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ECONOMICS 5e
Michael Parkin
Possibilities,
Preferences, and
Choices
Learning Objectives
• Calculate and graph a household’s budget
line
• Work out how the budget line changes
when prices or income changes
• Make a map of preferences by using
indifference curves
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-2
Learning Objectives (cont.)
• Explain the choices that households make
• Predict the effects of price and income
changes on consumption choices
• Predict the effects of wage changes on
work-leisure choices
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-3
Learning Objectives
• Calculate and graph a household’s budget
line
• Work out how the budget line changes
when prices or income changes
• Make a map of preferences by using
indifference curves
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-4
Consumption Possibilities
• Consumption choices are limited by income
and prices.
• A budget line describes the limits to a
household’s consumption choices.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-5
Consumption Possibilities
Divisible and Indivisible Goods
Divisible goods can be bought in any quantity
desired
ex. gasoline
Indivisible goods cannot be bought in all
quantities
ex. movies
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-6
The Budget Line
Lisa’s Income is $30
Consumption
Movies ($6)
Soda ($3)
possibility
(per month)
(six-packs per month)
a
0
10
b
1
8
c
2
6
d
3
4
e
4
2
f
5
0
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-7
Soda (six-packs per month)
The Budget Line
10
a
b
8
Income $30
Movies $6
Soda
$3
c
6
Unaffordable
d
4
Affordable
e
2
f
0
1
2
3
4
5
6
7
8
9
10
Movies (per month)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-8
The Budget Equation
The budget equation is based upon:
Expenditure = Income
$3Qs + $6Qm = $30
Qs = 10 – 2Qm
The quantity of soda can be found by first
setting the quantity of movies.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-9
The Budget Equation
Real Income is the maximum quantity of a
good that a household can afford to buy.
Lisa’s Real Income (in terms of soda) is:
Income/Price of soda = y/Ps
$30/$3 = 10 six packs
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-10
Learning Objectives
• Calculate and graph a household’s budget
line
• Work out how the budget line changes
when prices or income changes
• Make a map of preferences by using
indifference curves
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-11
The Budget Equation
Relative Price
A relative price is the price of one good
divided by the price of another good.
Lisa’s relative price of a movie in terms of
soda: $6/$3 = 2 six-packs per movie
In other words, to see one more movie, Lisa
must give up 2 six-packs (i.e. opportunity
cost)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-12
Soda (six-packs per month)
Changes in Prices and Income
A Change in Price
10
a
Price of a
movie is...
8
6
4
2
0
Copyright © 1998 Addison Wesley Longman, Inc.
…$12
…$6
f
…$3
1 2 3 4 5 6 7 8 9 10
Movies (per month)
TM 9-13
Changes in Prices and Income
Soda (six-packs per month)
A Change in Income
10
a
8
6
4
2
0
Copyright © 1998 Addison Wesley Longman, Inc.
Income
$15
1
2
3
4
f
5
Income
$30
6
7
8
9
10
Movies (per month)
TM 9-14
Learning Objectives
• Calculate and graph a household’s budget
line
• Work out how the budget line changes
when prices or income changes
• Make a map of preferences by using
indifference curves
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-15
Preferences and
Indifference Curves
An indifference curve is a line that shows
combinations of goods among which a
consumer is indifferent.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-16
A Preference Map
Soda (six-packs per month)
An indifference curve
10
8
c
6
Preferred
4
Not
preferred
2
0
Copyright © 1998 Addison Wesley Longman, Inc.
2
4
g
6
8
10
Movies (per month)
TM 9-17
A Preference Map
A preference map is a series of indifference
curves.
A preference map consists of an infinite
number of indifference curves; each one
slopes downward, and none of them
intersects.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-18
Soda (six-packs per month)
A Preference Map
10
8
6
c
j
4
2
I2
g
I0
0
Copyright © 1998 Addison Wesley Longman, Inc.
2
4
6
8
I1
10
Movies (per month)
TM 9-19
Learning Objectives (cont.)
• Explain the choices that households make
• Predict the effects of price and income
changes on consumption choices
• Predict the effects of wage changes on
work-leisure choices
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-20
Marginal Rate of Substitution
The marginal rate of substitution (MRS) is
the rate at which a person will give up one
good in order to get more of another good
and at the same time remain indifferent.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-21
Marginal Rate of Substitution
The marginal rate of substitution (MRS) is
measured by the slope of an indifference
curve.
• Steep indifference curves have a high MRS.
• Flat indifference curves have a low MRS.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-22
Soda (six-packs per month)
Marginal Rate of Substitution
10
8
MRS = 2
6
c
4
MRS = 1/2
2
g
I1
0
2
4
6
8
10
Movies (per month)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-23
Marginal Rate of Substitution
Notice:
As the consumption of movies increases,
the MRS decreases.
