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8
POSSİBİLİTİES,
PREFERENCES,
AND CHOİCES
Outline
Subterranean Movements
A. Like the continents floating on the earth’s mantle, spending
patterns change slowly over time, but as they change, business
empires rise and fall.
B. The model of consumer choice that we study in this chapter
explains such things as why we download music, even if it costs
the same as buying a CD and why we don’t (much) download audio
books, even though they are cheaper than buying them on audio
tapes.
I.
Consumption Possibilities
A. 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.
Figure 8.1 (page 168) shows a consumer’s budget line.
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1.Divisible goods can be bought in any quantity desired
(gasoline, for example)
2.Indivisible goods must be bought in whole units (movies, for
instance).
B. The Budget Equation
1. We can describe the budget line by using a budget equation,
which states that income equals expenditure.
a) Calling the price of soda PS, the quantity of soda QS, the
price of a movie PM, the quantity of movies QM, and income
Y, we can write Lisa’s budget equation as:
PSQS + PMQM = Y,
which can be rearranged as:
QS = Y/PS – PM/PS  QM.
2. A household’s real income is the household’s income expressed
as a quantity of goods the household can afford to buy. For
example, the vertical intercept for the above budget line,
Y/PS ,is the consumer’s real income in terms of soda.
3. A relative price is the price of one good divided by the price
of another good. For example, the magnitude of the slope of
the budget line, PM/PS is the relative price of a movie in
terms of soda. This relative price shows how many sodas must
be foregone to see an additional movie.
4. The budget line slope is reflects the rate at which one good
can be substituted for another good while keeping the level
of income unchanged. The budget line changes if the relative
price of a good changes or shifts if the household’s income
changes.
a) A fall in the price of the good on the horizontal
(vertical) axis increases the total affordable quantity of
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that good and decreases (increases) the slope of the
budget line. Figure 8.2a (page 170) shows the rotation of
a budget line after a change in the relative price of
movies.
b) An increase (decrease) in the household income causes a
parallel shift of the budget line rightward (leftward).
The slope of the budget line does not change with income,
as is indicated in Figure 8.2b (page 170).
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II. Preferences and Indifference Curves
A. Figure 8.3 (page 171) illustrates a consumer’s indifference
curve and indifference map, which is based on the idea that
people can sort all possible combinations of goods into three
groups: preferred, not preferred and indifferent.
1. An indifference curve shows those combinations of goods among
which a consumer is indifferent.
a) The consumer prefers points above the curve to points on
the curve. And the consumer prefers points on the curve to
points below the curve.
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b) But the consumer is indifferent among (hence its name) all
the points on an indifference curve.
2. A single indifference curve is one of a family of curves that
form an indifference map, which resemble the contour lines on
a topographical map.
B. Marginal Rate of Substitution
1. The marginal rate of substitution, (MRS) measures the rate at which
a person will give up good y, (the good measured on the yaxis) 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).
2. The magnitude of the slope of the indifference curve measures
the marginal rate of substitution.
a)If the indifference curve is relatively steep (flat), the
MRS is high (low).
3. The diminishing marginal rate of substitution is the tendency for the
marginal rate of substitution of good x for good y to fall as
more of good x is consumed. Figure 8.4 (page 172) shows the
diminishing MRS of movies for soda.
C.
Degree of Substitutability
1.Figure 8.5a (page 173) shows the indifference curves for
ordinary goods, which display diminishing MRS.
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2.Figure 8.5b (page 173) shows the indifference curves for
perfect substitutes, which are straight lines with a constant
MRS.
3.Figure 8.5c (page 173) shows the indifference curves for
perfect compliments, which are L-shaped.
III. Predicting Consumer Behavior
A. The consumer’s best affordable point, illustrated in Figure 8.6
(page 174) is:
1. On the budget line.
2. On the highest attainable indifference curve.
3. Has a marginal rate of substitution between the two goods
equal to the relative price of the two goods.
B. A Change in Price
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1. The price effect shows how a change in the price of a good
affects the quantity of that good demanded.
