Lecture Eleven: Possibilities, Preferences and Choices
November 3, 2011
A Rise in Income
When income increases, the demand for a normal good increases.
- When income increases the demand for inferior goods decreases
Measuring Marginal Utility
Marginal utility is measured in units called “utils”, which are arbitrarily assigned
and vary from person to person.
It is hard to measure the amount of satisfaction one will receive from having a
good, so these are mainly estimates. There is no official scale to determine
precisely what is worth how many utils.
The Paradox of Value
The paradox of value “Why is water, which is essential, is far cheaper than
diamonds which are not essential?” is resolved by distinguishing between total
utility and marginal utility.
We use so much water that the marginal utility from water consumed is small, but
the total utility is large.
We buy few diamonds so the marginal utility from diamonds is large, but the total
utility is small.
Value and Consumer Surplus
The supply of water is perfectly elastic so the quantity of water consumed is large
and the consumer surplus from water is large.
In contrast, the supply of diamonds is perfectly inelastic, so the price is high and
the consumer surplus from diamonds is small.
Possibilities, Preferences and Choices
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 households consumption choices.
Anything along or within the budget line is affordable, anything outside the
budget line is not affordable.
There are two types of goods
-Divisible goods can be bought in any quantity along the budget line (such as
-Indivisible goods must be bought in whole unites at the points marked
(movies, for example. You cannot buy a ticket to see half a movie).
The Budget Equation
We can describe the budget line by using a budget equation.
The budget equation states that:
Expenditure = Income
There is no allocation for borrowing money, paying interest ect.
Real Income vs. Relative Price
Real Income - income expressed as a quantity of goods the household an afford
• This is seen on the graph as the intercept on the axis
Relative Price - the magnitude of the slope of the budget line
• The relative price shows the amount of x which must be forgone to have one
additional unit of y
• It is the oppor