The budget line is also referred to as budget restriction, balance line or consumption possibility limit. This is a straight line on which there are all points that represent a representation of combinations of goods.
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Definition / explanation
The consumption theory states that every consumer has only a limited income and is therefore confronted with a budget constraint. The consumer's income (= budget) is equal to the total amount spent - according to the theory. Every consumer strives to get the best possible personal benefit from it.
In this context, the budget line ensures that the actor does not spend more money than he has available. The budget line can also be constructed for several points in time.
Graphic construction (two-goods case)
For the sake of simplicity, we assume that a consumer only buys two goods with his budget. He spends his entire income on this. This form of budget restriction is also referred to as the “two-goods case” in the standard model of household theory. The time unit of the consumed amount of one good is plotted horizontally (X-axis) and the amount of the second good on the vertical (Y-axis) in the positive area of the coordinate system.
The budget line in the illustration is a straight line from the vertical point where the entire budget is spent on good 2 to the point on the horizontal axis where the entire budget is spent on good 1. This results in a combination of both goods, which the consumer can purchase with his income.
At the intersection of the straight line with an axis, one good is consumed - the entire income is spent on it. The combination of goods on the budget line can be freely selected between the intersection points.
Calculation of the budget line
The following variables are used in the calculation:
- E. = the budget or income
- Px = Price of good 1
- Py = Price of good 2
- X = Number of good 1
- Y = Number of good 2
The following formula shows how the slope Y is calculated
Y = (E / Py) - (Px / Py) * X