9 POSSIBILITIES PREFERENCES AND CHOICES 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 The iPad has revolutionized the way we read magazines books and even recipes in the kitchen Yet the magazine racks and bookstore shelves are still stuffed with traditional printed paper Similarly low priced on demand movies and DVD rentals have made it easier to watch a movie at home Yet we re also going to movie theaters in ever greater numbers In this chapter we ll study a model that explains the choices we make and applies it to choices about using new and old technologies Consumption Possibilities A household s 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 2014 Pearson Addison Wesley Consumption Possibilities Lisa has 40 to spend the price of a movie is 8 and the price of soda is 4 a case 2014 Pearson Addison Wesley Consumption Possibilities Lisa can afford any of the combinations at points A to F 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 line through points A to F is Lisa s budget line 2014 Pearson Addison Wesley Consumption Possibilities 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 2014 Pearson Addison Wesley Consumption Possibilities 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 soda PS the quantity of soda QS the price of a movie PM the quantity of movies QM and income Y Lisa s budget equation is PSQS PMQM Y 2014 Pearson Addison Wesley Consumption Possibilities PSQS PMQM Y Divide both sides of this equation by PS to give QS PM PS QM Y PS Then subtract PM PS QM from both sides of the equation to give QS Y PS PM PS QM Y PS is Lisa s real income in terms of soda PM PS is the relative price of a movie in terms of soda 2014 Pearson Addison Wesley Consumption Possibilities 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 soda 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 soda must be forgone to see an additional movie 2014 Pearson Addison Wesley Consumption Possibilities A Change in Prices A change in the price of the good on the x axis changes the slope of the budget line Figure 9 2 a shows the rotation of a budget line after a change in the relative price of movies 2014 Pearson Addison Wesley Consumption Possibilities 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 2014 Pearson Addison Wesley Preferences and Indifference Curves 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 soda a month Figure 9 3 a illustrates Lisa s indifference curve 2014 Pearson Addison Wesley Preferences and Indifference Curves Lisa can sort all possible combinations of goods into three groups preferred not preferred and just as good 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 C and G 2014 Pearson Addison Wesley Preferences and Indifference Curves Lisa prefers any point above the indifference curve to any point on the curve Lisa prefers any point on the indifference curve to any point below the indifference curve 2014 Pearson Addison Wesley Preferences and Indifference Curves 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 2014 Pearson Addison Wesley Preferences and Indifference Curves 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 2014 Pearson Addison Wesley Preferences and Indifference Curves 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 remaining indifferent remaining on the same indifference curve The magnitude of the slope of the indifference curve measures the marginal rate of substitution 2014 Pearson Addison Wesley Preferences and Indifference Curves 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 2014 Pearson Addison Wesley Preferences and Indifference Curves A diminishing marginal rate of substitution is the key assumption of consumer theory 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 good x increases 2014 Pearson Addison Wesley Preferences and Indifference Curves Figure 9 4 shows the diminishing MRS of movies for soda At point C Lisa is willing to give up 2 cases of soda to see one more movie her MRS is 2 At point G Lisa is willing to give up 1 2 a case of soda to see one more movie her MRS is 1 2 2014 Pearson Addison Wesley Preferences and Indifference Curves 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 perfect substitutes and perfect complements 2014 Pearson Addison Wesley