ch 09 possibilities, preferences and choices.docx

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Accounting & Financial Management
AFM 102
Tom Vance

09 – possibilities, preferences andchoices Chapter 9: Possibilities, Preferences and Choices Consumption Possibilities  budget line: describes the limits to its consumption choices  divisible and indivisible goods  divisible goods can be bought in any quantity (gas, electricity)  suppose all goods are indivisible to get a better understanding of household choices  affordable and unaffordable quantities  points outside of the budget line are unaffordable and points under the budget line are affordable Budget Equation expenditure  income expenditure P x P xQ yY y Q  Py Q  Y x P y P x x Y Py Q x  Q y Px Px  real income is household income expressed as a quantity of goods that the household can afford to buy  real income = Y/Px  relative price: the price of one good divided by the price of another good  relative price of good X in terms of good Y =xPy/P  also the opportunity cost of consuming x (in terms of y) ΔP y  slope of the budget line: ΔP x  when prices change, the budget line changes (more specifically, the slope of the budget line & intercepts)  ex: if the price falls, the budget line rotates outward and become flatter  when income changes, the intercepts of the budget line changes, but slope stays the same Preferences and Indifference Curves  indifference curve: a line that shows combinations of goods among which a consumer is indifferent  a consumer is just as happy to consume any combinations of x and y on the indifference curve  a consumer will prefer a point above the indifference curve and not a point below the curve Marginal Rate of Substitution (MRS)  marginal rate of substitution: the rate at which a person will give up good y to get one more unit of good x  the slope of an indifference curve measures the MRS  if the indifference curve is steep, then MRS is high and a person is willing to give up a a lot of y for more x  if the indifference curve is flat, then MRS is low and a person is willing to give up a little of y for more x  diminishing marginal rate of substitution: a general tendency for a person to be willing to give up less of good y to get more of good x while at the same time remaining indifference as the quantity of x increases Degree of Substitutability  close substitutes: goods which substitute so easily that consumers can’t tell the difference between the 2  indifference curve have a slope of -1  complements: goods which are bought/used together (left running shoe and right running shoe)  perfect complements have an indifference curve in an “L” shape (corner @ (1,1)) page 1 of 3 09 – possibilities, preferences andchoices Predicting Consumer Choices Best Affordable Choice  a consumer spends on their income and is on their highest attainable indifference curve to make the best affordable choice  the best affordable choice
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