Ch08 - CHAPTER 8 Possibilities, Preferences, and Choices...

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Possibilities, Preferences, and Choices CHAPTER 8
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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 Make a map of preferences by using indifference curves and explain the principle of diminishing marginal rate of substitution Predict the effects of changes in prices and income on consumption choices Predict the effects of changes in wage rates on work-leisure choices
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Subterranean Movements Like the continents floating on the earth’s mantle, spending patterns change slowly over time, but as they change, business empires rise and fall. The model of consumer choice that we study in this chapter explains such things as: Why as the prices of a music download, iPod, and CD burner have fallen, people are buying more downloads and fewer CDs. Why we don’t (much) buy too many electronic textbooks, even though they are cheaper than printed textbooks.
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Consumption Possibilities 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.
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Consumption Possibilities Figure 8.1 shows Lisa’s budget line. Divisible goods can be bought in any quantity along the budget line (gasoline, for example). Indivisible goods must be bought in whole units at the points marked (movies, for example). Lisa can afford any point on the budget line or inside it.
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Consumption Possibilities The budget line is a constraint on Lisa’s choices. Lisa can afford any point on her budget line or inside it. Lisa cannot afford any point outside her budget line.
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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 P S , the quantity of soda Q S , the price of a movie P M , the quantity of movies Q M , and income Y . Lisa’s budget equation is: P S Q S + P M Q M = Y.
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Consumption Possibilities P S Q S + P M Q M = Y Divide both sides of this equation by P S , to give: Q S + ( P M /P S )Q M = Y/P S Then subtract ( P M /P S )Q M from both sides of the equation to give: Q S = Y/P S – ( P M /P S )Q M The term Y/P S is Lisa’s real income in terms of soda. The term P M /P S is the relative price of a movie in terms of soda.
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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 sodas must be
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Ch08 - CHAPTER 8 Possibilities, Preferences, and Choices...

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