8 Possibilities, Preferences, and Choices CHAPTER Possibilities, Preferences, and Choices Notes and teaching tips: 4, 15, 30, 35, and 39. To view a full-screen figure during a class, click the red “expand” button. To return to the previous slide, click the red “shrink” button. To advance to the next slide, click anywhere on the full screen figure.

After studying this chapter you will be able to Describe a household’s budget line and show how it changes when prices or income change Make a map of preferences by using indifference curves and explain the principle of diminishing marginal rate of substitution Predict the effects of changes in prices and income on consumption choices

Consumption Possibilities The budget line is a constraint on Lisa’s choices. Lisa can afford any point on her budget line or inside it. Lisa cannot afford any point outside her budget line.

Consumption Possibilities The Budget Equation We can describe the budget line by using a budget equation. The budget equation states that Expenditure = Income Call the price of soda PS, the quantity of soda QS, the price of a movie PM, the quantity of movies QM, and income Y. Lisa’s budget equation is: PSQS + PMQM = Y.

Consumption Possibilities PSQS + PMQM = Y Divide both sides of this equation by PS, to give: QS + (PM/PS)QM = Y/PS Then subtract (PM/PS)QM from both sides of the equation to give: QS = Y/PS – (PM/PS)QM The term Y/PS is Lisa’s real income in terms of soda. The term PM/PS is the relative price of a movie in terms of soda.

Consumption Possibilities A Change in Prices A rise in the price of the good on the x-axis decreases the affordable quantity of that good and increases the slope of the budget line. Figure 8.2(a) shows the rotation of a budget line after a change in the relative price of movies.

Consumption Possibilities A Change in Income An change in money income brings a parallel shift of the budget line. The slope of the budget line doesn’t change because the relative price doesn’t change. Figure 8.2(b) shows the effect of a fall in income.

Preferences and Indifference Curves An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. Figure 8.3(a) illustrates a consumer’s indifference curve. At point C, Lisa consumes 2 movies and 6 six-packs a month. Decisions, decisions: Chardonnay or cheesecake? What combination of food and drink will the diner select? It depends upon the willingness to give up some food for additional drink. Is the diner willing to forgo the appetizer in order to enjoy a second glass of wine with dinner? Or will the diner have only ice water in order to afford a dessert after the main course? Have them construct a preference map reflecting the diner’s indifference between exchanging a quantity of drink for a quantity of food. (Be sure that the indifference curves for both scenarios reflect diminishing marginal rate of substitution.)

Preferences and Indifference Curves Lisa can sort all possible combinations of goods into three groups: preferred, not preferred, and indifferent. An indifference curve joins all those points that Lisa says are just as good as C. G is such a point. Lisa is indifferent between C and G.

Preferences and Indifference Curves All the points above the indifference curve are preferred to the points on the curve. And all the points on the indifference curve are preferred to the points below the curve.

Preferences and Indifference Curves A preference map is series of indifference curves. I2 is an indifference curve above I1. Lisa prefers any point on I2 to any point on I1 . For example, Lisa prefers point J to either point C or point G.

Preferences and Indifference Curves Marginal Rate of Substitution The marginal rate of substitution, (MRS) measures the rate at which a person is willing to give up good y, (the good measured on the y-axis) to get an additional unit of good x (the good measured on the x-axis) and at the same time remain indifferent (remain on the same indifference curve). The magnitude of the slope of the indifference curve measures the marginal rate of substitution.

Preferences and Indifference Curves A diminishing marginal rate of substitution is the key assumption of consumer theory. A diminishing marginal rate of substitution is a general tendency for a person to be willing to give up less of good y to get one more unit of good x, and at the same time remain indifferent, as the quantity of good x increases.

Preferences and Indifference Curves Figure 8.4 shows the diminishing MRS of movies for soda. At point C, Lisa is willing to give up 2 six-packs to see one more movie—her MRS is 2. At point G, Lisa is willing to give up 1/2 a six-pack to see one more movie—her MRS is 1/2.

Preferences and Indifference Curves Degree of Substitutability The shape of the indifference curves reveals the degree of substitutability between two goods. Figure 8.5 shows the indifference curves for ordinary goods, perfects substitutes, and perfect complements.

Predicting Consumer Behavior The consumer’s best affordable point is: On the budget line On the highest attainable indifference curve Has a marginal rate of substitution between the two goods equal to the relative price of the two goods

Predicting Consumer Behavior Here, the best affordable point is C. Lisa can afford to consume more soda and see fewer movies at point F. And she can afford to see more movies and consume less soda at point H. But she is indifferent between F, I, and H and she clearly prefers C to I. Waiter? We’re ready to order now. Have the students identify which combination of food and drink would equate the MRS to the relative price ratio for a given budget. Have the students show how a rise in the price of drinks would rotate the budget line and push the diner away from drink and toward food. Show how an increase in income shifts the budget line, allowing both dessert and the second glass of wine. The meaning of tangency. Emphasize to the student the meaning behind the tangency point between the indifference curve and the budget line. The marginal rate of substitution (MRS) shows the consumer’s willingness to give up one good to get more of the other good. The relative price of the two goods shows what the consumer must give up one good to get more of the other good. When a consumer equates the marginal rate of substitution (MRS) with the relative price ratio, he or she leaves no unrealized gains from substituting one good for another. The consumer is just willing to give up what he or she must give up, and there are no unrealized gains from substituting one good for another.

Predicting Consumer Behavior At point F, Lisa’s MRS is greater than the relative price. At point H, Lisa’s MRS is less than the relative price. At point C, Lisa’s MRS is equal to the relative price.

Predicting … A Change in Price The effect of a change in the price of a good on the quantity of the good consumed is called the price effect. Figure 8.7 illustrates the price effect and shows how the consumer’s demand curve is generated. Initially, the price of a movie is $6 and Lisa consumes at point C in part (a) and at point A in part (b).

Predicting … The price of a movie then falls to $3. The budget line rotates outward. Lisa’s best affordable point is now J in part (a). Explain that the fall in the price of a movie leads Lisa to substitute away from sodas and into movies. The change in the relative price changes the best affordable point. She can reach a higher indifference curve by substituting away from the relatively more expensive good and toward the relatively inexpensive good. The new consumption bundle satisfies the three properties: it is on the new budget line, it is on the highest attainable indifference curve, and the MRS has changed, matching the slope of new budget line. Also emphasize that tracking the change in the quantity of the good for which the price falls reveals the demand curve for that good. In part (b), Lisa moves to point B, which is a movement along her demand curve for movies.

Predicting … A Change in Income The effect of a change in income on the quantity of a good consumed is called the income effect. Figure 8.8 illustrates the effect of a decrease in Lisa’s income. Initially, Lisa consumes at point J in part (a) and at point B on demand curve D0 in part (b).

Predicting … Lisa’s income decreases and her budget line shifts leftward in part (a). Her new best affordable point is K in part (a). Her demand for movies decreases, shown by a leftward shift of her demand curve for movies in part (b).

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