Lecture 9 - Preferences

Chapter 9
POSSIBILITIES, PREFERENCES, AND CHOICES
ECO1021A - Principles of Micro - Ch. 9 Preferences

Midterm Check-In 2
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After studying this chapter, you will be able to: 3
• Describe a household’s budget line and show how it changes when prices
or income change
• Use indifference curves to map preferences and explain the principle of

diminishing marginal rate of substitution
• Predict the effects of changes in prices and income on consumption

choices

Consumption Possibilities 4
• The budget line is a constraint on Lisa’s

consumption choices.
– Lisa can afford any point on her budget

line or inside it.
– Lisa cannot afford any point outside her

budget line.

• The Budget Equation
– We can describe the budget line by using a budget equation.
– The budget equation states that
Expenditure = Income
– Call the price of cola PC, the quantity of cola QC, the price of a movie
PM, the quantity of movies QM, and income Y.
– Lisa’s budget equation is:
PCQC + PMQM = Y

PCQC + PMQM = Y
• Divide both sides of this equation by PC, to give:
QC + (PM/PC)QM = Y/PC
• Then subtract (PM/PC)QM from both sides of the equation to give:
QC = Y/PC – (PM/PC)QM
• Y/PC is Lisa’s real income in terms of cola.
• PM/PC is the relative price of a movie in terms of cola.

• 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 cola 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 cola must be forgone to
see an additional movie.

• A Change in Prices
– A rise in the price of the good on the x-

axis decreases the affordable quantity of
that good and increases the slope of the
Recall:
budget line. V-axis  income/price
– Figure 9.2(a) shows the rotation of a
budget line after a change in the relative
price of a movie.
$40/$16 = 2.5
$40/$8 = 5
$40/$4 = 10

• A Change in Income
– An 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.
– Figure 9.2(b) shows the effect of a

fall in income.

Budget Constraint 10
• Suppose: QC Y/PC
– Y = $100 𝑷 𝑪 𝑸 𝑪 +𝑷 𝑴 𝑸 𝑴=𝒀 50
𝟐 𝑸 𝑪 +𝟓 𝑸 𝑴 =𝒀
– PM = $5
𝟐 𝑸 𝑪=𝒀 −𝟓 𝑸 𝑴
– PC = $2 𝟏 𝟓
𝑸𝑪= 𝒀 − 𝑸 𝑴
𝟐 𝟐
• Y-Intercept = Y/PC Relative price is the magnitude

of the slope of the budget line.
• X-intercept = Y/PM The relative price shows how Y/PM
many cases of cola must be
forgone to see an additional QM
20
movie.

– Y = $100 𝑷 𝑪 𝑸 𝑪 +𝑷 𝑴 𝑸 𝑴=𝒀 50
𝟐 𝑸 𝑪 +𝟓 𝑸 𝑴 =𝒀
– PM = $5 𝟏 𝟓
𝑸𝑪= 𝒀 − 𝑸 𝑴
𝟐 𝑸 𝑪=𝒀 −𝟓 𝑸 𝑴 𝟐 𝟐
– PC = $2 𝑷𝑴
𝑺𝒍𝒐𝒑𝒆 =−
𝑷𝑪
• Y-Intercept = Y/PC
• X-intercept = Y/PM Y/PM
20 QM

– Y = $100 𝑷 𝑪 𝑸 𝑪 +𝑷 𝑴 𝑸 𝑴=𝒀 50
𝟐 𝑸 𝑪 +𝟓 𝑸 𝑴 =𝒀
– PM = $5
𝟐 𝑸 𝑪=𝒀 −𝟓 𝑸 𝑴
– PC = $2 𝑷𝑴
𝟏 𝟓
𝑸𝑪 = 𝒀 − 𝑸 𝑴 𝑺𝒍𝒐𝒑𝒆 =−
𝟐 𝟐 𝑷𝑪
20 QM

– Y = $100 𝑷 𝑪 𝑸 𝑪 +𝑷 𝑴 𝑸 𝑴=𝒀 50
𝟐 𝑸 𝑪 +𝟓 𝑸 𝑴 =𝒀
– PM = $5
𝟐 𝑸 𝑪=𝒀 −𝟓 𝑸 𝑴
– PC = $2 𝑷𝑴
𝟏 𝟓
𝟐 𝟐 𝑷𝑪
20 QM

– Y = $100 𝑷 𝑪 𝑸 𝑪 +𝑷 𝑴 𝑸 𝑴=𝒀 50
𝟐 𝑸 𝑪 +𝟓 𝑸 𝑴 =𝒀
– PM = $5
𝟐 𝑸 𝑪=𝒀 −𝟓 𝑸 𝑴
– PC = $2 𝑷𝑴
𝟏 𝟓
𝟐 𝟐 𝑷𝑪
20 QM

Preferences and Indifference Curves 15
• An indifference curve is a line that shows

combinations of goods among which a
consumer is indifferent.
– At point C, Lisa sees

2 movies and drinks
6 cases of cola a month.

