Chapter 9: Possibilities, Preferences
Consumption possibilities: Consumption choices are
limited by income and by prices. A household’s
budget line describes the limits to its consumption
Divisible and Indivisible Goods: some goods can be
bought in any quantity desired. Examples are gasoline
Affordable and Unaffordable Quantities: It marks the
boundary between what is affordable and what is
Budget Equation: We can describe the budget line by
using a budget equation. The budget equation starts
with the fact that:
Expenditure is equal to the sum of the price of each
good multiplied by the quantity bought.
Expenditure= (price of pop x Quantity of pop) =
(Price of movie x Quantity of movies). Call the price of pop Pp the quantity of pop Qp, the
price of a movie Pm, the quantity of movies Qm, and
income Y. We can now write Lisa’s budget equation
PpQp + PmQm= Y
Real Income: A household’s real income is its income
expressed as a quantity of goods that the household
can afford to buy.
Relative Price: A relative price is the price of one
good divided by the price of another good.
A Change in Price: When prices change, so does the
budget line. The lower the price of the good measured
on the x-axis, other things remaining the same, the
flatter 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 its slope does not
change. Preferences and Indifference Curves:
An indifference curve is a line that shows
combinations of goods among which a consumer is
Marginal Rate of Substitution (MSR): is the rate at
which a person will give up good “y” to get an
additional unit of good “x” while remaining indifferent
(remaining in the same indifference curve). The
magnitude of the slope of an indifference curve
measures the marginal rate of substitution.
o If the indifferent curve is steep, the marginal rate