Unit 8

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.
Make a map of preferences by using indifference curves and
explain the principle of diminishing marginal rate of
substitution.
Predict the effects of changes in prices and income on
consumption choices.
Themes of this chapter:
1.Consumption Possibilities
2.Preferences and Indifference Curves
3.Predicting Consumer Behaviour
 Consumption Possibilities
Consumption choices are limited by income and by prices. A household
has a given amount of income to spend and cannot infl uence the prices
of the goods and services it buys. A household’s budget line describes
the limits to its consumption choices.
Let’s look at Lerato’s budget line. She has an income of R30 a day to
spend. She buys two goods: cans of cooldrink and bars of chocolate. Th
e price of a can of cooldrink is R6, and the price of a bar of chocolate is
R3. Figure 7.1 shows alternative aff ordable ways for Lerato to consume
cans of cooldrink and bars of chocolate. Row A in the table says that she
can buy 10 bars of chocolate and drink no cans of cooldrink, a
combination of cans of cooldrink and bars of chocolate that exhausts her
daily income of R30. Row F says that Lerato can drink 5 cans of
cooldrink and eat no bars of chocolate – another combination that
exhausts theR30 available. Each of the other rows in the table also
exhausts Lerato’s income. The numbers in the table define Lerato’s
consumption possibilities. We can graph Lerato’s consumption
possibilities as points A to F in Figure 7.1.
Divisible and Indivisible Goods
Some goods – called divisible goods – can be bought
in any quantity desired. Examples are petrol and
electricity. We can best understand household
choice if we suppose that all goods and services are
divisible. For example, Lerato can consume a half a
can of cooldrink a day on average by drinking one
can of cooldrink every two days. When we think of
goods as being divisible, the consumption
possibilities are not just the points A to F shown in
Figure 8.1, but those points plus all the intermediate
points that form the line running from A to F. Such a
line is a budget line.
Lerato’s budget line is a constraint on her choices. It
marks the boundary between what is affordable and
what is unaffordable.
She can afford any point on the line and inside it.
She cannot afford any point outside the line. The
constraint on her consumption depends on prices and
her income, and the constraint changes when the
price of a good or her income changes. Let’s see
how by studying the budget equation
which states that: Expenditure = Income
A Change in Prices and Income
A 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.
Real income is expressed as the physical quantities of goods that can be purchased.
For example, if the price of a can of cooldrink falls from R6 to R3, real income in
terms of bars of chocolate does not change but the relative price of a can of cooldrink
falls. The budget line rotates outward and becomes flatter, as Figure 8.2(a) illustrates.
The higher the price of the good measured on the horizontal axis, other things
remaining the same, the steeper is the budget line. For example, if the price of a can of
cooldrink rises from R6 to R12, the relative price of a can of cooldrink increases. The
budget line rotates inward and becomes steeper, as Figure 8.2(a) illustrates.
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 a household’s
money income, the bigger is real income and the farther to the right is the budget line. The
smaller a household’s money income, the smaller is real income and the farther to the left is the
budget line. Figure 8.2(b) shows the effect of a change in money income on Lerato’s budget
line. The initial budget line when Lerato’s income is R30 is the same one that we began with in
Figure 7.1. The new budget line shows how much Lisa can consume if her income falls to R15
a day. The two budget lines have the same slope because the relative price is the same. The new
budget line is closer to the origin because Lerato’s real income has decreased.
Changes in income and/or prices of goods will affect the position
of the budget line and the final consumption combinations.
The budget line shows all possible consumption combinations
for two goods.

