FACULTY OF BUSINESS ADMINISTRATION

ECONOMICS I
ECN101
[Handout]
C h a p t e r N i n e

9 POSSIBILITES, PREFERENCES, AND CHOICES

Possibilities, Preferences, and Choices

• A person’s budget in combination with his or her preferences determines what goods
and services the person consumes.

I. Consumption Possibilities
• A household’s consumption choices are
constrained by its income and the prices of the
goods and services available. A household’s
budget line describes the limits to its
consumption choices.
• The figure to the right shows a budget line for
a household that buys only pizzas and books.
The household can buy any combination of
pizza and books that lies on or within the
budget line. Combinations that lie beyond the
budget line are unaffordable.
• Divisible goods can be bought in any quantity
and we can best understand household choices
if we assume all goods are divisible.
• The budget line illustrates a constraint on choices. Any point on or inside the line can be
purchased. Any point outside the line is unaffordable and cannot be purchased.
Budget Equation
• We can describe the budget line by using a budget equation, which states that income
equals expenditure.
• Calling the price of a book PB, the quantity of books QB, the price of a pizza PP, the
quantity of pizza QP, and income Y, we can write a budget equation as:
PB  QB + PP  QP = Y.
• A household’s Maximum Consumption is the maximum quantity of a good that the
household can afford to buy. In the figure above, in terms of books, the household’s
maximum consumption is Y/PB (5 books), which is the vertical intercept of the budget
line.

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A Change In Price
• The price effect shows how a change in the price of a good affects the quantity
consumed of that good.
• When the price of the good on the x-axis falls, the budget line rotates around the y-axis
intercept and becomes flatter. The person moves to a new consumption point.
• When the price of the good measured along the horizontal axis (pizzas) changes, the
budget line rotates around the vertical intercept. If the price of the good falls, the
budget line rotates outward and becomes flatter; if the price of the good rises, the
budget line rotates inward and becomes steeper.

A Change In Income
• The income effect shows how a change in income affects the buying plans of
consumers.
• When the price of the goods remains constant, a change in income shifts the budget
line.
• When income changes, the budget line shifts, and its slope does not change. If income
increases, the budget line shifts outward; if income decreases, the budget line shifts
inward.
• If income rises and more is consumed at each price (or if income falls and less is
consumed at each price) the good is a normal good.

II. Preferences and Indifference Curves

• A preference map shows how a person
ranks various combinations of goods and
services.
• Indifference curves are used to illustrate a
person’s preference map. An indifference
curve is a line that shows combinations of
goods among which a consumer is
indifferent. The figure to the right shows
three of a person’s indifference curves
between pizza and books.
• By construction the consumer is
indifferent among all the points on any
particular indifference curve.
• The consumer prefers points above any
particular indifference curve to points on the curve. And the consumer prefers
points on the indifference curve to points below the curve. In the figure, the
consumer prefers any point on indifference curve I2 to any point on I1 and any point
on I3 to any point on I2.

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III. Predicting Consumer Choices
Best Affordable Choice
• The consumer will select his or her best
affordable point. This point:
1. is on the budget line,
2. is on the highest attainable indifference
curve.
• The figure shows the best affordable point, 2
pizzas and 3 books. This combination is on
the budget, and hence is “affordable.” It also
is on the highest indifference curve so the
point is “best.”

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