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Consumption I: Budget constraint

Summary

In this Learning Path we look at consumer behaviour from a theoretical perspective, trying to solve the basic problem we all face every day: how to get as much of what we want or need without blowing our budget.

The basics:

Utility and budget:

Consumption duality I:

Utility maximisation

Consumer behaviour is a maximisation problem. It means making the most of our limited resources to maximise our utility. As consumers are insatiable, and utility functions grow with quantity, the only thing that limits our consumption is our own budget (assuming, of course, we are dealing with normal goods, not negative or harmful goods which consumption we want to limit).

A budget constraint (green line in the adjacent figure) provides the second half of the maximisation problem. We need to balance the utility we derive from consumption with the budget we have.

Supposing we have a choice of two goods, 1 and 2, then our restriction is as follows:

which simply means that our budget must be at least as much as the price of the two goods times their respective price.

This simply shows that our consumption is capped and that the more we spend on one good, the less we can on the other.
Video – Budget constraint:

Finally, let’s put it all together. We have an idea of what we want from our utility functions and we know how much we want to spend from our budget constraint. We therefore have a utility maximisation problem: how to get the most satisfaction whilst staying within budget. Let’s have a look at it in more detail.

Consumption I: Indifference curves Consumption I: Utility maximisation