Budget constraint is a basic concept in economic modeling. The framework helps researchers analyze all possible consumption choices that a consumer can make within the constraints of his budget. This can be expressed as a mathematical equation and is equally useful whether the consumer is an individual, a family or a business.
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Budget constraint is a common concept in people's daily lives. Assume, for instance, that you set aside $120 for entertainment per month and enjoy going to the movies as well as eating out. Suppose going to the movies cost $20, while eating at your favorite restaurant costs $30. With your $120, you can go to the movies six times, or eat out four times in a month. However you cannot watch six movies while also eating at the restaurant four times within the same month.The more you engage in one of these activities, the less you can enjoy the other. Budget constraint simply aims to formally express this basic concept.
In the above example, you have other viable ways to divide up your budget between your two favorite types of entertainment activities. You can stay within your budget if you forgo eating out completely and watch six movies in a month. You can also skip the movies and eat out four times a month. Furthermore, you may watch three movies and eat out twice. Or, you can go to the movies just once and eat out three times. This last combination will leave you with $10, which is not enough to watch an additional movie or eat out again.
The amount of money you spend on entertainment per month can be expressed by creating variables for each potential expense, as related to your total amount of money to spend. In the above example, the budget constraint can be written as EC = 20M +30R, where EC stands for entertainment cost, M is the number of times you go the movies and R is the number of times you eat out during the month. To see if a given combination is financially feasible, you can plug the numbers in this equation and compare the resulting EC to your budget. Going to the movies twice and eating out three times produces an expenditure of $130, for example, and exceeds your budget.
The concept of budget constraint is equally useful for a business. Naturally, a large business may spend money on a wider variety of items than a single individual or a family. Therefore, businesses use financial software to crunch complex budget equations. The basic idea is always the same; your total expenditure must stay below your budget and the more you spend on one good or service, the less you can allocate to others. To ease the calculations, large businesses divide their budgets among departments or activities such as marketing, production and customer service, performing calculations separately for each department.