Diploma in Management Studies

Microeconomics ECO001
Lecture 6- Possibilities, Preferences & Choices
Topics to be discussed:
Budget Line and Consumption Possibilities
Indifference Curve and Indifference Map
Marginal Rate of Substitution
Consumers Best Affordable Point
Ref: Parkin, Chapter 8
1

Learning Outcomes
After this lecture, students should be able to:
Describe a households budget line and
show how it changes when prices or income
change
Make a map of preferences by using
indifference curves and explain the optimal
consumption choice
Predict the effects of changes in prices and
income on consumption choices
2

Consumption Possibilities
Household consumption choices are
constrained by its income and the prices of
the goods and services available.
The budget line describes the limits to the
households consumption choices.

Consumption Possibilities
The figure shows Lisas budget line.
Divisible goods can be
bought in any quantity
along the budget line
(gasoline, for example).
Indivisible goods must be
bought in whole units at
the points marked
(movies, for example).
Lisa can afford any point
on the budget line or
inside it.
4

Consumption Possibilities
The budget line is a constraint on Lisas
choices.

Lisa can afford

any point on her
budget line or
inside it.
Lisa cannot
afford any point
outside her
budget line.
5

Budget Equation
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.
Lisas budget equation is:

PSQS + PMQM = Y.
6

Real Income and Relative Price

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
The term Y/PS is Lisas real income in terms of
soda.
The term PM/PS is the relative price of a movie in
terms of soda.
7

Real Income and Relative Price

A households real income is the income expressed as
a quantity of goods the household can afford to buy.
Lisas 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 sodas must be
forgone to see an additional movie.
8

Change in Prices
A rise in the price of
the good on the xaxis decreases the
affordable quantity of
that good and
increases the slope
of the budget line.
The figure shows the
rotation of a budget
line after a change in
the relative price of
movies.

Change in Income
An change in money
income brings a
parallel shift of the
budget line.
The slope of the
budget line doesnt
change because the
relative price doesnt
change.
The figure shows the
effect of a fall in
income.
10

Indifference Curve
An indifference
curve is a line that
shows combinations
of goods among
which a consumer is
indifferent.
The figure illustrates
a consumers
indifference curve.
At point C, Lisa
consumes 2 movies
and 6 six-packs a
month.
11

Preferences and Indifference Curves

Lisa can sort all possible
combinations of goods
into three groups:
preferred, not preferred,
and indifferent.
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.
12

Preferences and Indifference Curves

All the points above
the indifference
curve are preferred
to the points on the
curve.
And all the points
on the indifference
curve are preferred
to the points below
the curve.
13

Preference Map
A preference map is series of indifference
curves.
Call the indifference
curve that weve just
seen I1.
I0 is an indifference
curve below I1.
Lisa prefers any
point on I1 to any
point on I0 .
14

Preference Map
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.

15

Marginal Rate of Substitution

The marginal rate of substitution, (MRS)
measures the rate at which:
A person is willing to give up good y, (the
good measured on the y-axis) to get an
additional unit of good x (the good
measured on the x-axis) and
At the same time remain indifferent (remain
on the same indifference curve).
The magnitude of the slope of the
indifference curve measures the marginal
rate of substitution.
16

Marginal Rate of Substitution

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.
17

Diminishing Marginal Rate of

Substitution
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, and at the
same time remain indifferent, as the
quantity of good x increases.

18

Diminishing MRS
The figure shows the diminishing MRS of
movies for soda.
At point C, Lisa is
willing to give up 2 sixpacks to see one more
movieher MRS is 2.
At point G, Lisa is
willing to give up 1/2 a
six-pack to see one
more movieher MRS
is 1/2.

19

Degree of Substitutability
Degree of Substitutability
The shape of the indifference curves reveals the
degree of substitutability between two goods.
The figures below show the indifference curves
for ordinary goods, perfects substitutes, and
perfect complements.

20

Consumers Best Affordable Point

The consumers best affordable point is:
On the budget line
On the highest attainable indifference curve
Has a marginal rate of substitution between
the two goods (Slope of indifference curve)
equal to the relative price of the two goods
(slope of budget line)

21

Best Affordable Point

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 clearly prefers C to
I.