• Figure 9.3(a) illustrates a consumer’s

indifference curve.
– Lisa can sort all possible combinations of

goods into three groups: preferred, not
preferred, and just as good as point C.
– An indifference curve joins all those

points that Lisa says are just as good as
C.
– G is such a point. Lisa is indifferent

between point C and point G.

– All the points on the indifference

curve are preferred to all the points
below the indifference curve.
– And 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.
– Call the indifference curve that

we’ve just seen I1.
– I0 is an indifference curve below I1.
– Lisa prefers any point on I1 to any

point on I0 .

– I2 is an indifference curve above

I1.
– Lisa prefers any point on I2 to any

point on I1 .
– For example, Lisa prefers point J

to either point C or point G.

• Marginal Rate of Substitution
– 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 the key assumption of

consumer theory.
– It 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
remaining indifferent as the quantity of good x increases.
In other words, as the consumer has more

and more of good X, he is prepared to
forego less and less of good Y.

• Figure 9.4 shows the diminishing MRS of

movies for cola.
– At point C, Lisa is willing to give up 2

cases of cola to see one more movie—her
MRS is 2.
– At point G, Lisa is willing to give up 1/2

case of cola to see one more movie—her
MRS is 1/2.

• Degree of Substitutability
– The shape of the indifference curves reveals the degree of substitutability

between two goods.
– Figure 9.5 shows the indifference curves for ordinary goods, perfects
substitutes, and perfect complements.

Predicting Consumer Choices 25
• Best Affordable Choice
– 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 best affordable point is C.
– Lisa can afford to consume more cola

and see fewer movies at point F.
– And she can afford to see more 𝑷𝑴

𝑴𝑹𝑺=
movies and consume less cola at point 𝑷𝑪
H.
– But Lisa is indifferent between F, I,

and H, but she prefers C to I.

Understanding the Optimum 27
𝑷𝒙
𝑴𝑹𝑺=
• Marginal Rate of Substitution (MRS) 𝑷𝒚
– 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).
– Since MRS represents the maximum amount of y we are willing to give up in exchange for one
unit of x, it also represents how much value our consumer places on x in terms of y.
– Thus, MRS describes the Marginal Benefit (MB) of good x in terms of good y
• The Relative Price (Px/Py)
- The relative price shows how much y must be forgone to get an additional x.
- Thus, the budget line tells us the Marginal Cost (MC) of good x in terms of good y.
- Marginal Analysis  Keep consuming x if the MB>MC  MB=MC

Understanding the Optimum 28
𝑷𝒙
𝑴𝑹𝑺=
𝑷𝒚
• If MRS > Px/Py, the consumer will consume more x and less y.
• If MRS < Px/Py, the consumer will consume less x and more y.
• If MRS = Px/Py, the consumer will not change their consumption.

• At point F, Lisa’s MRS is greater than

the relative price.
– (i.e. MB>MC)
• At point H, Lisa’s MRS is less than the

relative price.
– (i.e. MB>MC)
• At point C, Lisa’s MRS is equal to the

relative price.
– (i.e. MB=MC)

Predicting 30
• A Change in Price
– The effect of a change in the price of a good

on the quantity of the good consumed is
called the price effect.
• Figure 9.7 illustrates the price effect and shows

how the consumer’s demand curve is generated.
– Initially, the price of a movie is $8 and Lisa

consumes at point C in part (a) and at point
A in part (b).

Predicting 31
• The price of a movie then falls to $4.
– The budget line rotates outward.
– Lisa’s best affordable point is now J in

part (a).
𝑷𝑴
– In part (b), Lisa moves to point B, which 𝑴𝑹𝑺=
𝑷𝑪
is a movement along her demand curve
for movies.

Predicting 32
• A Change in Income
– The effect of a change in income on the

quantity of a good consumed is called the
income effect.
• Figure 9.8 illustrates the effect of a decrease in

Lisa’s income.
– Initially, Lisa consumes at point J in part (a)

and at point B on demand curve D0 in part
(b).

Predicting 33
• Lisa’s income decreases and her budget line

shifts leftward in part (a).
– Her new best affordable point is K in part

(a).
– Her demand for movies decreases, shown

by a leftward shift of her demand curve for
movies in part (b).

