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Chapter 8

Economics 1021A Chapter 8


Department
Economics
Course Code
ECON 1021A/B
Professor
Terry Biggs
Chapter
8

Page:
of 3
Economics 1021A Chapter 9 2013-10-22
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.
Some goods are indivisible goods and must be bought in whole units at the points marked (such as
movies).
Other goods are divisible goods and can be bought in any quantity (such as gasoline).
The budget line is a constraint on Lisa’s consumption choices.
Lisa can afford any point on her budget line or inside it, but she cannot afford any point outside her budget
line.
We can describe the budget line by using a budget equation:
Expenditure = Income
Lisa’s budget equation is: PPQP + PMQM = Y.
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 pop 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.
Relative price is the magnitude of the slope of the budget line.
The relative price shows how many cases of pop must be forgone to see an additional movie.
A rise in the price of the good on the x-axis decreases the maximum affordable quantity of that good and
increases the slope of the budget line.
A change in money 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.
An indifference curve is a line that shows combinations of goods among which a consumer is
indifferent.
All the points on the indifference curve are preferred to all the points below the indifference curve.
All the points above the indifference curve are preferred to all the points on the indifference curve.
A preference map is a series of indifference curves.
The marginal rate of substitution, (MRS) measures the rate at which a person is willing to give up
good y to get an additional unit of good x while at the same time remain indifferent (remain on the same
indifference curve).
The magnitude of the slope of the indifference curve measures the marginal rate of substitution.
If the indifference curve is relatively steep, the MRS is high.
In this case, the person is willing to give up a large quantity of y to get a bit more x.
If the indifference curve is relatively flat, the MRS is low.
In this case, the person is willing to give up a small quantity of y to get more x.
A diminishing marginal rate of substitution is 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 remain indifferent as the
quantity of good x increases.
The shape of the indifference curves reveals the degree of substitutability between two goods.
The consumer’s best affordable choice is:
On the budget line
On the highest attainable indifference curve
Has a marginal rate of substitution between the two goods equal to the relative price of the two goods
The effect of a change in the price of a good on the quantity of the good consumed is called the price
effect.
The effect of a change in income on the quantity of a good consumed is called the income effect.
For a normal good, a fall in price always increases the quantity consumed.
We can prove this assertion by dividing the price effect into two parts:
Substitution effect
The substitution effect is the effect of a change in price on the quantity bought when the consumer
remains on the same indifferent curve.
When the relative price falls, the consumer always substitutes more of that good for other goods.
Income effect
For a normal good, the income effect reinforces the substitution effect so we can be sure that the demand
curve slopes downward.
For an inferior good, when income increases, the quantity bought decreases.
The income effect is negative and works against the substitution effect.
So long as the substitution effect dominates, the demand curve still slopes downward.