ECONOMICS

Twelfth Edition, Global Edition

Michael Parkin
 POSSIBILITIES,

9 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

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 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.

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 Consumption Possibilities
Budget Line
Lisa has $40 to spend, the price of a movie is $8, and the
price of soda is $4 a case.

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 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).

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 Consumption Possibilities

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.

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 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.

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 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.

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 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.

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 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.

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 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.

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 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.

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 Preferences and Indifference Curves

We can represent Lisa’s

preference as a map.
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.
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 Preferences and Indifference Curves

Lisa can sort all possible

combinations of goods into
three groups: preferred to,
not preferred to, and just as
good as 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 C and G.

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 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.

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 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 .

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 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.

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 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.

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 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.

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 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.

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 Preferences and Indifference Curves

Figure 9.4 shows the

diminishing MRS of
movies for soda.
At point C, Lisa is willing
to give up 10 cases of
soda to see 5 more
movies—her MRS is 2.
At point G, Lisa is willing
to give up 4.5 cases of
soda to see 9 more
movies—her MRS is ½ .

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 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.

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 Predicting Consumer Choices

Best Affordable Choice

The consumer’s best affordable choice
 Is on the budget line.
 Is on the highest attainable indifference curve.
 Has marginal rate of substitution equal to relative price.

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 Predicting Consumer Choices

Here, the best affordable

point is C.
Lisa can afford to consume
more soda and see fewer
movies at point F.
And she can afford to see
more movies and consume
less soda at point H.
But she is indifferent between
F, I, and H and she prefers
C to I.

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 Predicting Consumer Choices

At point F, Lisa’s MRS is

greater than the relative
price.
At point H, Lisa’s MRS is
less than the relative
price.
At point C, Lisa’s MRS is
equal to the relative price
PM/PS .

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 Predicting …

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).
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 Predicting …

Now the price of a movie

falls to $4.
The budget line rotates
outward.
Lisa’s best affordable
point is now J in part (a).
In part (b), Lisa moves to
point B, which is a
movement along her
demand curve for movies.

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 Predicting …

A Change in Income
The effect of a change in
income on buying plans is
called the income effect.
Figure 9.8 illustrates the effect
of a decrease in Lisa’s income
with no change in the prices.
Initially, Lisa consumes at point
J in part (a) and at point B on
demand curve D0 in part (b).

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 Predicting …

When Lisa’s income

decreases, 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).

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 Predicting Consumer Choices

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:
 Substitution effect
 Income effect

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 Predicting Consumer Choices

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 then J.
The move from point C to
point J is the price effect.

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 Predicting Consumer Choices

We’re going to break the

move from point C to point
J into two parts:
1. The substitution effect
2. The income effect

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 Predicting Consumer Choices

Substitution Effect
The substitution effect is
the effect of a change in
price on the quantity bought
when the consumer remains
on the same indifference
curve.

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 Predicting Consumer Choices

To isolate the substitution

effect, we give Lisa a
hypothetical pay cut.
Lisa is now back on her
original indifference curve
but with the price of a
movie at $4.
Her best affordable point
is K.
The move from C to K is
the substitution effect.

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 Predicting Consumer Choices

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.

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 Predicting Consumer Choices

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.

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 Predicting Consumer Choices

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.
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 Predicting Consumer Choices

Inferior Goods
For an inferior good, when income increases, the quantity
bought decreases.
The income effect is negative and works against the
substitution effect.
As long as the substitution effect dominates, the demand
curve still slopes downward.

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 Predicting Consumer Choices

If the negative income effect is stronger than the

substitution effect, a lower price for inferior goods brings a
decrease in the quantity demanded—the demand curve
slopes upward!
This case does not appear to occur in the real world.
Back to the Facts
The best affordable choices determine spending patterns.
Changes in prices and incomes change the best
affordable point and change consumption patterns.

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