COECA1-B11

Chapter 9: Possibilities, Preferences and Choices.

 Learning Outcomes
After studying this chapter, you will be able to:

• 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
• Consumption choices are limited by income and by prices.
• A household’s budget line describes the limits to its consumption choices.
• Divisible and Indivisible Goods
• Some goods – called divisible goods – can be bought in any quantity desired.
• Examples are petrol and electricity.
• We can best understand household choice if we suppose that all goods and
services are divisible.
• For example, Lerato can eat half a bar of chocolate a month on average by eating
one bar of chocolate every two months..
Consumption Possibilities

• When we think of goods as being

divisible, the consumption possibilities
are not only the points A to F shown in
Figure 9.1, but also all the intermediate
points that form the line running from A
to F. This line is Lerato’s budget line.
• Intermediate points is the point between
A and B.
 Consumption Possibilities
Affordable and Unaffordable Quantities
• This marks the boundary between what is affordable and what is unaffordable.
• She can afford any point on the line and inside it.
• She cannot afford any point outside the line.
• The constraint on her consumption depends on the prices and her income, and the
constraint changes when the price of a good or her income changes.
 Consumption Possibilities
Budget Equation
• We can describe the budget line by using a budget equation.
• The budget equation starts with the fact that: Expenditure = Income
• Expenditure is equal to the sum of the price of each good multiplied by the
quantity bought.
Real Income
• A household’s real income is its income expressed as a quantity of goods that the
household can afford to buy.
 Real Income
• A household’s real income is its income expressed as a quantity of goods that the
household can afford to buy. Expressed in terms of cool drink, Lerato’s real
income is Y/P Cd.
• This quantity is the maximum quantity of cool drink that she can buy.
• It is equal to her money income divided by the price of cool drink.
• Lerato’s money income is R40 and the price of cool drink is R4 a can, So her real
income in terms of cool drink is 10 cans, which is shown in Figure 9.1 as the point
at which the budget line intersects the y-axis.
 Consumption Possibilities
Relative Price
• A relative price is the price of one good divided by the price of another good.
• In Lerato’s budget equation, the variable P Ch/PCd is the relative price of a bar of
chocolate in terms of cool drink.
• For Lerato, PCh is R8 a bar of chocolate and PCd is R4 a can, so PCh/PCd is
equal to 2 cans of cool drink per bar of chocolate.
 Relative Price
• That is, to eat 1 bar of chocolate, Lerato must give up 2 cans of cool drink.
• You have just calculated Lerato’s opportunity cost of eating a bar of chocolate.
• The relative price of a bar of chocolate in terms of cool drink is the magnitude of
the slope of Lerato’s budget line.
 Relative Price/ Slope
• To calculate the slope of the budget Line.
Slope equals the change in the variable measured on the y-axis divided by the
change in the variable measured on the x-axis as we move along the line.
• Along Lerato’s budget line, as cool drink decreases from 10 to 0 cans, bars of
chocolate increase from 0 to 5. So the magnitude of the slope of the budget line is
10 cans divided by 5 bars of chocolate, or 2 cans of cool drink per bar of
chocolate.
• The magnitude of this slope is exactly the same as the relative price we have just
calculated. It is also the opportunity cost of a bar of chocolate.
 A Change in Prices
A Change in Prices
• 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 the budget line.
• The higher the price of the good measured on the x-axis, other things remaining
the same, the steeper the budget line.
• For example, if the price of a bar of chocolate falls from R8 to R4, real income in
terms of cool drink does not change but the relative price of a bar of chocolate
falls.
• The budget line rotates outward and becomes flatter, as Figure 9.2(a) illustrates.
 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.
• An increase in money income increases real income and shifts the budget line
rightward.
• A decrease in money income decreases real income and shifts the budget line
leftward.
Changes in Price and Income
 Changes in Price and Income
• In part (a), the price of a bar of chocolate changes. A fall in the price from R8 to
R4 rotates the budget line outward and makes it flatter.
• A rise in the price from R8 to R16 rotates the budget line inward and makes it
steeper.
• In part (b), income falls from R40 to R20 while the prices of chocolate and cool
drink remain the same.
• The budget line shifts leftward, but its slope does not change.
 Preferences and indifference curves
• A preference map is based on the intuitively appealing idea that people can sort all
the possible combinations of goods into three groups: preferred, not preferred and
indifferent.
• An indifference curve is a line that shows combinations of goods among which a
consumer is indifferent.
• The indifference curve in Figure 9.3(a) tells us that Lerato is just as happy to eat 2
bars of chocolate and buy 6 cans of cool drink a month at point C as she is to have
the combination of chocolate and cool drink at point G or at any other point along
the curve.
Preferences and indifference curves

• Lerato also says that she prefers

all the combinations of chocolate
and cool drink above the
indifference curve in Figure 9.3(a)
– the yellow area – to those on the
indifference curve.

