9 POSSIBILITIES,

PREFERENCES, AND
CHOICES
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

Use indifference curves to map preferences and

explain the principle of diminishing marginal rate
of substitution

Predictthe effects of changes in prices and

income on consumption choices
CONSUMPTION POSSIBILITIES

• A household’s 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.
 CONSUMPTION POSSIBILITIES

• Budget Line
• Lisa has $40 to spend, the price of a movie is $8, and the price of soda is $4 a
case.
 CONSUMPTION POSSIBILITIES

• Lisa can afford any of the

combinations at points A to
F.
• Some goods are indivisible
goods and must be bought
in whole units at the points
marked.
• Movies are indivisible
goods.
 CONSUMPTION POSSIBILITIES

• Other goods are divisible

goods and can be bought
in any quantity.
• Gasoline is a divisible
good.
• The line through points A
to F is Lisa’s budget line.
 CONSUMPTION POSSIBILITIES

• The budget line is a

constraint on Lisa’s
consumption 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

• PS Q S + PM Q M = 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

• Y/PS is Lisa’s real income in terms of soda.

• PM/PS is the relative price of a movie in terms of soda.

CONSUMPTION POSSIBILITIES

• A household’s real income is the income expressed as a

quantity of goods the household can afford to buy.
• Lisa’s real income in terms of soda is the point on her budget
line where it meets the y-axis.
• A relative price is the price of one good divided by the price
of another good.
• Relative price is the magnitude of the slope of the budget
line.
• The relative price shows how many cases of soda must be
forgone to see an additional movie.
 CONSUMPTION POSSIBILITIES

•A Change in Prices
•A change in the price of the good on
the x-axis changes the slope of the
budget line.
•Figure 9.2(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 9.2(b) shows the effect of a fall
in income.
 PREFERENCES AND INDIFFERENCE
CURVES
•We can represent Lisa’s preference as
a map.
•An indifference curve is a line that
shows combinations of goods among
which a consumer is indifferent.
•At point C, Lisa sees 2 movies and
drinks 6 cases of soda a month.
•Figure 9.3(a) illustrates Lisa’s
indifference curve.
 PREFERENCES AND INDIFFERENCE
CURVES
• Lisa can sort all possible
combinations of goods into
three groups: preferred to C, not
preferred to C, and just as good
as C.
• 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
• Lisa prefers any point above the
indifference curve to any point
on the curve.
• Lisa prefers any point on the
indifference curve to any point
below the indifference curve.
 PREFERENCES AND INDIFFERENCE
CURVES
•A preference map is a series of
indifference curves.
•Call the indifference curve that we’ve
just seen I1.
•I0 is an indifference curve below I1.
• Lisa prefers any point on I1 to any
point on I0 .
 PREFERENCES AND 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
to get an additional unit of good x, while at the same
time remaining indifferent (remaining on the same
indifference curve).
• The magnitude of the slope of the indifference curve
measures the marginal rate of substitution.
 PREFERENCES AND INDIFFERENCE
CURVES
 If the indifference curve is relatively steep, 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, MRS is low.
• In this case, the person is willing to give up a small quantity of y
to get more x.
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, while at the same time
remaining indifferent as the quantity of good x increases.
 PREFERENCES AND INDIFFERENCE
CURVES
• Figure 9.4 shows the diminishing
MRS of movies for soda.
• At point C, Lisa is willing to give up
10 cases of soda to see 5 more
movies—her MRS is 2.
• At point G, Lisa is willing to give up
4.5 cases of soda to see 9 more
movies—her MRS is ½.
 PREFERENCES AND INDIFFERENCE
CURVES
• Degree of Substitutability
• The shape of the indifference curves reveals the degree of substitutability
between two goods.
• Figure 9.5 shows the indifference curves for ordinary goods, perfect substitutes,
and perfect complements.
 PREDICTING CONSUMER
CHOICES
• Best Affordable Choice
• The consumer’s best affordable choice
Is on the budget line.
Is on the highest attainable indifference curve.
Has marginal rate of substitution equal to relative price.
 PREDICTING CONSUMER CHOICES

• 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 prefers
C to I.
 PREDICTING CONSUMER CHOICES

• 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 PM/PS .
 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 9.7 illustrates the price effect and
shows how the consumer’s demand curve is
generated.
• Initially, the price of a movie is $8 and Lisa
consumes at point C in part (a) and at point
A in part (b).
 PREDICTING …

• Now the price of a movie falls to $4.

• The budget line rotates outward.
• Lisa’s best affordable point is now J in
part (a).
• 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
buying plans is called the income
effect.
• Figure 9.8 illustrates the effect of a
decrease in Lisa’s income with no
change in the prices.
• Initially, Lisa consumes at point J in part
(a) and at point B on demand curve D0 in
part (b).
 PREDICTING …

• When Lisa’s income decreases, 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).
PREDICTING CONSUMER
CHOICES
• 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
 Income effect
 PREDICTING CONSUMER CHOICES

• Initially, Lisa has an income of $40,

the price of a movie is $8, and she
consumes at point C.
• The price of a movie falls from $8 to
$4 and her budget line rotates
outward.
• Lisa’s best affordable point is then J.
• The move from point C to point J is
the price effect.
 PREDICTING CONSUMER CHOICES

• We’re going to break the move from

point C to point J into two parts:
• 1. The substitution effect
• 2. The income effect
 PREDICTING CONSUMER CHOICES

• Substitution Effect
• The substitution effect is the effect
of a change in price on the quantity
bought when the consumer remains
on the same indifference curve.
 PREDICTING CONSUMER CHOICES

• To isolate the substitution effect,

we give Lisa a hypothetical pay
cut.
• Lisa is now back on her original
indifference curve but with the
price of a movie at $4.
• Her best affordable point is K.
• The move from C to K is the
substitution effect.
 PREDICTING CONSUMER CHOICES

• The direction of the substitution effect

never varies:
• When the relative price falls, the
consumer always substitutes more of
that good for other goods.
• The substitution effect is the first
reason why the demand curve slopes
downward.
 PREDICTING CONSUMER CHOICES

• 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).
• Lisa is now back on indifference
curve I2 and her best affordable point
is J.
• The move from K to J is the income
effect.
 PREDICTING CONSUMER CHOICES

• For Lisa, movies are a normal good.

• With more income to spend, she sees
more movies—the income effect is
positive.
• For a normal good, the income effect
reinforces the substitution effect and
is the second reason why the demand
curve slopes downward.
PREDICTING CONSUMER
CHOICES
• Inferior Goods
• For an inferior good, when income increases, the quantity
bought decreases.
• The income effect is negative and works against the
substitution effect.
• As long as the substitution effect dominates, the demand
curve still slopes downward.
PREDICTING CONSUMER
CHOICES
• If the negative income effect is stronger than the substitution
effect, a lower price for inferior goods brings a decrease in
the quantity demanded—the demand curve slopes upward!
• This case does not appear to occur in the real world.
• Back to the Facts
• The best affordable choices determine spending patterns.
• Changes in prices and incomes change the best affordable
point and change consumption patterns.