Source: Image of Budget Constraint Graph created by Kate Eskra, Image of Price Change on Budget Constraint Graph created by Kate Eskra
Hi. Welcome to Economics. This is Kate. This tutorial is called budget constraints when there's a change in price. As always, my key terms will be in red, and my examples will be in green. So in this tutorial, we'll be talking about how a change in price affects the budget constraint. I'll also be talking about how two different effects come into play-- both the income and the substitution effects-- and how they impact our consumption when prices do change. OK.
So let's start with your first key term, and that's the budget constraint. This is the graphical depiction of consumer income relative to the price of goods available. Where the budget constraint touches the highest indifference curve available, that's where we are said to be optimizing our consumption. Those indifference curves help us maximize our utility, or satisfaction. And I'll be showing you, on my graphs, both budget constraints combined with our indifference curves. OK.
So I'm using myself in this example today. And I am saying that I put aside $100 a month for my budget to go out to lunch. And my two favorite places to go are the local Mexican restaurant and the local Italian restaurant, and both are costing $10. What my budget constraint is going to do, is it will list all of my possible combinations if I spend all $100 of my budget here going out to lunch between the two places. So what does it look like? OK.
So the black line here is my budget constraint. Notice that at the extremes-- right here, this point where it touches the y-axis-- represents if I'm spending all $100 going to the Mexican restaurant. Where I got that 10 is because 10, times $10 for the Mexican meals, will be spending all $100. Likewise, where it hits this axis here, the x-axis, is where I'm spending all of my money going to the Italian restaurant. So again, 10 times $10 would represent me spending all $100 there. OK.
So where the indifference curve comes into play-- and that's this blue curve-- is this will show me, well, what combination do I want? Because most people probably wouldn't prefer all of one or all of the other. The budget constraint shows that I can also afford any combination. So anything in here is affordable-- that's within my budget constraint. But I'm maximizing my utility if I go on my highest indifference curve. And here, that's showing that I would like five of each.
All right, but what if something changes? The subject of this tutorial is what happens when prices change. And simply defined, prices are just the cost of goods or services to the consumer. So what if the Italian restaurant decides to end their lunch special, and now it's going to cost me $20 to go to lunch there? That will certainly impact my budget constraint. And ultimately, let's see how it impacts my final choice.
So notice my budget itself did not change. I still have $100. It didn't go up, it didn't go down. But it's the price of only Italian meals that increased. So here's my old budget constraint, able to afford 10 and 10. Notice with my new budget constraint-- this one right here-- nothing changed with the Mexican restaurant meals. They're still only $10. So at the extreme, I can still afford 10 of them. So where it hits the y-axis is still at 10.
But I really cannot afford as many Italian meals now. In fact, it's in half. I used to be able to afford 10 if I spent all my money there, now I could only afford to go there 5 times. Because 5 times $20 would mean I'm spending all my $100 at the Italian restaurant. So this is what we call a pivot. It did not shift completely in parallel, because nothing changed with the Mexican restaurant meals. And nothing changed with my budget.
A change in income would have shifted the entire thing in parallel, but that did not happen. This is what we call a pivot, because it stayed the same here, but only change in price was on the Italian restaurant's meals. Now how is that going to impact my ultimate choice? That's what we're interested in.
We use this indifference curve to see where I was my old budget constraint line, but that, notice now, is outside of my new budget constraint. I cannot afford this. So we need a new indifference curve to see what's going on. So let's take a look. OK.
So before the price change, I just wanted to remind you that I was enjoying five of each. That's what maximized my utility. But now that my budget constraint is here, the indifference curve that's going to maximize my utility will place me at having three Italian meals and four Mexican meals. OK?
Let's talk about these two effects, because they actually both came into play in my decision. The income effect says that consumers' purchasing power changes as income changes, due to a price change affecting demand for a good or service. But the substitution effect says that when income decreases or price rises, cheaper goods and services are consumed instead of the more expensive alternative. OK.
So I think the first one here is actually the more difficult one to understand. Notice that as the price of Italian meals went up, I actually, not only did I buy fewer Italian meals, but I bought fewer Mexican meals as well. That's what we call the income effect. As the price of Italian meals went up, that had an impact on my purchasing power, or on my income. So I'm buying fewer of both. Even though only one got more expensive, if I still want some of that Italian meal, that's impacted my overall purchasing power.
So when I decreased my Mexican meal consumption from five down to four, that had nothing to do with Mexican meals changing in price. It was because my purchasing power over all went down. And that is the income effect.
The one that's easier to understand is this one. Now that Italian meals have become more expensive, I'm dining at the Mexican restaurant more. So even though my consumption at the Mexican restaurant went down from five to four, I'm still dining there now more than I do at the Italian restaurant. So at the Italian restaurant, I'm only going three times. That's the substitution effect.
So even though I'm able to afford both a little bit less, I'm substituting more times now at the Mexican restaurant than the more expensive alternative, which was the Italian restaurant. So that's what we call the substitution effect.
So what did you learn in this tutorial? You learned that the budget constraint pivots, not shifts, but pivots when there's a change in the price of one good. And we talked about the difference between the substitution and the income effects. Remember, substitution is when we substitute out what's more expensive and begin buying what's less expensive.
The income effect, again, showed the effect on our purchasing power. So that was the income effect. Thanks so much for listening. Have a great day.