2. As the price of the good on the x-axis decreases (increases),
the budget line rotates on the y-axis intercept quantity and
becomes flatter (steeper).
a) Figure 8.7a (page 175) shows how a fall in the price of
movies leads the consumer to substitute away from sodas
and into movies. The change in the relative price changes
the best affordable point. The consumer can reach a higher
indifference curve by substituting away from the
relatively more expensive good and toward the relatively
inexpensive good.
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b) 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.
3. Tracking the change in the quantity of the good for which the
price falls reveals the demand curve for that good, like the
one shown in Figure 8.7b (page 175).
C. A Change in Income
1. The income effect is the effect of a change in income on the
quantity of a good consumed.
2. As the consumer’s income increases, the budget line shifts
outward from the origin. The set of affordable combinations
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of goods increases, which enables the consumer to reach a
higher indifference curves. Figure 8.8a (page 176) shows how
a decrease in a consumer’s income forces her to a lower
indifference curve and decreases the demand for movies.
3. The relative price of the goods has not changed, so the slope
of the budget line remains constant. 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.
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4. When a good is a normal good, the quantity of the good
consumed will increase (decrease) as income increases
(decreases). Since the quantity of the good consumed has
increased (decreased) without a change in the relative price
for the goods, this indicates that the demand curve for that
good has shifted rightward (leftward) as income increased
(decreased). Figure 8.8b (page 176) shows how a decrease in a
consumer’s income forces her to consume fewer movies even
though the price hasn’t changed. This reveals that the demand
curve for movies has shifted leftward.
5. When a good is an inferior good, the quantity of the good
consumed will decrease (increase) as income increases
(decreases). Since the quantity of the good consumed has
decreased (increased) without a change in the relative price
for the goods, this indicates that the demand curve for that
good has shifted leftward (rightward) as income increased
(decreased).
D. Substitution Effect and Income Effect
1. For a normal good, a fall in price always increases the
quantity consumed. We can prove this proposition by breaking
the price effect in two different parts:
a) The substitution effect is the effect of a change in price on
the quantity bought when the consumer remains indifferent
between the original situation and the new situation. To
analyze this effect, let the consumer move along the same
indifference curve until the MRS equals the slope of the
new budget line reflecting the change in price. This
increases the quantity of lower priced good.
b) The income effect is the effect of a change in income
sufficient to get the consumer to the highest affordable
indifference curve attainable on the new budget line
reflecting the price change. To analyze this effect, shift
the budget line away from the origin until the highest
affordable indifference curve is reached. With a normal
good, the quantity of the good consumed increases with
income.
2. In the case of normal goods, the substitute effect and the
income effect reinforce each other, and a decrease (increase)
in the price of a good will always cause an increase
(decrease) in the quantity of the good demanded. This is a
downward-sloping demand curve for that good.
3. Figure 8.9a (page 177) shows the price effect from a relative
price change for movies. Figure 8.9b (page 177) shows how
this price effect can be broken down into the substitution
effect and the income effect.
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4.For an inferior good, a fall (rise) in price will not always
increase (decrease) the quantity consumed.
a) In this case the income effect is negative and counteracts
the substitution effect.
b) If the negative income effect is stronger than the
substitution effect, then a lower (higher) price for
inferior goods does not lead to an increase (decrease) in
the quantity of that good demanded.
c) The demand curve in this case will have a positive slope,
but such a case has not been found in any market for real
world goods or services.
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IV. Work-Leisure Choices
A. Labor Supply
1. Indifference curves can be used to study the allocation of
time between work and leisure.
2. The two “goods” are leisure and income, which represents all
other goods.
B. The Labor Supply Curve
1. By changing the wage rate, we can find a person’s labor
supply curve.
2. A higher wage rate makes leisure relatively more expensive
(higher opportunity cost to not working) and has a
substitution effect toward less leisure (toward more work).
3. A higher wage also has a positive income effect, which
encourages increased consumption of leisure (less work).
a) If the income effect is weaker than the substitution
effect, the quantity of work hours increases with the wage
rate.
b) If the income effect is stronger than the substitution
effect, then the quantity of work hours could decrease with
the wage rate.
4.Historical evidence shows that the average workweek has
declined over the centuries, implying that people have
preferred to seek greater leisure despite its higher
opportunity cost.