Economics » Choice in a World of Scarcity » How Individuals Make Choices Based on Their Budget Constraint

Key Concepts and Summary

Key Concepts and Summary

Economists see the real world as one of scarcity: that is, a world in which people’s desires exceed what is possible. As a result, economic behavior involves tradeoffs in which individuals, firms, and society must give up something that they desire to obtain things that they desire more. Individuals face the tradeoff of what quantities of goods and services to consume. The budget constraint, which is the frontier of the opportunity set, illustrates the range of choices available. The slope of the budget constraint is determined by the relative price of the choices. Choices beyond the budget constraint are not affordable.

Opportunity cost measures cost by what is given up in exchange. Sometimes opportunity cost can be measured in money, but it is often useful to consider time as well, or to measure it in terms of the actual resources that must be given up.

Most economic decisions and tradeoffs are not all-or-nothing. Instead, they involve marginal analysis, which means they are about decisions on the margin, involving a little more or a little less. The law of diminishing marginal utility points out that as a person receives more of something—whether it is a specific good or another resource—the additional marginal gains tend to become smaller. Because sunk costs occurred in the past and cannot be recovered, they should be disregarded in making current decisions.

Glossary

budget constraint

all possible consumption combinations of goods that someone can afford, given the prices of goods, when all income is spent; the boundary of the opportunity set

law of diminishing marginal utility

as we consume more of a good or service, the utility we get from additional units of the good or service tend to become smaller than what we received from earlier units

marginal analysis

examination of decisions on the margin, meaning a little more or a little less from the status quo

opportunity cost

measures cost by what is given up in exchange; opportunity cost measures the value of the forgone alternative

opportunity set

all possible combinations of consumption that someone can afford given the prices of goods and the individual’s income

sunk costs

costs that are made in the past and cannot be recovered

utility

satisfaction, usefulness, or value one obtains from consuming goods and services

Self-Check Question

Suppose Alphonso’s town raised the price of bus tickets to $1 per trip (while the price of burgers stayed at $2 and his budget remained $10 per week.) Draw Alphonso’s new budget constraint. What happens to the opportunity cost of bus tickets?

Solution

The opportunity cost of bus tickets is the number of burgers that must be given up to obtain one more bus ticket. Originally, when the price of bus tickets was 50 cents per trip, this opportunity cost was 0.50/2 = .25 burgers. The reason for this is that at the original prices, one burger ($2) costs the same as four bus tickets ($0.50), so the opportunity cost of a burger is four bus tickets, and the opportunity cost of a bus ticket is .25 (the inverse of the opportunity cost of a burger). With the new, higher price of bus tickets, the opportunity cost rises to $1/$2 or 0.50. You can see this graphically since the slope of the new budget constraint is flatter than the original one. If Alphonso spends all of his budget on burgers, the higher price of bus tickets has no impact so the horizontal intercept of the budget constraint is the same. If he spends all of his budget on bus tickets, he can now afford only half as many, so the vertical intercept is half as much. In short, the budget constraint rotates clockwise around the horizontal intercept, flattening as it goes and the opportunity cost of bus tickets increases.

Review Questions

  • Explain why scarcity leads to tradeoffs.
  • Explain why individuals make choices that are directly on the budget constraint, rather than inside the budget constraint or outside it.

Critical Thinking Question

Suppose Alphonso’s town raises the price of bus tickets from $0.50 to $1 and the price of burgers rises from $2 to $4. Why is the opportunity cost of bus tickets unchanged? Suppose Alphonso’s weekly spending money increases from $10 to $20. How is his budget constraint affected from all three changes? Explain.

Problems

Use this information to answer the following 4 questions: Marie has a weekly budget of $24, which she likes to spend on magazines and pies.

  • If the price of a magazine is $4 each, what is the maximum number of magazines she could buy in a week?
  • If the price of a pie is $12, what is the maximum number of pies she could buy in a week?
  • Draw Marie’s budget constraint with pies on the horizontal axis and magazines on the vertical axis. What is the slope of the budget constraint?
  • What is Marie’s opportunity cost of purchasing a pie?
 

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