• Substitution Effect and 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 in two
parts:
1. Substitution effect
2. Income effect

• Initially, Lisa has an income of $40,

the price of a movie is $8, and she
consumes at point C.
• The price of a movie falls from $8 to

$4 and her budget line rotates
outward.
• Lisa’s best affordable point is now J.
• The move from point C to point J is

the price effect.

• We’re going to break the move from

point C to point J into two parts:
1. Substitution effect
2. Income effect.

1. Substitution Effect
– The substitution effect is the

effect of a change in price on the
quantity bought when the
consumer remains on the same J
indifferent curve.

– To isolate the substitution effect,

we give Lisa a hypothetical pay
cut.
– Lisa is now back on her original

indifference curve but with a lower
price of movies and her best
affordable point is K.
– The move from C to K is the

substitution effect.

– The direction of the substitution

effect never varies:
– When the relative price falls, the

consumer always substitutes more
of that good for other goods.
– The substitution effect is the first

reason why the demand curve
slopes downward.

• Income Effect
– To isolate the income effect, we

reverse the hypothetical pay cut
and restore Lisa’s income to its
original level (its actual level).
– Lisa is now back on

indifference curve I2 and her
best affordable point is J.
– The move from K to J is the

income effect.

• For Lisa, movies are a normal

good.
– With more income to spend, she

sees more movies—the income
effect is positive.
– For a normal good, the income

effect reinforces the substitution
effect and is the second reason
why the demand curve slopes
downward.

Another Illustration
42

Illustration: 43
Deriving a Demand Curve
Here we vary the price from

P1 to P3 and plot the
corresponding Qs.

Next Class 44
• Chapter 10
– Output and costs

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Chapter 9

POSSIBILITIES, PREFERENCES, AND CHOICES

ECO1021A - Principles of Micro - Ch. 9 Preferences

• Your feedback is very helpful and appreciated!

• Please visit the link below:

ECO1021A - Principles of Micro - Ch. 9 Preferences

• Use indifference curves to map preferences and explain the principle of

• Predict the effects of changes in prices and income on consumption

ECO1021A - Principles of Micro - Ch. 9 Preferences

• The budget line is a constraint on Lisa’s

– Lisa can afford any point on her budget

– Lisa cannot afford any point outside her

ECO1021A - Principles of Micro - Ch. 9 Preferences

• The Budget Equation

– We can describe the budget line by using a budget equation.

– The budget equation states that

– Lisa’s budget equation is:

ECO1021A - Principles of Micro - Ch. 9 Preferences

• Divide both sides of this equation by PC, to give:

• Then subtract (PM/PC)QM from both sides of the equation to give:

• Y/PC is Lisa’s real income in terms of cola.

• PM/PC is the relative price of a movie in terms of cola.

ECO1021A - Principles of Micro - Ch. 9 Preferences

• A household’s real income is the income expressed as a quantity of goods

– Relative price is the magnitude of the slope of the budget line.

ECO1021A - Principles of Micro - Ch. 9 Preferences

– A rise in the price of the good on the x-

ECO1021A - Principles of Micro - Ch. 9 Preferences

– An change in money income brings

– The slope of the budget line

– Figure 9.2(b) shows the effect of a

ECO1021A - Principles of Micro - Ch. 9 Preferences

• Y-Intercept = Y/PC Relative price is the magnitude

ECO1021A - Principles of Micro - Ch. 9 Preferences

• X-intercept = Y/PM Y/PM

ECO1021A - Principles of Micro - Ch. 9 Preferences

• X-intercept = Y/PM Y/PM

ECO1021A - Principles of Micro - Ch. 9 Preferences

• X-intercept = Y/PM Y/PM

ECO1021A - Principles of Micro - Ch. 9 Preferences

• X-intercept = Y/PM Y/PM

ECO1021A - Principles of Micro - Ch. 9 Preferences

• An indifference curve is a line that shows

– At point C, Lisa sees

ECO1021A - Principles of Micro - Ch. 9 Preferences

• Figure 9.3(a) illustrates a consumer’s

– Lisa can sort all possible combinations of

– An indifference curve joins all those

– G is such a point. Lisa is indifferent

ECO1021A - Principles of Micro - Ch. 9 Preferences

– All the points on the indifference

– And all the points above the

ECO1021A - Principles of Micro - Ch. 9 Preferences

• A preference map is a series of

– Call the indifference curve that

– I0 is an indifference curve below I1.

– Lisa prefers any point on I1 to any

ECO1021A - Principles of Micro - Ch. 9 Preferences