22

Best Affordable Point

At point F, Lisas
MRS is greater than
the relative price.
At point H, Lisas
MRS is less than the
relative price.
At point C, Lisas
MRS is equal to the
relative price.
23

Price Effect
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.
The figure illustrates the price
effect and shows how the
consumers demand curve is
generated.
Initially, the price of a movie is
$6 and Lisa consumes at point
C in part (a) and at point A in
part (b).
24

Derive Demand Curve

The price of a movie
then falls to $3.

The budget line rotates

outward.
Lisas 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.
25

Income Effect
A Change in Income
The effect of a change in
income on the quantity of
a good consumed is
called the income effect.
The figure illustrates the
effect of a decrease in
Lisas income.
Initially, Lisa consumes at
point J in part (a) and at
point B on demand curve
D0 in part (b).
26

Income Effect
Lisas income decreases
and 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).
27

Exercise 6.1
Anna earns $150 a week and she consumes fish
and shrimp. The price of fish is $3 a pound and
the price of shrimp is $5 a pound. Anna can
therefore buy a maximum of _____ pounds of
fish or a maximum of _____ pounds of shrimp.
(A) 30, 50
(B) 50, 30
(C) 15, 30
(D) 30,15
(E) 50,15
28

Answers to Exercise 6.1

The correct answer is (B).
Out of $150, he can buy a maximum of
$150/$3 = 50 pounds of fish, or a
maximum of $150/$5 = 30 pounds of
shrimps.

29

Exercise 6.2
The quantity of Revlon nail polish demanded by
Jen decreased after the price of Revlon nail
polish increased. Jen decides to find a cheaper
brand of nail polish. This is called

A)
substitution effect of a price change

B)
increase in buyer's reservation price

C)
income effect of a price change

D)
shift in the supply curve

E)
decrease in buyer's reservation price
30

Answers to Exercise 6.2

The correct answer is (A)
When a consumer switch to a cheaper
substitute due to a higher price of the
original product, this reflects the
substitution effect of a price change.

31

Exercise 6.3
Units
1
2
3
4

Total Utility
of Food
75
135
180
210

Total utility of rooms

480
720
960
1120

Refer to the table above. If the price of Food is $5 and the

price of Rooms is $80, then the best spending
consumption implies _____ units of Food and ______
Rooms will be purchased.
(A) 4;3
(B) 3;4
(C) 4;4
(D) 3;3
(E) 4;1
32

Answers to Exercise 6.3

The correct answer is (E).
We need to calculate the
MU/P for both products.
The optimal consumption
combination occurs when
(MU/P)Food = (MU/P)Room.
From the table, the best
combination is 4 units of
food and 1 unit of room
Note that if information on
income is available, then
this combination should
also exhaust the income.

Unit

MU/P
Food

MU/P
Room

15

12

Exercise 6.4
(a) Explain why the best affordable
point is the point at which the budget
line touches the highest attainable
indifference curve.
(b) What happen when the consumer
has a higher income and one of the
product is an inferior good?

34

Answers to Exercise 6.4(a)

At the tangency point of an indifference
curve with the budget line, the
consumer gets the highest total utility
given his budget constraint, and hence
the point is the optimal consumption
point. Y
IC3
IC2
IC1
X

Answers to Exercise 6.4(b)

With a higher
income, the budget
line shifts outwards
in a parallel manner.
Assume that X is
inferior and Y is
normal. The final
equilibrium must
indicate a smaller
quantity of X
demanded and a
larger Y demanded

IC2
IC1
X2 X1

Exercise 6.5
Considers two products, A and B.
Represent A on the Y axis and B on the
X axis and establish the best affordable
point. What happen to the best
affordable point when the price of B
increases and B is a normal good?

37

Answers to Exercise 6.5

With a higher price
of B, the budget line
becomes steeper.
Consumption of B
decreases

A
F
G

E
IC2
B2

IC1
B1