Figure 8.2
An indifference curve is a line that shows combinations of goods
among which a consumer is
indifferent. The indifference curve in Figure 7.3(a) tells us that Lerato is
just as happy to consume
2 cans of cooldrink and 6 bars of chocolate a day at point C as she is to
consume the combination
of cans of cooldrink and bars of chocolate at point G or at any other
point along the curve.
Lerato also says that she prefers all the combinations of cans of
cooldrink and bars of
chocolate above the indifference curve in Figure 7.3(a) – the light blue
area – to those on
the indifference curve. And she prefers any combination on the
indifference curve to any
combination in the grey area below the indifference curve.
The indifference curve in Figure 7.3(a) is just one of a whole family of
such curves. This
indifference curve appears again in Figure 7.3(b) labelled I1. The curves
Preferences and Indifference Curves
An indifference curve is a ‘map’ of a consumer’s preferences.
A single indifference curve shows a given level of utility.
An indifference curve is a line that shows combinations of goods among which a
consumer is indifferent. The indifference curve in Figure 8.3(a) tells us that Lerato is
just as happy to consume 2 cans of cooldrink and 6 bars of chocolate a day at point C
as she is to consume the combination of cans of cooldrink and bars of chocolate at
point G or at any other point along the curve.
Lerato also says that she prefers all the combinations of cans of cooldrink and bars of
chocolate above the indifference curve in Figure 8.3(a) – the light blue area – to those
on the indifference curve. And she prefers any combination on the indifference curve
to any combination in the grey area below the indifference curve.
The indifference curve in Figure 8.3(a) is just one of a whole family of such curves. This
indifference curve appears again in Figure 8.3(b) labelled I1. The curves labelled I0 and I2 are
two other indifference curves. Lerato prefers any point on indifference curve I2 to any point on
indifference curve I1, and she prefers any point on I1 to any point on I0. We refer to I2 as being
a higher indifference curve than I1 and I1 as being higher than I0.
A preference map is a series of indifference curves that resemble the contour lines on a
map. By looking at the shape of the contour lines on a map, we can draw conclusions about the
terrain. Similarly, by looking at the shape of indifference curves, we can draw conclusions
about a person’s preferences.
Figure 8.3
Marginal Rate of Substitution
The marginal rate of substitution is the slope of an indifference curve. The steeper the
indifference curve the higher is the marginal rate of substitution.
The marginal rate of substitution (MRS) is the rate at which a person will 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 an indifference curve measures the
marginal rate of substitution.
■If the indifference curve is steep, the marginal rate of substitution is high. The person
is willing to give up a large quantity of good y to get an additional unit of good x while
remaining indifferent.
■If the indifference curve is flat, the marginal rate of substitution is low. The person is
willing to give up a small amount of good y to get an additional unit of good x to
remain indifferent.
Figure 8.4 shows you how to calculate the marginal rate of substitution. Suppose that
Lerato eats 6 bars of chocolate and drinks 2 cans of cooldrink at point C on indifference
curve I1. To calculate her marginal rate of substitution we measure the magnitude of
the slope of the indifference curve at point C. To measure this magnitude, place a
straight line against, or tangent to, the indifference curve at point C. Along that line, as
the quantity of bars of chocolate decreases by 10, the number of cans of cooldrink
increases by 5 – an average of 2 bars of chocolate per can of cooldrink.
So at point C, Lerato is willing to give up bars of chocolate for cans of
cooldrink at the rate of 2 bars of chocolate per can of cooldrink – a
marginal rate of substitution of 2.
Now suppose that Lerato eats 1,5 bars of chocolate and drinks 6 cans of cooldrink
at point G in Figure 8.4. Her marginal rate of substitution is now measured by the
slope of the indifference curve at point G. That slope is the same as the slope of the
tangent to the indifference curve at point G. Here, as the quantity of bars of chocolate
decreases by 4,5, the number of cans of cooldrink increases by 9 – an average of 1–2
bar of chocolate per can of cooldrink. So at point G, Lerato is willing to give up bars of
chocolate for cans of cooldrink at the rate of 1–2 bar of chocolate per can of cooldrink
– a marginal rate of substitution of 1–2 .
As Lerato drinks more cans of cooldrink and eats less bars of chocolate, her marginal
rate of substitution diminishes. 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 x increases. In Lerato’s case, she is less willing to
give up chocolate to drink one more can of cooldrink as the number of cans of
cooldrink she drinks increases.
Figure 8.4
Degree of Substitutability
Most of us would not regard cans of cooldrink and bars of chocolate as being close substitutes.
We probably have some fairly clear ideas about how many cans of cooldrink we want to drink
each day and how many bars of chocolate we want to eat. But to some degree, we are willing to
substitute between these two goods. No matter how big a chocolate addict you are, there is surely
some increase in the number of cans of cooldrink you can drink that will compensate you for
being deprived of a bar of chocolate. Similarly, no matter how much you like cooldrink, surely
some number of bars of chocolate will compensate you for being deprived of drinking one can of
cooldrink. A person’s indifference curves for cans of cooldrink and bars of chocolate might look
something like those shown in Figure 8.5(a).
Close Substitutes
Some goods substitute so easily for each other that most of us do not even notice which we are
consuming. The different brands of personal computers are an example. As
long as it has an “Intel inside” and runs Windows, most of us don’t care whether our PC is a
Dell, a Compaq, a Sony, or any of a dozen other brands. The same holds true for marker pens.
Most of us don’t care whether we use a marker pen from the campus bookstore or one from the
local supermarket. When two goods are perfect substitutes, their indifference curves are straight
lines that slope downward, as Figure 8.5(b) illustrates. The marginal rate of substitution is
constant.
Complements
Some goods cannot substitute for each other at all. Instead, they are complements. The
complements in Figure 8.5(c) are left and right running shoes. Indifference curves of perfect
complements are L-shaped. One left running shoe and one right running shoe are as good as one
left shoe and two right ones. Having two of each is preferred to having one of each, but having
Figure 8.5
Predicting Consumer Behaviour
The position of the highest indifference curve and the budget line
predicts the combination of goods that will maximise utility.
At this point the marginal rate of substitution for the two goods
equals the ratio of their prices.

Figure 8.6
A Change in Price
Price changes lead to income
and substitution effects.

