Economics 001
Principles of Microeconomics
Professor Arik Levinson
•Lecture 9
– household choice
– budgets
– indifference curves
– MRS
– demand again
A diagram of the economy
Demand
Households
goods and
services
$
Firms
Supply
Household budget constraint
• $100 per week to spend on food and clothing
– food costs $5 per meal
– clothing costs $10 per article
10
unaffordable
P
slope 
P
clothing
food
clothes
affordable
20
food
Consumption Possibilities
PCQC + PFQF = Y
Divide both sides of this equation by PC, to give:
QC + (PF/PC)QF = Y/PC
Then subtract (PF/PC)QF from both sides of the equation to
give:
QC = Y/PC – (PF/PC)QF
The term Y/PC is the left intercept: real income in terms of
clothes, the maximum that can be spent entirely on
clothes.
The term PF/PC is the relative price of a food in terms of
clothes, the slope of the budget line.
3 changes:
• 1) Price inflation
• 2) Income increases
• 3) Relative price changes
1) Price inflation
10
• Inc = $150
• Pfood=$7.50
• Pclothes=$15
Nothing changes!
clothing
20
food
2) Income grows 50%
15
• Inc = $150
• Pfood=$5
• Pclothes=$10
10
clothing
20
food
30
3) Food price doubles
• Inc = $100
• Pfood=$10
• Pclothes=$10
10
clothing
10
20
food
Preferences
• Assumption #1: More is better.
• DN: Indifference curve = set of points
(combinations of goods) among which a consumer
is indifferent.
An indifference curve
10
Clothing
8
c
6
Preferred
4
Not
Preferred
2
0
2
4
g
6
8
Food
10
A set of indifference curves
10
Clothes
8
c
6
j
4
I2
2
0
g
2
4
6
I1
I0
8
Food
10
• Assumption #2: Indifference curves never
cross
• Assumption #3: Indifference curves not
bowed outwards from origin
Marginal Rate of Substitution
DN: Marginal rate of substitution (MRS)
= rate at which consumer willing to trade goods
= slope of indifference curve
= how much Y (clothes) for 1 unit X (food)
Marginal Rate of Substitution
10
8
Clothes
MRS = 2
6
c
4
MRS = 1/2
2
g
I1
0
2
4
6
8
Food
10
Marginal Rate of Substitution
• Notice: As the consumption of food
increases, the MRS decreases.
– This is referred to as the diminishing marginal
rate of substitution.
Substitutes and complements
(again)
• The shape of the indifference curves reveals
the degree of substitutability between two
goods.
Marker pens at the local supermarket
Degree of Substitutability
10
Perfect
substitutes
8
6
4
2
0
2
4
6
8
10
Marker pens at the campus bookstore
Left running shoes
Degree of Substitutability
5
Perfect
complements
4
3
2
1
0
1
2
3
4
5
Right running shoes
Budget
Preferences
C
C
F
F
•Defined by:
•PC, PF, income
•Assumptions:
•more better
•no X-ing
•bowed in
•Slope = PF/PC
•Slope = MRS
Soda (six-packs per month)
Put the two together . . . .
12
f
•Inc=$36
•Pmovie=$6
•Psoda=$3
Best
affordable
point: MRS=Pmovies/Psoda
c
6
d
i
I2
h
I1
I0
0
3
6
Movies (per month)
•Inc falls to $24
•Pmovie=$6
•Psoda=$3
Soda (six-packs per month)
Income effects
12
Income
$36
8
j
6
4
I2
Income
$24
0
I1
2 3
4
6
Movies (per month)
•Inc=$36
•Pmovie falls to $3
•Psoda=$3
Soda (six-packs per month)
Price effects
12
Best affordable
point: movies $6
c
6
j
3
Best affordable
point: movies $3
I1
0
3
6
9
12
Movies (per month)
I2
Good Y
Good X
Good Y
Demand Curve
Good X
Px
Good X