CHAPTER 9: POSSIBILITIES, PREFERENCES AND CHOICES
1. Consumption Possibilities
Divisible & indivisible goods
Affordable & unaffordable quantities
2. Effects of changing price & income on the budget line
3. Preferences and Indifference Curves
Properties of indifference curve
negative slope (usually)
never cross each other
convex to the origin (diminishing MRS)
4. Degree of substitutability
Indifference curves for ordinary goods, perfect substitutes &
5. Predicting Consumer Choices
best affordable choice
a change in price
a change in income
6. Substitution effect & Income effect
7. Work leisure choices & the Labour supply curve I. Consumption Possibilities
A. 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.
Figure 1 shows a consumer’s budget line.
1. Divisible goods can be bought in any quantity desired (gasoline, for
2. Indivisible goods must be bought in whole units (movies, for
B. The Budget Equation
1. We can describe the budget line by using a budget equation, which
states that income equals expenditure.
a) Calling the price of Pop P , the quantity Pf pop Q , the price of
a movie PM, the quantity of movieM Q , and income Y, we can
write Lisa’s budget equation as
PP P + P M M= Y,
which can be rearranged as Q p= Y/P P– P MP p Q .M
2. A household’s real income is the household’s income expressed as
a quantity of goods the household can afford to buy. For example,
the vertical intercept for the above budget line, Y/P , is tPe
consumer’s real income in terms of pop.
3. A relative price is the price of one good divided by the price of
another good. For example, the magnitude of the slope of the
budget line, P MP Ps the relative price of a movie in terms of pop.
This relative price shows how much pop must be forgone to see an
4. The budget line slope is reflects the rate at which one good can be
substituted for another good while keeping the level of income
unchanged. The budget line changes if the relative price of a good
changes or shifts if the household’s income changes.
a) A fall in the price of the good on the horizontal (vertical) axis
increases the total affordable quantity of that good and decreases
(increases) the slope of the budget line.
Figure 2(a)) shows the rotation of a budget line after a change in
the relative price of movies. b) An increase (decrease) in the household income causes a
parallel shift of the budget line rightward (leftward). The slope
of the budget line does not change with income, as is indicated
in Figure 2(b)
II. Preferences and Indifference Curves
A. Figure 3 illustrates a consumer’s indifference curve and indifference
map, which is based on the idea that people can sort all possible combinations of goods into three groups: preferred, not preferred and
1. An indifference curve shows those combinations of goods among
which a consumer is indifferent.
a) The consumer prefers points above the curve to points on the
curve. And the consumer prefers points on the curve to points
below the curve.
b) But the consumer is indifferent among (hence its name) all the
points on an indifference curve.
2. A single indifference curve is one of a family of curves that form
an indifference map (Figure 4), which resemble the contour lines
on a topographical map.
Figure 4 B. Marginal Rate of Substitution
1. The marginal rate of substitution, (MRS) measures 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
xaxis) and at the same time remain indifferent (remain on the same
2. The magnitude of the slope of the indifference curve measures the
marginal rate of substitution.
a) If the indifference curve is relatively steep (flat), the MRS is
3. The diminishing marginal rate of substitution is the tendency for
the marginal rate of substitution of good x for good y to fall as more
of good x is consumed. Figure) shows the diminishing MRS of
movies for pop. C. Degree of Substitutability
1. Figure 6(a) shows the indifference curves for ordinary goods,
which display diminishing MRS.
2. Figure 6(b) shows the indifference curves for perfect substitutes,
which are straight lines with a constant MRS.
3. Figure 6(c) shows the indifference curves for perfect complements,
which are Lshaped.
III. Predicting Consumer Behaviour
A. The consumer’s best affordable point, illustrated in Figure 7 is:
1. On the budget line. 2. On the highest attainable indifference curve.
3. Has a marginal rate of substitution between the two goods equal to
the relative price of the two goods.
B. A Change in Price
1. The price effect shows how a change in the price of a good affects
the quantity of that good demanded.
2. As the price of the good on the xaxis decreases (increases), the
budget line rotates on the yaxis intercept quantity and becomes
a) Figure 8(a) shows how a fall in the price of movies leads the
consumer to substitute away f