Budget Constraints and Utility Maximization#
In this section, we will assume that \(\alpha = 0.5\) (i.e. the utility function is: \(u(x_1, x_2) = x_1^{0.5}x_2^{0.5}\)).
Now we introduce the concept of money into our model. Consumers face a budget constraint when choosing to maximize their utility. Given an income \(M\) and prices \(p_1\) for good \(x_1\) and \(p_2\) for good \(x_2\), the consumer can at most spend up to \(M\) for both goods:
Since goods will always bring non-negative marginal utility, consumers will try to consume as many goods as they can. Hence, we can rewrite the budget constraint as an equality instead (since if they have more income leftover, they will use it to buy more goods).
This means that any bundle of goods \((x_1,x_2)\) that consumers choose to consume will adhere to the equality above. What does this mean on our graph? Let’s examine the indifference curve plots, assuming that \(M = 32\), and \(p_1 =2\) and \(p_2 = 4\).
[Following image is s graph of a series of nested convex Indifference Curves with a budget constraint ]
The budget constraint is like a possibilities curve: moving up or down the constraint means gaining more of one good while sacrificing the other.
Let’s take a look at what this budget constraint means. Because of the budget constraint, any bundle of goods \((x_1,x_2)\) that consumers ultimately decide to consume will lie on the budget constraint line. Adhering to this constraint where \(M=32, p_1 = 2, p_2 = 4\), we can see that consumers will be able to achieve 2 units of utility, and can also achieve 4 units of utility. But what is the maximum amount of utility that consumers can achieve?
Notice an interesting property about indifference curves: the utility level of the indifference curves gets larger as we move up and to the right. Hence, the maximizing amount of utility in this budget constraint is the rightmost indifference curve that still touches the budget constraint line. In fact, it’ll only ‘touch’ (and not intersect) the budget constraint and be tangential to it.
[Following image is s graph of a series of nested convex Indifference Curves with a budget constraint ]
Notice that as the price of one good increases, the indifference curve that represents the maximum attainable utility shifts towards the left (i.e. the max utility decreases). Intuitively, this makes sense. As the price of one good increases, consumers have to make adjustments to their consumption bundles and buy less of one, or both, goods. Hence, their maximum utility will decrease.
Let’s visualize the budget constraint in 3D where \(M=30, p_1=3, p_2=3\). Here, any point along the curve in which the 2 planes intersect represents an amount of utility in which the budget constraint holds true (i.e. where we’ve spent all our income). The utility maximizing quantity is a point on this intersecting curve at which the utility level is the highest.
[Following image is an interactive 3D plot of Utility increasing with X1 and X2, wih a plane representing the budget constraint]