110Ch08

# 110Ch08 - Chapter 8: Possibilities, Preferences, and...

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Chapter 8: Possibilities, Preferences, and Choices – Objectives Describe a household’s budget line and show how it changes when prices or income changes Make a map of preferences by using indifference curves 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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Consumption Possibilities Household consumption choices are constrained by income and prices. The budget line describes the limits to the household’s consumption choices. Divisible goods can be bought in any quantity desired along the budget line (e.g. gasoline) Indivisible goods are bought in whole units (points marked on the budget line (e.g. movies).
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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The Budget Equation 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 : 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. Similarly, Q M = Y/P M – ( P S /P M )Q S
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 and equals the magnitude of the slope of the budget line. The relative price shows how many sodas must be forgone to see an additional movie.

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Consumption Possibilities A fall in the price of the good on the x -axis increases the affordable quantity of that good and decreases the slope of the budget line. The figure shows the rotation of a budget line after a change in the relative price of movies.
Consumption Possibilities An change in the household’s 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. The figure shows the effect of a fall in income.

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An indifference curve is a curve that shows combinations of goods among which a consumer is indifferent ; she gets the same utility from all points on the curve. At point
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## This note was uploaded on 05/21/2011 for the course ECON 110 taught by Professor Tan during the Spring '07 term at HKUST.

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110Ch08 - Chapter 8: Possibilities, Preferences, and...

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