Chapter8&9
1. Consumption Possibilities
a. Budget Constraint
An individual has 𝐼 dollars to allocate between good 𝑥 and good 𝑦. If 𝑃𝑥 is the price of good 𝑥 and 𝑃𝑦
is the price of good 𝑦, then the individual is constrained by 𝐼 ≥ 𝑃𝑥 𝑥 + 𝑃𝑦 𝑦.
Quantity of y
I = Px x + Py y
I Px
y= − x
Py Py
Slope of budget line
The slope of budget line (relative price)
shows how 𝑦 can be traded for 𝑥 in
Quantity of x the market.
b. Change in price V.S. Change in income
2. Consumption Preference
a. Indifference Curves
Shows a set of consumption bundles about which the individual is indifferent. That is, the bundles provide the
same level of utility (e.g. satisfaction, happiness)
Quantity of y
Increasing Utility
U3 > U2 > U1
y1 A
U3
U2
y2 B
U1
Quantity of
x1 x2
Both consumption bundle A and B generates the same utility level
Movements in a northeast direction represent movements to higher levels of satisfaction
b. Indifference Curves Cannot Intersect
c. Marginal Rate of Substitution (MRS)
It is the slope of the indifference curve. The rate at which a person is willing to give up good y to get an
additional unit of good x (remain on the same indifference curve)
∆𝑈 = 𝑀𝑈𝑥 ∆𝑥 + 𝑀𝑈𝑦 ∆𝑦
0 = 𝑀𝑈𝑥 ∆𝑥 + 𝑀𝑈𝑦 ∆𝑦 (Along the indifference ∆U = 0
∆Y 𝑀𝑈
𝑀𝑅𝑆 = ∆X = 𝑀𝑈𝑥
𝑦
Quantity of y
Diminishing Marginal Rate of Substitution (DMRS):
It is a general tendency for a person to be willing to give up
less good 𝑦 to get one more unit of good 𝑥, while at the
same time remaining indifferent as the quantity of good 𝑥
DMRS
increases.
+1 unit
+1 unit U1
Quantity of x
3. Utility Maximization and Choice
Point A represents the highest utility level that can be
𝑀𝑈 𝑃𝑥
reached by the individual ( 𝑀𝑅𝑆 = 𝑀𝑈𝑥 = 𝑃𝑦 ), given the
𝑦
Quantity of
budget constraint
y I' B
Py
𝑃
At point B,𝑀𝑅𝑆 > 𝑃𝑥 , increase the consumption of 𝑥
𝑦
E
𝑃
y* A At point D,𝑀𝑅𝑆 < 𝑃𝑥 , decrease the consumption of 𝑥
𝑦
C
Point E is not attainable
U3
D
U2
U1
Quantity of
x* I'
Px
4. Separating Income Effect and Substitution Effect
How price change affects the quantities demanded? – Price effect
Normal goods:
Quantity of y
I'
Py
y* A
U1
Quantity of x
x* I'
Px
Practice Questions
1. Katy has made her best affordable choice of noodles and iced tea. She spends all of her income on 15
packets of instant noodles at $3 each and 30 cups of iced tea at $2 each. Now the price of a packet of noodles
rises to $3.5 per packet and the price of iced tea falls to $1.75 a cup.
a) Will Katy now be able to consume 15 packets of instant noodles and 30 cups of iced tea?
b) If Katy changes the quantities she buys, will she buy more or fewer packets of instant noodles? Explain
your answer.
2. Sara's income is $12 a week. The price of popcorn is $3 a bag, and the price of cola is $1.5 a can. Assume
that both are normal goods.
a) By using the budget line and indifference curves, graphically demonstrate Sara's optimal consumption
behavior.
b) Suppose that the price of cola rises to $3 a can. All other things remain the same. Graphically demonstrate
Sara's optimal consumption behavior.
c) Graphically demonstrate the price effect. Especially, you need to separate the income effect and the
substitution effect clearly.
Appendix:
Mathematics review:
