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Budget Constraints: Effect on Goods

Budget Constraints: Effect on Goods

Author: Kate Eskra

Identify the type of good effected by a change in income.

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Budget Constraints: Change in Income

Source: Image of Budget Constraint Graph created by Kate Eskra, Image of Income Change on Budget Constraint created by Kate Eskra

Video Transcription

Hi. Welcome to Economics. This is Kate. This tutorial is called Budget Constraints, Change in Income. As always, my key terms will be in red, and my examples will be in green.

So in this tutorial, you will learn how a change in income affects the budget constraint. And we'll compare the effect on consumption of normal and inferior goods when income changes.

So let's start out with the key term of a budget constraint. It's just the graphical depiction of consumer income relative to the prices of goods available. Where the budget constraint touches the highest indifference curve available, the consumer is defined to be optimizing consumption.

So let's use an example. Let's say that Kim has a budget of $100 every month that she sets aside for fun. The two activities that she must choose between are going to the movies and ordering Chinese takeout.

Let's say that the movies cost her $20, between the ticket and some concession stand purchases, and Chinese takeout, which is a little bit cheaper, costs her $10. So what the budget constraint does is it lists all of the possible combinations that Kim can afford if, in fact, she spends all $100 on these two activities.

So let's take a look at the graph. So where her budget is $100, we graph her budget. So we start with the extremes right here. This would represent if she spent all of her money going to the movies. And where I got the five is five times $20-- she would be spending all $100 on the movies.

Down here is the other extreme. She would be ordering Chinese takeout 10 times, because 10 times $10 would give you the $100 budget. And then we connect those two extremes. And really, she can afford any combination along her budget constraint line.

Anything in here is within her budget. Anything here is not. It's greater than $100. So like I said, she can afford either five trips to the movies, 10 Chinese takeout meals, or some combination.

But what if her income changes? What if all the sudden she's making more money? And now she says, well, you know what? I can afford $200 a month on fun.

So if we did the same mathematical calculations, that means that she can afford 10 trips to the movies, because they didn't change in price. It's still costing her $20 each time. She can afford double of them.

Same with Chinese takeout. She could order 20 Chinese takeout meals because they're $10 each. Or, again, she can have some combination.

So if we graph those two extremes, 20 Chinese takeout or 10 times to the movies, and connected them with a budget constraint, you can see that whenever there is a change in income the budget constraint simply shifts parallel out to the right, parallel to the old one. OK?

So now that she has a new budget constraint, how might she choose to spend her money? Really it depends on what types of goods these are to her. So that's that second part of things that I said we were going to go over in this tutorial.

It really depends on whether the goods are what we would consider normal. These are most goods, goods for which demand increases as we make more money. So normal goods are anything that we want to buy more of as we have more money.

There are things called inferior goods, though, where when we make more money we actually buy less of them. So some classic examples of inferior goods are ramen noodles or Spam or something like that. Where we make more money, we don't have to buy them as much anymore. Like off brands, generic brands.

So here's a summary of what happens as our income increases. Most goods, we find, are normal. So as our income goes up, we can go on vacations more often, we can go out to dinner more often. We can afford a lot of things more now that we have more money.

But the inferior good, our demand actually falls as our income increases. So like I gave you the example of Spam. We buy less Spam now that our income has increased because we can afford more expensive meats.

So again looking at Kim's budget constraint, where her budget is now $200, the question really is, so what is she going to decide? What will optimize her choice?

Well, let's use the example. What if she views going to the movies as a normal good but ordering Chinese takeout as kind of an inferior good? That would really affect the combination of the two goods she chooses now that her income is increased.

Really, to see what combination she would purchase, we would need indifference curves on this budget constraint. Remember, it's the indifference curves that helps show us Kim's preferences. So I just made up an indifference curve.

Let's say that that was where her indifference curve was on her old budget constraint. Well now certainly we can increase our utility now that our budget constraint is out here. Remember, more is always better.

But what if her indifference curve that actually was tangent to the budget constraint is out over here? That would show you that even though she's able to afford more of both, she's actually purchasing many more tickets to the movies but a little bit less Chinese takeout, because maybe she sees that as an inferior good and the movies definitely a normal good.

So the key to all of this is that consumers want to make the optimal choice. And the optimal choice is defined as goods and services purchased by a consumer that provides the highest level of utility or satisfaction possible. So really in this tutorial, you see everything coming together here, with the budget constraint, the indifference curve showing us the optimal choice.

And when our income increases, we noticed in this tutorial that the budget constraint shifts out parallel any time there is a change in income-- an increase in income. For a decrease in income, it would obviously shift into the left parallel. And we talked about the difference between normal and inferior goods. Remember, as there's an increase in income, we buy more of normal goods but less of an inferior good.

Thanks so much for listening. Have a great day.

Terms to Know
Budget Constraint

The graphical depiction of consumer income relative to the price of goods available. Where the budget constraint touches the highest indifference curve available, the consumer is defined to be optimizing consumption.

Inferior Goods

Goods for which demand decreases as income increases.

Normal Goods

Goods for which demand increases as income increases.

Optimal Choice

Goods and services purchased by a consumer that provides the highest level of utility possible.