ECONOMICS

Twelfth Edition, Global Edition

Chapter 9
Possibilities,
Preferences, and
Choices

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 Chapter Outline and Learning Objectives

9.1 Describe a household’s budget

line and show how it changes when
prices or income change

9.2 Use indifference curves to map

preferences and explain the
principle of diminishing marginal
rate of substitution

9.3 Predict the effects of changes in

prices and income on consumption
choices

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 Consumption Possibilities (1 of 10)

• 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 (2 of 10)

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

Consumption Movies Soda

possibility (per month) (cases per month)
A 0 10
B 1 8
C 2 6
D 3 4
E 4 2
F 5 0

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 Consumption Possibilities (3 of 10)

• 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 (4 of 10)

• 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 (5 of 10)

• 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 (6 of 10)

• 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:

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 Consumption Possibilities (7 of 10)

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 Consumption Possibilities (8 of 10)

• 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. It is also the
opportunity cost of a movie.

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 Consumption Possibilities (9 of 10)

• 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 (10 of 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.

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 Preferences and Indifference Curves
(1 of 10)

• 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
(2 of 10)

• 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.
(indifferent combinations)
• G is such a point. Lisa is
indifferent between C and
G.

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 Assumptions about preference:
• Assumption 1: Completeness
• If X and Y are any situations, the individual can
always specify exactly one of the following three
possibilities:
 “X is preferred to Y”
 “Y is preferred to X”
 “X and Y are equally attractive”

• Complete preferences means consumer can

always make a clear choice over any two bundles

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 • Assumption 2:Transitivity
– if an individual reports that “X is preferred to Y” and that
“Y is preferred to Z,” then he or she must also report
that “X is preferred to Z”.
– Transitivity means a consumers choices must be
logically consistent.
• Assumption 3:Non Satiation or More is good.
– An economic good is one that yields positive benefits to
people. Thus, more of a good is, by definition, better.

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 The Characteristics of the Indifference Curve
• (1)There are many (or countless) indifference curves in
the X-Y plane, in which each point must have an
indifference curve passing through it.
• (2) An indifference curve above and to the right of
another represents preferred combination of
commodities.
• (3) An indifference curve has negative slope.
• (4) Indifference curve can never intersect.
• (5) The shape of indifference curve is convex to the
origin.
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 Preferences and Indifference Curves
(3 of 10)

• 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
(4 of 10)

• 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
(5 of 10)

• 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
(6 of 10)

• 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.
‒ MRSXY= - △Y/ △X

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 Preferences and Indifference Curves
(7 of 10)

• 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
(8 of 10)

• 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
(9 of 10)

• 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
(10 of 10)

• 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 (1 of 17)

• 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.

 income 用尽， utility 最大

 预算线 与 无差异曲线相切。
 相对价格 与 边际替代率 MRS

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 Predicting Consumer Choices (2 of 17)

• 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 (3 of 17)

• 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 Consumer Choices (4 of 17)

• 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 Consumer Choices (5 of 17)

• 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 Consumer Choices (6 of 17)

• 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 Consumer Choices (7 of 17)

• 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 (8 of 17)

• 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 (9 of 17)

• 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 (10 of 17)

• We’re going to break the

move from point C to point
J into two parts:
‒ The substitution effect
‒ The income effect

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 Predicting Consumer Choices (11 of 17)

• 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.

• 剔除收入效应，只有价格变化引起的变化就是替代
效应
• 效用水平不变 = 实际收入不变

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 Predicting Consumer Choices (12 of 17)

• 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 (13 of 17)

• 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 (14 of 17)

• 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 (15 of 17)

• 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 (16 of 17)

• 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 (17 of 17)

• 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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