Chapter 9: Possibilities, preferences and choices
Consumption possibilities
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Household consumption choices are constrained by its income and the prices of the goods and services available. The budget line describes the limits to the household’s consumption choices.
The Budget Equation: We can describe the budget line by using a budget equation. Expenditure = Income.
For example: Lisa’s budget equation is: price of pop PP, the quantity of pop QP+ the price of a movie PM, the quantity of movies QM = income Y
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.
tity of that good and increases the slope of the budget line.
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.
Preferences and indifferences curves
Preferences
Utility is the measurement of preference
We always want to consume more (satisfaction)
A household’s preferences determine the benefits or satisfaction a person receives consuming a good or service.
The benefit or satisfaction from consuming a good or service is called utility.
Total utility is the total benefit (satisfaction) a person gets from the consumption of goods. Generally, more consumption gives more utility.
An indifference curve: An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. (convex/variety/combo is preferred)
The slope of IC is decreasing = -MRS
Marginal Rate of Substitution (MRS) measures 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 (remain on the same indifference curve). The magnitude of the slope of the indifference curve measures the marginal rate of substitution.
If the indifference curve is relatively steep, the MRS is high. In this case, the person is willing to give up a large quantity of y to get a bit more x.
If the indifference curve is relatively flat, the MRS is low. In this case, the person is willing to give up a small quantity of y to get more x.
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, while at the same time remain indifferent as the quantity of good x increases.
Degree of Substitutability: The shape of the indifference curves reveals the degree of substitutability between two goods.
Best/Optimal Affordable Choice: The consumer’s best affordable choice 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.
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.
A Change in Income: The effect of a change in income on the quantity of a good consumed is called the income effect
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Substitution Effect and Income Effect
For a normal good, a fall in price always increases the quantity consumed.
We can prove this assertion by dividing the price effect in two parts: Substitution effect and Income effect
The substitution effect is the effect of a change in price on the quantity bought when the consumer remains on the same indifferent curve.
Income Effect To isolate the income effect, we reverse the hypothetical pay cut and restore Lisa’s income to its original level (its actual level).
Inferior Goods
For an inferior good, when income increases, the quantity bought decreases.
The income effect is negative and works against the substitution effect.
So long as the substitution effect dominates, the demand curve still slopes downward.