capacity is limited by his or her income or budget. For example, if a consumer has only $100 US Dollars (USD) to spend and he or she desires to buy some wine priced at $10 USD per bottle, then he or she can afford to buy only 10 bottles. As an economic tool, a budget constraint can be plotted on a graph, and it typically is demonstrated using an example of a consumer with a specific budget dedicated to purchase two products with certain prices. Such an example will show the many possible combinations of the two products that the consumer can afford to buy within his or her budget.

Essentially, the budget constraint concept demonstrates the relationship between income and spending power. To demonstrate this relationship, economists normally use a basic example of a consumer who has a specific amount of money and a choice between two goods, such as good A and good B. The consumer can, however, choose to buy a combination of good A and good B according to his or her preferences and particular needs. Any combination is more or less achievable as long as it remains within the budget. In practice, consumers buy more than just two goods, however, the use of two goods in the example keeps things simple.

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To illustrate, one could consider a consumer who has a budget of $1,000 USD per week to spend on good A and good B. Good A costs $5 USD and good B costs $20 USD. At the extremes, the consumer can choose to spend all of his or her money on good A, which means he or she could buy 200 units of good A per week. If he or she bought only good B, then 50 units would be acquired per week.

On a graph, good A and good B can be represented on the Y-axis and X-axis, respectively. The Y-axis is the vertical line and the X-axis is the horizontal line on the graph. Using the example above, a point can be marked on the Y-axis at 200, denoted as point A, and another point can be marked on the X-axis at 50, denoted as point B. Then what is called a budget constraint slope can be drawn diagonally from point to A to B, and it will visually show all possible combinations of good A and good B as limited by the $1,000 USD budget. The slope shows the maximum number of goods and services that can be purchased given a specific budget and specific prices.

On the graph, the budget constraint slope is calculated using the following formula: "rise over run." In other words, the "rise" which is the change in the value of Y, is divided by the change in value of X, also referred to as the "run." In the above example, the change in Y would be 200, and the change in the X would be 50, so the slope would be 200/50, which is equal to 4.

There is also what is called an intertemporal budget constraint, which is the spending limit possible over a long time, depending on the resources available during that period. That is, the intertemporal budget limit equals the entire income that a consumer earns or expects to earn in his or her lifetime, including any other assets he or she might have. This concept is also based on the fact that consumers make choices on how to spend their money, and one of its purposes is to help them make the most of their resources, whether it is in the present or the future.

Theoretically, an intertemporal budget constraint can help all kinds of consumers make choices of either spending money now or at a later date in the future. For example, with this theory, they might make some calculations and figure that they can postpone present consumption and invest their money instead. This approach may make them richer in the future, for instance, and thus increases their spending capacity, which means that they might eventually gain more by growing their money first before spending it.

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