possibilities, preferences, and choices (Consumption Possibilities (…
possibilities, preferences, and choices
Household consumption choices are constrained by its income and the prices of the goods and services available
the limits to the household’s consumption choices.
The Budget Equation
Expenditure = Income
PPQP + PMQM = Y
QP = Y/PP – (PM/PP)QM
A relative price is the price of one good divided by the price of another good.
A household’s real income is the income expressed as a quantity of goods the household can afford to buy.
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
A Change in Income
An change in money income brings a parallel shift of the budget line.
Preferences and Indifference Curves
An indifference curve is a line that shows combinations of goods among which a consumer is indifferent.
All the points on the indifference curve are preferred to all the points below the indifference curve.
Marginal Rate of Substitution
the rate at which a person is willing to give up good y to get an additional unit of good x while at the same time remain indifferent
The magnitude of the slope of the indifference curve
the marginal rate of substitution
If the indifference curve is relatively flat
the MRS is low
If the indifference curve is relatively steep
the MRS is high
diminishing marginal rate of substitution
the key assumption of consumer theory
a general tendency for a person to be willing to give up less of good y to get one more unit of good x, while at the same time remain indifferent as the quantity of good x increases
Best Affordable Choice
The consumer’s best affordable choice
On the budget line
Has a marginal rate of substitution between the two goods equal to the relative price of the two goods
On the highest attainable indifference curve