Possibilities, Preferences and Choices

Possibilities, Preferences
and Choices

Consumption Possibilities
The GST
Interlude
Preferences and Indifference Curves
The Households Consumption Choice
Consumption Possibilities
Constraint on consumption possibilities--the budget
line
Example: Lisa has $30; pop costs $3 per six-pack,
movies cost $6 each--just like the case weve
studied already
Consumption Possibilities
Consumption Movies Pop
possibility (per month) (per month)
a 0 10
b 1 8
c 2 6
d 3 4
e 4 2
f 5 0
 Consumption Possibilities
Fig. 8.1 shows
Lisas budget line
Its position
depends on Lisas
income and on the
prices she faces
 The Budget Equation
In General In Lisa's Case
1. The variables
Income = y y = $30
Price of movies = Pm Pm = $6
Price of pop = Pp Pp = $3
Quantity of movies = Qm Qm = Lisas choice
Quantity of pop = Qp Qp = Lisas choice
The Budget Equation

2. The budget

PpQp + PmQm = y

$3Qp + $6Qm = $30

The Budget Equation

3. The budget line

PpQp + PmQm = y
Divide both sides of equation by Pp
Qp + (Pm/Pp)Qm = y/Pp
Subtract (Pm/Pp)Qm from both sides of equation
Qp = y/Pp- (Pm/Pp)Qm
The Budget Equation

4. The budget line with numbers

$3Qp + $6Qm = $30
Divide both sides of equation by Pp ($3)
Qp + ($6/$3)Qm = $30/$3
Subtract ($6/$3)Qm from both sides of equation
Qp = 10 - 2Qm
 The Budget Equation
Fig. 8.1 shows
the budget line
for the case
weve just
calculated
It is the line
abcdef
A Change in Prices
A change in the price of movies--price of a movie falls
to $3
Qp = y/Pp- (Pm/Pp)Qm
Qp = $30/$3 - ($3/$3)Qm
Qp = 10 - Qm
 The Budget Equation
Fig. 8.2(a) shows
the original
budget line
labeled $6
 The Budget Equation
Fig. 8.2(a) also
shows the
budget line for
the case weve
just calculated
It is the line
labeled $3
A Change in Prices
A change in the price of movies--price of a movie
rises to $12
Qp = y/Pp- (Pm/Pp)Qm
Qp = $30/$3 - ($12/$3)Qm
Qp = 10 - 4Qm
 The Budget Equation
Fig. 8.2(a) shows
the budget line
for the case
weve just
calculated
It is the line
labeled $12
A Change in Prices
A change in the price of pop--price rises from $3 to
$6
Qp = y/Pp- (Pm/Pp)Qm
Qp = $30/$6 - ($12/$6)Qm
Qp = 5 - 2Qm
[No picture for this case]
A Change in Income
A change in income--income falls from $30 to $15
[prices remain at $3 for pop and $6 for movies]
Qp = y/Pp- (Pm/Pp)Qm
Qp = $15/$3 - ($6/$3)Qm
Qp = 5 - 2Qm
 The Budget Equation
Fig. 8.2(b)
shows the
budget line for
the case weve
just calculated
It is the line
labeled Income
$15
The GST
GST replaced FST
GST--7% on most goods and services
FST--13% on goods only
How did the GST change peoples budget lines?
GST Example
Exaggerated so we can see the effects more easily
Movie, a service is taxed at 25%, previously untaxed
$6 x 1.25 = $7.50
Pop, a good tax is taxed at 25% under GST but 50%
FST is removed
($3 x 1.25)/1.50 = $2.50
GST Example
Originally
Qp = y/Pp- (Pm/Pp)Qm
Qp = $30/$3 - ($6/$3)Qm
Qp = 10 - 2Qm
New
Qp = $30/$2.5 - ($7.5/$2.5)Qm
Qp = 12 - 3Qm
Preferences
Four fundamental assumptions
Preferences do not depend on prices
Preferences do not depend on income
More of any good is preferred to less
The more of good A and the less of good B is
consumed, the less willing is a consumer to give up
B in exchange for A
 Mapping Preferences
Fig. 8.3 shows
preference
relations
Along the green
indifference
curve, Lisa is
indifferent
 Mapping Preferences
Combination c is
just as good as
combination g
 Mapping Preferences
The points above
the indifference
curve, are
preferred to the
points on the
curve
 Mapping Preferences
The points on
the indifference
curve, are
preferred to the
points below the
curve
 Preference Map
Fig. 8.4 shows a
preference map
Indifference
curves are like
contours on a
regular map
 Preference Map
A point on I2,
such as point j is
preferred to
points on I1 such
as c and g
 Preference Map
Points on I1 are
preferred to
points on I0
Marginal Rate of
Substitution
The marginal rate of substitution--MRS--is the rate
at which a person gives up good Y to get more of
good X and at the same time remain indifferent.
The MRS is the slope of an indifference curve
 Marginal Rate of
Substitution
Fig. 8.5 shows
the marginal
rate of
substitution
At point c, the
MRS is 2
 Marginal Rate of
Substitution
At point g, the
MRS is 1/2
As more movies
and less pop is
consumed, the
MRS diminishes
Marginal rate of
substitution
Recall assumption 4 about preferences
The more of good A and the less of good B is
consumed, the less willing is a consumer to give up B
in exchange for A
Assumption 4 is the law of diminishing marginal
rate of substitution
Substitutes and
Complements
Degree of substitutability
Ordinary goods
Perfect substitutes
Perfect complements
Fig. 8.6 shows the indifference curves for these
three cases
 Substitutes and
Complements
Figure 8.6(a)
shows the
indifference
curves for
ordinary goods
and services
The marginal
rate of
substitution
diminishes
 Substitutes and
Complements
Figure 8.6(b)
shows the
indifference
curves for
perfect
substitutes
The marginal
rate of
substitution is
constant
 Substitutes and
Complements
Figure 8.6(c)
shows the
indifference
curves for
perfect
complements
The Households
Consumption Choice
The household chooses the best affordable point
The best affordable point has two properties. It is
On the budget line
On the highest attainable indifference curve
Fig. 8.7 shows the best affordable point
 The Households
Consumption Choice
Point c is the
best affordable
point
Lisa can
consume at
point h, but this
point is inferior
to c
 The Households
Consumption Choice
At the best
affordable
point, the MRS
equals the
relative price