Figure 8.7
The Demand Curve
We’ve seen in Unit 3, that the demand curve slopes downward.
We can now derive a demand curve from a consumer’s budget line and indifference
curves.
By doing so, we can see that the law of demand and the downward-sloping demand
curve are consequences of the consumer’s choosing his or her best affordable
combination of goods.
To derive Lerato’s demand curve for cans of cooldrink, lower the price of a can and
find her best affordable point at different prices. We’ve just done this for two cooldrink
prices in Figure 8.7(a). Figure 8.7(b) highlights these two prices and two points that lie
on Lerato’s demand curve for cooldrink. When the price of a can of cooldrink is R6,
Lerato drinks 2 cans a day at point A.
When the price falls to R3, she increases the number of cans she drinks to 5 a day at
point B. The demand curve is made up of these two points plus all the other points that
tell us Lerato’s best affordable consumption of cans of cooldrink at each can of
cooldrink price, given the price of bars of chocolate and Lerato’s income. As you can
see, Lerato’s demand curve for cans of cooldrink slopes downward – the lower the
price of a can of cooldrink, the more cans of cooldrink she drinks each day. This is the
law of demand.
Next, let’s see how Lerato changes her consumption of cans of cooldrink and bars of
chocolate when her income changes.
A Change in Income
The effect of a change in income on consumption is called the income effect. Let’s
work out the income effect by examining how consumption changes when income
changes and prices remain constant. Figure 8.8 shows the income effect when Lerato’s
income falls. With an income of R30 and with the price of a can of cooldrink at R3 and
the price of chocolate at R3 a bar, she consumes at point J – 5 cans of cooldrink and 5
bars of chocolate. If her income falls to R21, she consumes at point K – she drinks 4
cans of cooldrink and eats 3 bars of chocolate. When Lerato’s income falls, she
consumes less of both goods. Cans of cooldrink and bars of chocolate are normal
goods.
The Demand Curve and the Income Effect
A change in income leads to a shift in the demand curve, as shown in Figure 8.8(b).
With an income of R30, Lerato’s demand curve is D0, the same as in Figure 8.7(b). But
when her income falls to R21, she plans to drink fewer cans of cooldrink at each price,
so her demand curve shifts leftward to D1.
Figure 8.8
Substitution Effect and Income Effect
For a normal good, a fall in price always increases the quantity bought. We can prove
this assertion by dividing the price effect into two parts:
■Substitution effect
■Income effect
Figure 8.9(a) shows the price effect, and in Figure 8.9(b) we separate the price effect
into its two parts.
Substitution Effect
The substitution effect is the effect of a change in price on the quantity bought when the
consumer (hypothetically) remains indifferent between the original situation and the new one.
To work out Lerato’s substitution effect, when the price of a can of cooldrink falls, we cut her
income by enough to leave her on the same indifference curve as before.
When the price of a can of cooldrink falls from R6 to R3, suppose (hypothetically)
that we cut Lerato’s income to R21. What’s special about R21? It is the income that is
just enough, at the new price of a can of cooldrink, to keep Lerato’s best affordable
point on the same indifference curve as her original consumption point C. Lerato’s budget line
is now the dark blue line in Figure 8.9(b).
With the lower price of cooldrink and a smaller income, Lerato’s best affordable point
is K on indifference curve I1. The move from C to K is the substitution effect of the price
change. The substitution effect of the fall in the price of a can of cooldrink is an increase in the
consumption of cans of cooldrink from 2 to 4. The direction of the substitution effect never
varies: When the relative price of a good falls, the consumer substitutes more of that good for
the other good.
Income Effect
To calculate the substitution effect, we gave Lerato a R9 pay cut. To calculate the
income effect, we give Lerato her R9 back. The R9 increase in income shifts Lerato’s
budget line outward, as shown in Figure 8.9(b). The slope of the budget line does not
change because both prices remain constant. This change in Lerato’s budget line is
similar to the one illustrated in Figure 8.8. As Lerato’s budget line shifts outward, her
consumption possibilities expand and her best affordable point becomes J on
indifference curve I2. The move from K to J is the income effect of the price change. In
this example, as Lerato’s income increases, she increases her consumption of cans of
cooldrink. For Lerato, a can of cooldrink is a normal good. For a normal good, the
income effect reinforces the substitution effect.
Inferior Goods
The example that we have just studied is that of a change in the price of a normal good. The
effect of a change in the price of an inferior good is different.
Recall that an inferior good is one whose consumption decreases as income increases.
For an inferior good, the income effect is negative. Thus for an inferior good, a lower
price does not always lead to an increase in the quantity demanded. The lower price
has a substitution effect that increases the quantity demanded. But the lower price also
has a negative income effect that reduces the demand for the inferior good. Thus the
income effect offsets the substitution effect to some degree. If the negative income effect
exceeded the positive substitution effect, the demand curve would slope upward. This case
does not appear to occur in the real world.
 Back to the Facts
We started this chapter
by observing how
consumer spending has
changed over the
years. The indifference
curve model explains
those changes. The
best affordable choices
determine spending
patterns. Changes in
prices and incomes
change the best
affordable choice and
change consumption
patterns.

Figure 8.9