• And she prefers any combination

on the indifference curve to any
combination in the grey area
below the indifference curve.
 Preferences and indifference curves
• The indifference curve in Figure 9.3(a) is just one of a whole family of such
curves.
• This indifference curve appears again in Figure 9.3(b), labelled I1.
• The curves labelled I0 and I2 are two other indifference curves.
• Lerato prefers any point on indifference curve I2 to any point on indifference
curve I1, and she prefers any point on I1 to any point on I0.
• We refer to I2 as being a higher indifference curve than I1 and I1 as being higher
than I0.
Preferences and Indifference Curves
Marginal Rate of Substitution
• The marginal rate of substitution (MRS) is the
rate at which a person will give up good y (the
good measured on the y-axis) to get an additional
unit of good x (the good measured on the x axis)
while remaining indifferent (remaining on the
same indifference curve)

• If the indifference curve is steep, the marginal rate

of substitution is high.
• If the indifference curve is flat, the marginal rate
of substitution is low.
 Marginal Rate of Substitution
• The magnitude of the slope of an indifference curve is called the marginal rate of
substitution (MRS).
• The red line at point C tells us that Lerato is willing to give up 10 cans of cool
drink to eat 5 bars of chocolate.
• Her marginal rate of substitution at point C is 10 divided by 5, which equals 2..
• The red line at point G tells us that Lerato is willing to give up 4.5 cans of cool
drink to eat 9 bars of chocolate.
• Her marginal rate of substitution at point G is 4.5 divided by 9, which equals 1/2
 Diminishing marginal rate of substitution
• Diminishing marginal rate of substitution is the key assumption about preferences.
• 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 remaining indifferent as the quantity of x increases.
• In Lerato’s case, she is less willing to give up cool drink to eat one more bar of
chocolate as the number of bars of chocolate she eats increases.
Degree of Substitutability
Predicting Consumer Choices
Best Affordable Choice
On the Budget Line
• The best affordable point is on the budget line.
On the Highest Attainable Indifference Curve
• Every point on the budget line lies on an indifference
curve.
• Marginal Rate of Substitution equals Relative Price.
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.
Predicting Consumer Choices

The Demand Curve

• The law of demand and the downward sloping
demand curve are consequences of a consumer’s
choosing her or his best affordable combination of
goods.
A Change in Income
• The effect of a change in income on buying plans is
called the income effect.
The Demand Curve and the Income Effect
• A change in income leads to a shift in the demand
curve.
 Substitution Effect and Income Effect
Substitution effect
• The substitution effect is the effect of a change in price on the quantity bought
when the consumer (hypothetically) remains indifferent between the original
situation and the new one.
• To work out Lerato’s substitution effect when the price of chocolate falls, we must
lower her income by enough to keep her on the same indifference curve as before.
 Substitution effect
• Figure 9.9(a) shows the price effect of a fall in the price of a bar of chocolate from
R8 to R4.
• The number of bars of chocolate increases from 2 to 6 a month.
• When the price falls, suppose (hypothetically) that we lower Lerato’s income to
R28. What is special about R28?
• It is the income that is just enough, at the new price of chocolate, to keep Lerato’s
best affordable point on the same indifference curve (I1) as her original point C.
• Lerato’s budget line is now the medium orange line in Figure 9.9(b).
 Substitution effect
• With the lower price of chocolate and a smaller income, Lerato’s best affordable
point is K.
• The move from C to K along indifference curve I is the substitution effect of the
1

price change.
• The substitution effect of the fall in the price of chocolate is an increase in the
quantity of bars of chocolate from 2 to 4.
Substitution effect
Income Effect

Income Effect
• As Lerato’s income increases, she eats
more chocolate. For Lerato, chocolate is a
normal good.
• For a normal good, the income effect
reinforces the substitution effect.
 Predicting Consumer Choices
Inferior Goods
• An inferior good is a good for which demand decreases when income increases.
• For an inferior good, the income effect is negative, which means that a lower
price does not inevitably lead to an increase in the quantity demanded.
• The substitution effect of a fall in the price increases the quantity demanded, but
the negative income effect works in the opposite direction and offsets the
substitution effect to some degree.