This is referred to as the diminishing marginal
rate of substitution.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-24
The Degree of Substitutability
The shape of the indifference curves reveals
the degree of substitutability between two
goods.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-25
Soda (cans)
Degree of Substitutability
Ordinary goods
10
8
6
4
2
0
2
4
6
8
10
Movies
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-26
Marker pens at the local supermarket
Degree of Substitutability
Perfect substitutes
10
8
6
4
2
0
2
4
6
8
10
Marker pens at the campus bookstore
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-27
Left running shoes
Degree of Substitutability
Perfect complements
5
4
3
2
1
0
1
2
3
4
5
Right running shoes
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-28
Predicting Consumer Behavior
Individuals maximize their utility given
their income budget line when they:
• Are on their their highest attainable indifference
curve.
• Have a marginal rate of substitution between
the two goods equal to their relative price.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-29
Soda (six-packs per month)
The Best Affordable Point
10
Best
affordable
point
8 f
c
6
4
i
I2
2
0
h
2
4
I0
6
8
I1
1
10
Movies (per month)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-30
Learning Objectives (cont.)
• Explain the choices that households make
• Predict the effects of price and income
changes on consumption choices
• Predict the effects of wage changes on
work-leisure choices
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-31
Predicting Consumer Behavior
What effect will changes in prices and income
have on the best affordable point?
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-32
A Change in Price
Price effect
The effect of a change in price on
quantity of a good consumed.
A change in the price of a good will
shift the budget line and will change
the best affordable combination.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-33
Soda (six-packs per month)
Price Effect and Demand Curve
10
Best affordable
point: movies $6
8
c
6
5
4
j
Best affordable
point: movies $3
I2
2
I1
0
2
4 5 6
8
10
Movies (per month)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-34
Price (dollars per movie)
Price Effect and Demand Curve
a
6
5
4
b
3
2
Lisa’s demand
curve for movies
1
0
Copyright © 1998 Addison Wesley Longman, Inc.
2
4
5 6
8
10
Movies (per month)
TM 9-35
Predicting Consumer Behavior
What effect will changes in Lisa’s income have
on the best affordable point?
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-36
A Change in Income
Income effect
The effect of a change in income on
consumption.
A change in income will shift the
budget line and will change the best
affordable combination.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-37
Soda (six-packs per month)
Income Effect and
Change in Demand
10
8
Income
$30
6
j
4
3
2
0
Copyright © 1998 Addison Wesley Longman, Inc.
I2
Income
$21
2
I1
4
6
8
10
Movies (per month)
TM 9-38
Price (dollars per movie)
Income Effect and
Change in Demand
6
5
4
b
c
3
2
1
0
Copyright © 1998 Addison Wesley Longman, Inc.
D1 D0
2
4
6
8
10
Movies (per month)
TM 9-39
Substitution Effect and
Income Effect
Substitution effect
The effect of a change in price on the
quantity bought when the consumer
(hypothetically) remains indifferent
between the original and the new situation.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-40
Substitution Effect and
Income Effect
Income effect
The change in consumption that results
from a change in the consumer’s income,
ceteris paribus.
The substitution and income effects can be
calculated using the indifference curves and
budget line.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-41
Soda (six-packs per month)
Substitution Effect and
Income Effect
Price Effect
10
Income $30
Movies $3
8
c
6
5
4
2
0
Copyright © 1998 Addison Wesley Longman, Inc.
j
I2
Income $30
Movies $6
2
I1
4
5 6
8
10
Movies (per month)
TM 9-42
Soda (six-packs per month)
Substitution Effect and
Income Effect
Substitution effect and price effect
10
8
7
6
5
4
3
2
Substitution
effect
c
Income
effect
j
k
Substitution
effect
I2
I1
0
Copyright © 1998 Addison Wesley Longman, Inc.
2
4 5
6
8
10
Movies (per month)
TM 9-43
Learning Objectives (cont.)
• Explain the choices that households make
• Predict the effects of price and income
changes on consumption choices
• Predict the effects of wage changes on
work-leisure choices
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-44
Work-Leisure Choices
• Households must also make choices on how
to allocate their time between labor and
leisure.
• More leisure means less income. We buy
leisure by foregoing income.
• The relationship between leisure and
income is described by the income-time
budget line.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-45
Work-Leisure Choices
• As wage rates increase, people substitute
labor for leisure — substitution effect.
• However, higher wage rates lead to higher
income which causes people to shift toward
more leisure — income effect.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-46
The Supply of Labor
Income (dollars per week)
Time allocation decision
$15
$10
450
350
c
b
$5
100
0
100
Copyright © 1998 Addison Wesley Longman, Inc.
a
133 138 148
Z
I2
I1
I0
168
Leisure (hours per week)
TM 9-47
Wage rate (dollar per hour)
The Supply of Labor
c
LS
15
b
10
5
0
Copyright © 1998 Addison Wesley Longman, Inc.
a
20
30
35
Labor (hour per week)
TM 9-48
Labor Supply
Real World Applications
• Work week declines.
• Women in the workforce.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 9-49