ECN 201

Principles of Microeconomics
Consumption Possibilities
A household’s budget line describes the limits to its
consumption choices.
Divisible and Indivisible Goods
Some goods – called divisible goods – can be bought in
any quantity desired.
Examples are gasoline and electricity.
When we think of goods as being divisible, then it
includes all the intermediate points between A to F
along with A to F on Lisa’s budget line. (Figure 9.1)
Consumption Possibilities
Consumption Possibilities
Budget Equation
We can describe the budget line using a budget
equation. The budget equation starts with the fact
Expenditure = Income
Using Lisa’s Example
 Expenditure = (Price of Soda * Quantity of Soda) + (Price of
Movie * Quantity of Movie)
P Q +P Q =Y
S S M M

 Or, $4QS + $8QM = $40

Consumption Possibilities
After dividing both sides by PS and subtracting (PM/PS )*
QM , we get
QS = Y/PS – PM/PS * QM
Using figures
QS = $40/$4 – $8/$4 * QM
Or,
QS = 10 – 2QM
Consumption Possibilities
The budget equation contains two variables, which the
household can choose. They are:
 QM & Q S
And two variables, which are given. They are:
 Y/PS & PM/PS
We use these variables to understand Real Income and
Relative Price.
Real Income
 A household’s real income is its income expressed as a
quantity of goods that the household can afford to buy.
Consumption Possibilities
In terms of soda, Lisa’s real income is Y/PS.
This quantity is the maximum quantity of soda that she can
buy.
Lisa’s money income is $40, price of soda is $4. So her real
income is 10 cases of soda.
Relative Price
A relative price is the price of one good divided by the
price of another good.
In Lisa’s case PM/PS is the relative price of a movie in terms
of soda, which is 2 cases of soda.
Consumption Possibilities
That is, to see 1 movie Lisa must give away 2 cases of
soda.
This is also her opportunity cost.
The relative price of a movie in terms of soda is the
magnitude of the slope of Lisa’s budget line.
A Change in Prices
When prices change, so does the budget line.
The lower the price of the good measured on the x-axis,
other things remaining the same, the flatter is the
budget line. (Figure 9.2 a)
Consumption Possibilities
Consumption Possibilities
If the price of movie falls from $8 to $4, then the budget
line rotates outward and becomes flatter.
Real income in terms of soda does not change but the
relative price of a movie falls.
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.
A decrease in money income decreases real income and
shifts the budget line leftward. (figure 9.2 b)
Consumption Possibilities
Preferences and Indifference Curves
A preference map is based on the intuitively appealing
idea that people can sort all the possible combinations
of goods into three groups: preferred, not preferred
and indifferent.
Figure 9.3 (a) shows the three groups.
Indifference Curve
An indifference curve is a line that shows
combinations of goods among which a consumer is
indifferent.
Preferences and Indifference Curves
Preferences and Indifference Curves
Four properties of indifference curves
• Higher indifference curves are preferred to lower ones
– Higher indifference curves – consume more
• Indifference curves are downward sloping
• Indifference curves do not cross
• Indifference curves are bowed inward toward the
graph’s origin
Preferences and Indifference Curves
The Impossibility of Intersecting Indifference Curves
Quantity
of Pepsi
C
A

0 Quantity of Pizza

A situation like this can never happen. According to these indifference curves, the
consumer would be equally satisfied at points A, B, and C, even though point C has
more of both goods than point A.

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 Bowed Indifference Curves
Quantity of Pepsi
Indifference curves are usually
bowed inward. This shape
implies that the marginal rate
14 of substitution (MRS) depends
on the quantity of the two
goods the consumer is
MRS=6 currently consuming.
At point A, the consumer has
A little pizza and much Pepsi, so
8 she requires a lot of extra
1 Pepsi to induce her to give up
one of the pizzas: The MRS is
6 liters of Pepsi per pizza.
4 B Indifference
MRS=1 At point B, the consumer has
3 curve
1 much pizza and little Pepsi, so
she requires only a little extra
Pepsi to induce her to give up
0 2 3 6 7 Quantity of Pizza one of the pizzas: The MRS is 1
liter of Pepsi per pizza.

17
Preferences and Indifference Curves
In figure 9.3 (b) Lisa is indifferent between points C and
G and prefers J over C and G.
 Among the 3 indifference curves combinations on I0 is
the least preferred and I2 is the most preferred.
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) while remaining
indifferent.
Preferences and Indifference Curves
Preferences and Indifference Curves
The magnitude of the slope of an indifference curve
measures the marginal rate of substitution.
If the indifference curve is steep, MRS is high.
If the Indifference curve is flat, MRS is low.
In figure 9.4, at point C, Lisa is willing to give up more
soda to get 1 additional movie – MRS is high.
At point G, Lisa is willing to give up less soda to get 1
additional movie – MRS is low.
Preferences and Indifference Curves
Diminishing marginal rate of substitution
 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 x increases.
Degree of Substitutability
Movies and soda are not close substitutes but they are
substitutes.
A person’s indifference curve for movies and soda will
look like the one for ordinary goods in figure 9.5 (a)
Preferences and Indifference Curves –
Degree of Substitutability
Preferences and Indifference Curves
Close Substitutes
 These are goods which can be easily substituted for each
other.
 Examples include different brands of marker pens and pencils.
 MRS is constant. (Figure 9.5 (b))

Complements
 Some goods do not substitute for each other at all. Instead,
they are complements.
 In figure 9.5 (c) we see left and right running shoes are perfect
complements.
 Indifference curves of perfect complements are L-shaped.
Preferences and Indifference Curves
Usually indifference curves are between the two extreme
cases.
If two goods are closer to close substitutes, the curves
are close to straight line and MRS is closer to constant.
For poorer substitutes, the indifference curve is tightly
curved.
Predicting Consumer Choices
We now predict the quantities of movies and soda Lisa
chooses to buy.
And how these quantities change when a price or
income changes.
Best Affordable Choice
For best affordable choice, Lisa spends all her income
and is on her highest attainable indifference curve.
The best affordable point is on the budget line and on
the highest attainable indifference curve.
Predicting Consumer Choices- Best
Affordable Choice
Predicting Consumer Choices
That is, this point occurs when the highest attainable
indifference curve is tangent to the budget line.
In figure 9.6, point C is the best affordable point.
At this point MRS (slope of indifference curve) is equal
to relative price (slope of budget line).
A Change in Price
Price Effect: The effect of a change in the price of a
good on the quantity of the good consumed is called the
price effect.
Predicting Consumer Choices- A Change in
Price
Predicting Consumer Choices
Figure 9.7 (a) shows price effect.
Initially, Lisa’s best affordable point is C.
When price of movies fall from $8 to $4, the budget line
rotate outwards and J becomes best affordable point.
At point J, Lisa is at a higher indifference curve.
Figure 9.7 (b) shows the demand curve, which is derived
from consumer’s budget line and indifference curve.
Lisa’s demand curve is downward sloping- the lower the
price of movie, the more movies she sees.
Predicting Consumer Choices
A Change in Income
Income Effect: The effect of a change in income on
buying plans is called the income effect.
Figure 9.8 shows the income effect when Lisa’s income
falls.
Lisa’s best affordable point changes from J to K as the
budget line shifts leftward.
She buys less of both goods when her income falls,
because both are normal goods.
A change in the income leads to a shift in the demand
curve. Shown in figure 9.8 (b).
Predicting Consumer Choices- A Change in
Income