Chapter 2: Problem 9

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

Short Answer

Expert verified

Individuals make choices directly on the budget constraint because it represents the highest satisfaction or utility they can achieve given their income and the prices of the goods. Choosing a combination inside the budget constraint results in the under-utilization of the consumer's income, leading to lower satisfaction. On the other hand, choosing a combination outside the budget constraint is not feasible due to limited income. Therefore, to maximize their satisfaction, individuals make choices directly on the budget constraint.

Step by step solution

1. Define the Budget Constraint

The budget constraint represents the combinations of two goods that a consumer can purchase given his income and the prices of the goods. Mathematically, it can be represented as: \(I = P_1Q_1 + P_2Q_2\), where \(I\) is the consumer's income, \(P_1\) and \(P_2\) are the prices of the two goods, and \(Q_1\) and \(Q_2\) are the quantities the consumer buys of each good respectively.

2. Graphical Representation of the Budget Constraint

The budget constraint can be illustrated graphically by plotting the combinations of the two goods on a graph with the quantity of one good on the x-axis and the quantity of the other good on the y-axis. The intercepts represent the maximum amount of each good the consumer can buy if they spend all their income on that good. The slope of the budget constraint is equal to the negative ratio of the prices: \(-\frac{P_1}{P_2}\). The budget constraint divides the graph into three regions: points on the budget constraint, points inside the budget constraint, and points outside the budget constraint.

3. Choices Inside the Budget Constraint

Choices made inside the budget constraint represent the combinations of the two goods where the consumer is not spending all of their income. This means that the consumer is not utilizing their purchasing power to the fullest, leading to lower overall satisfaction than they could achieve by choosing a combination on the budget constraint itself.

4. Choices Outside the Budget Constraint

The choices made outside the budget constraint represent unattainable combinations of the two goods. The consumer doesn't have enough income to purchase these combinations of goods, so these choices are not feasible.

5. Importance of Making Choices on the Budget Constraint

The optimal choice for a consumer is to choose a combination of goods on the budget constraint because it represents the highest satisfaction or utility that they can achieve given their income and the prices of the goods. Choosing a combination inside the budget constraint results in the under-utilization of the consumer's income, which leads to lower satisfaction. On the other hand, choosing a combination outside the budget constraint is not feasible due to the limited income. Therefore, individuals make choices directly on the budget constraint in order to maximize their satisfaction.