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UB ECO 182 - Chapter 9

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Slide 1After studying this chapter, you will be able to:Slide 3Consumption PossibilitiesConsumption PossibilitiesConsumption PossibilitiesConsumption PossibilitiesConsumption PossibilitiesConsumption PossibilitiesConsumption PossibilitiesConsumption PossibilitiesConsumption PossibilitiesPreferences and Indifference CurvesPreferences and Indifference CurvesPreferences and Indifference CurvesPreferences and Indifference CurvesPreferences and Indifference CurvesPreferences and Indifference CurvesPreferences and Indifference CurvesPreferences and Indifference CurvesPreferences and Indifference CurvesPreferences and Indifference CurvesPredicting Consumer ChoicesPredicting Consumer ChoicesPredicting Consumer ChoicesPredicting …Predicting …Predicting …Predicting …Predicting Consumer ChoicesPredicting Consumer ChoicesPredicting Consumer ChoicesPredicting Consumer ChoicesPredicting Consumer ChoicesPredicting Consumer ChoicesPredicting Consumer ChoicesPredicting Consumer ChoicesPredicting Consumer ChoicesPredicting Consumer Choices9POSSIBILITIES, PREFERENCES, AND CHOICESAfter 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 choicesThe 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.© 2014 Pearson Addison-WesleyConsumption PossibilitiesA 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-WesleyConsumption PossibilitiesLisa has $40 to spend, the price of a movie is $8 and the price of soda is $4 a case.© 2014 Pearson Addison-WesleyConsumption PossibilitiesLisa 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-WesleyConsumption PossibilitiesThe 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-WesleyConsumption PossibilitiesThe Budget EquationWe can describe the budget line by using a budget equation.The budget equation states thatExpenditure = IncomeCall 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-WesleyConsumption PossibilitiesPSQS + PMQM = YDivide both sides of this equation by PS, to give:QS + (PM/PS)QM = Y/PSThen subtract (PM/PS)QM from both sides of the equation to give:QS = Y/PS – (PM/PS)QMY/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-WesleyConsumption PossibilitiesA 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-WesleyConsumption PossibilitiesA Change in PricesA 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-WesleyConsumption PossibilitiesA Change in IncomeAn 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-WesleyPreferences and Indifference CurvesAn 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-WesleyPreferences and Indifference CurvesLisa 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-WesleyPreferences and Indifference CurvesLisa 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-WesleyPreferences and Indifference CurvesA 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-WesleyPreferences and Indifference CurvesI2 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-WesleyPreferences and Indifference CurvesMarginal Rate of SubstitutionThe 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-WesleyPreferences 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


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