1'CONSUMPTION POSSIBILITIES

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ECON 101 CHAPTER 9
POSSIBILITIES, REFERENCES, AND CHOICES

• 1. CONSUMPTION POSSIBILITIES
• Consumption choices are limited by income and by
  prices.
• Budget Line The limits to a households
  consumption choices are described by its budget
  line.
• Example Lisa has an income of 30 a month and
  she plans to buy only two goods , movies and
  soda. Movies cost 6 each, soda costs 3 a
  six-pack.

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• Figure 9.1 The Budget Line

Income 30 Soda 3 Movie 6
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• Divisible and Indivisible Goods
• Some goods are divisible and some goods are
  indivisible goods. Divisible goods for example,
  gas and electricity can be purchased in any
  amount. Indivisible goods can only be purchased
  in certain amounts.
•  In this chapter we shall assume that all goods
  and services are divisible.

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• The Equation for Lisa's Budget Line
• To calculate the equation for Lisas budget line,
  start with expenditure equal to income
• 3Qs 6Qm 30
• divide by 3 to obtain
• Qs 2Qm 10
• Subtract 2Qm from both sides to obtain
• Qs 10 2Qm

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• The Budget Equation
• We can describe the budget line by using a budget
  equation. The budget equation starts with the
  fact that
• Expenditure Income
• Expenditure (price of soda x quantity of
  soda) (price of movie X quantity of
  movies)
• Expenditure Ps Qs Pm Qm y
• From our example
• 3Qs 6Qm 30
• If Qm 0 , 3Qs 30 therefore, Qs 10
• If Qs 0, 6Qm 30 therefore, Qm 5

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• Budget equation contains two variables
• Qs and Qm - these variables are chosen
  by the household
• y/Ps and Pm/Ps these variables are given to
• the household
• Real Income A households real income is the
  households income expressed not as money but as
  a quantity of goods the household can afford to
  buy.
• Example Expressed in terms of soda, Lisas real
  income is y/Ps. 30/3 , Her real income in terms
  of soda is 10 six-packs of soda.

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• Relative Price A relative price is the price of
  one good divided by the price of another good.
• Example In Lisas budget equation, the variable
  Pm/Ps is the relative price of a movie in terms
  of soda.
• In Lisas budget equation , the variable Pm/ Ps
  is equal to (6/3) 2 six-packs soda per movie.
• That is, to see one more movie Lisa must give up
  2 six packs soda. This is Lisas opportunity cost
  of a movie.

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• Change in Prices When prices change, so does the
  budget line. The lower the price of the good
  measured on the horizontal axis other things
  remaining the same, the flatter is the budget
  line.
• 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. The bigger the money
  income is the bigger the real income and budget
  line is further on the right.

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Figure 9.2 Changes in Prices and Income


a
a
Price of Movie is.
10
10
8
8
6
6
Soda (six-packs per month)
Soda (six-packs per month)
Income 30
4
4
Income 15
2
2
3
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f

f

6
0
2
4
6
8
10
5
3
1
7
9
0
1
2
3
4
5
Movies (per month)
Movies (per month)
(a) A change in price
(b) A change in income
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2. PREFERENCE AND INDIFFERENCE CURVES

• In this section we shall draw a map of a persons
  preferences. A preference map is a series of
  indifference curves
•  
• Indifference Curve is a line that shows
  combinations of goods among which a consumer is
  indifferent.

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The Marginal Rate of Substitution (MRS) is the
rate at which a person will give up good y to get
more of good x and at the same time remain
indifferent (remain on the same indifference
curve).

• MRS is measured by the magnitude of the slope of
  an indifference curve.
• If the indifference curve is steep, the marginal
  rate of substitutions is high. The person is
  willing to give up a large quantity of good y to
  get a small quantity of good x while remaining
  indifferent.
• If the indifference curve is flat, the marginal
  rate of substitutions is low. The person is
  willing to give up only a small amount of good y
  to get a large amount of good x to remain
  indifferent.

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Figure 9.4 The Marginal Rate of Substitution
10
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MRS 2

c
6
Price (six-packs per month)
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g


2
0
2
4
6
8
10
Movies (per month)
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• Diminishing Marginal Rate of Substitution is a
  general tendency for the marginal rate of
  substitution to diminish as the consumer moves
  along an indifference curve, increasing
  consumption of the good measured on the X-axis
  and decreasing consumption of the good measured
  on the y-axis.

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Figure 9.5 The Degree of Substitutability
Perfect complements
Perfect substitutes
Ordinary goods
10
10
5
8
8
4
Soda (cans)
Left running shoes
Makers pens at the local supermarket
6
6
3
4
4
2
2
2
1
0
2
4
6
8
10
0
2
4
6
8
10
0
1
2
3
4
5
Movies
Makers pens at the campus bookstore
Right running shoes
a) Ordinary goods
b) Perfect substitutes
c) Perfect complements
The shape of the indifference curves reveals the
degree of substitutability between two goods.
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4. PREDICTING CONSUMER BEHAVIOR

• We are now going to predict the quantities of
  movies and soda that Lisa chooses to buy. We
  assume that Lisa consumes at her best affordable
  point, which is 2 movies and 6 packs of soda, at
  point c.

Figure 9.6 The Best Affordable Point
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Lisas best affordable point is c. At that point
she is on her budget line and also on the highest
attainable indifference curve. This point is on
the budget line and on the highest attainable
indifference curve and has a marginal rate of
substitution equal to relative price (the slope
of the indifference curve is equal to the slope
of the budget line).
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• A Change in Price (The Price Effect)
• The effect of a change in price on the quantity
  of a good consumed is called the price effect.
  The effect of a price change (the price effect)
  can be divided into a substitution effect and an
  income effect.
• Substitution Effect is the effect of a change
  in price on the quantity bought when the consumer
  remains indifferent between the original and the
  new situation.
• Income Effect (A Change in Income)
• The effect of a change in income on consumption
  is called the income effect.

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Figure 9.9 Substitution Effect and Income Effect

k
Substitution effect
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b) Substitution Effect and Income Effect
a) Price Effect