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Chapter 9- Possibilities, Preferences, and Choices

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ECON 101
Emanuel Carvalho

Chapter 9: Possibilities, Preferences, and Choices Consumption Possibilities  Consumption choices are limited by income and by prices  A household’s budget line describes the limits to its consumption choices Divisible and Indivisible Goods  Divisible goods- can be bought in any quantity desired (e.g. gasoline & electricity)  Divisible goods also have intermediate points that form on the budget line Affordable and unaffordable Quantities  A budget line is a constraint on one’s choices  Marks the boundary between what is affordable and what is unaffordable o Can afford any point on the line and inside it  The constraint on her consumption depends on the prices and her income, and the constraint changes when the price of a good or her income changes Budget Equation  Expenditure = Income  Expenditure is equal to the sum of the price of each good multiplied by the quantity bought  E.g. Expenditure = (Price of pop X Quantity of pop) + (Price of a movie X Quantity of movie) o PPQ P P M =MY  Example:  $4Q + $8Q = $40 P M o Person can choose quantities which satisfy the equation o Q P (PM/ P P X QM= Y/ PPDivide both sides of the equation by PP o Q = Y/ P - P / P X Q P P M P M  According to the quantities desired, sub into the equation o Q P $40/$4- $8/$4X Q M =10 - 2 QMInterpret equation from budget line (slope) Real Income  A household’s real income is its income expressed as a quantity of goods that the household can afford to buy  Equal to money divided by the price of the good Relative Price  Relative price is the price of one good divided by the price of another good  P / P M P  E.g $8/$2 o Two cases of pop per movie o Or to see one movie, person must give up two cases of pop  Opportunity cost of seeing a movie  The relative price of a movie in terms of pop is the magnitude of the slope of the budget line  Recall formula: Slop equals the change in the variable measured on the x-axis as we move along the line  Magnitude of slope = relative price also the opportunity cost of movie A Change in Prices  The lower the price of the good measured on the x-axis, other things remaining the same, the flatter is the budget line  The higher the price of the good measured on the x-axis, other things remaining the same, the steeper is the budget line A Change in Income  A change in money income changes real income but does not change the relative price  The budget line shifts but the slope does not change  Increase in money income shifts the budget line rightward and vice versa Preferences and Indifference Curves  A preference map is based on the intuitively appealing idea that people can sort all the possible combinations of goods into three groups: preferred, not preferred, and indifferent  Indifference curve: a line that shows combinations of goods among which a consumer is indifferent  Person is just as happy on any point of the curve  Prefers all the combinations above the indifference curve  Does not prefer the combinations below the indifference curve  If higher, called higher indifference curve  A preference map is a series of indifference curves that resemble the contour lines on a map  By looking at the shape of the contour lines, we can draw conclusions Marginal Rate of Substitution  Marginal rate of substitution (MRS): is the rate at which a person will give up good y (the good measured on the y-axis) to get an additional unit of good x (the good measured on the x- axis)while remaining indifferent (remaining on the same indifference curve)  The magnitude of the slope of an indifference curve measures the marginal rate of substitution  If the indifference curve is steep, the marginal rate of substitution is high. The person is willing to give up a large quantity of good y to get an additional unit of good x while remaining indifferent  If the indifference curve is flat, the marginal rate of substitution is low. The person is willing to give up a small amount of good y to get an additional unit of good x while remaining indifferent  To measure the magnitude, place a straight line against, or tangent to, the indifferent curve at point G See pg.208  As one consumers more of A and less of B, a person’s marginal rate of substitution diminishes  Diminishing marginal rate of substitution is the key assumption about preferences  Diminishing marginal rate of substitution: 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 x increases Your Own Diminishing Marginal Rate of Substitution  General rule: The greater of good A you consume, the smaller the quantity of good B you are willing to give up to consumer one additional A  The shape of a person’s indifference curves incorporates the principle of the diminishing marginal rates of substitution because the curves are bowed towards the origin  The tightness of the bend of an indifference curve tells us how willing a person is to substitute one good
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