9

C h a p t e r POSSIBILITES,
PREFERENCES,
AND CHOICES

The Big Picture

Where we have been:
This chapter, along with Chapter 8, examines the consumer choices that underlie the law
of demand. Budget lines were introduced in Chapter 8 and are more fully explored in this
chapter. This chapter shows how the substitution effect combined with the income effect
for a normal good always leads to the downward-sloping demand curve, which was
assumed in Chapter 3. The concept of slope, as explained in Chapter 1 (appendix), is
used to show that in equilibrium the MRS equals the relative price of the goods.

Where we are going:

Chapters 10 and 11 study the theory of the firm and the firm’s costs, and Chapters 12
through 15 look at firm behavior in different market structures.

New in the Thirteenth Edition

The material in this chapter is similar to the last edition, but the case studies have been
updated. The chapter opener considers why video streaming hasn’t completely replaced
movie theaters and why it is taking students longer to complete college degrees, both of
which are addressed in later examples. The Economics in Action has been updated and
expanded to include video streaming as an option. The Economics in News analysis considers
how rising costs for college have made some students take longer to finish their degrees.

© 2019 Pearson Education Ltd.

Lecture Notes
Possibilities, Preferences, and Choices
 A person’s budget in combination with his or her preferences determines what goods and services the
person consumes.
 Using the budget line and indifference curves, economists can predict how changes in the price of a
good or service affect the quantity a person demands.
I. Consumption Possibilities
 A household’s consumption choices are constrained by its income and the prices of the goods and
services available. A household’s budget line describes the limits to its consumption choices.
 The figure to the right shows a budget line for a
household that buys only pizzas and books. The
household can buy any combination of pizza and
books that lies on or within the budget line.
Combinations that lie beyond the budget line are
unaffordable.
 Divisible goods can be bought in any quantity and
we can best understand household choices if we
assume all goods are divisible.
 The budget line illustrates a constraint on choices.
Any point on or inside the line can be purchased.
Any point outside the line is unaffordable and cannot
be purchased.
Budget Equation
 We can describe the budget line by using a budget
equation, which states that income equals expenditure.
 Calling the price of a book PB, the quantity of books QB, the price of a pizza PP, the quantity of
pizza QP, and income Y, we can write a budget equation as PB  QB + PP  QP = Y, which can be
rearranged into slope-intercept form as QB = Y/PB  (PP / PB )  QP.
 A household’s real income is the household’s income expressed as a quantity of goods the
household can afford to buy. In the figure above, in terms of books, the household’s real income is
Y/PB (5 books), which is the vertical intercept of the budget line.
 A relative price is the price of one good divided by the price of another good. The magnitude of the
slope of the budget line, (PP / PB ), is the relative price of a pizza in terms of a book. A relative price
is an opportunity cost, so the relative price of a pizza in terms of books gives the opportunity cost of
a pizza in terms of books forgone.
 When the price of the good measured along the horizontal axis (pizzas) changes, the budget line
rotates around the vertical intercept. If the price of the good falls, the budget line rotates outward and
becomes flatter; if the price of the good rises, the budget line rotates inward and becomes steeper.
 When income changes, the budget line shifts and its slope does not change. If income increases, the
budget line shifts outward; if income decreases, the budget line shifts inward.

Example: The budget line as a menu. Emphasize that the consumer’s budget line is like that part of a menu
that delineates all affordable combinations of food and drinks that are available to the consumer given a
budget.
If you want to push this analogy, have the students assign a price to each of the two goods and then choose a
level of income to be spent on the dinner. Draw the budget line and then have the students show how a rise
in the price of drinks or the price of food would rotate the budget line and change relative prices. Then have
100 CHAPTER 9

the students help you illustrate how an increase in income shifts the budget line allowing more food (perhaps
dessert) and the second glass of wine.

II. Preferences and Indifference Curves

 A preference map shows how a person ranks various combinations of goods and services.
 Indifference curves are used to illustrate a person’s
preference map. An indifference curve is a line that
shows combinations of goods among which a
consumer is indifferent. The figure to the right shows
three of a person’s indifference curves between pizza
and books.
 By construction the consumer is indifferent
among all the points on any particular
indifference curve.
 The consumer prefers points above any
particular indifference curve to points on the
curve. And the consumer prefers points on the
indifference curve to points below the curve. In
the figure, the consumer prefers any point on
indifference curve I2 to any point on I1 and any
point on I3 to any point on I2.
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 remaining indifferent (remaining on the same indifference curve).
 The magnitude of the slope of the indifference curve at any point measures the marginal rate of
substitution between the goods. If the indifference curve is steep, the MRS is high; if the
indifference curve is flat, the MRS is small.
 The diminishing marginal rate of substitution is the general tendency for a person to be
willing to give up less of good y to get one unit of good x, and at the same time remain
indifferent, as the quantity of x increases. This principle implies that indifference curves
generally become flatter moving along them to the right.
Degree of Substitutability
 The indifference curves between most goods are bowed in, with a diminishing MRS.
 The indifference curves for perfect substitutes are linear, with a constant MRS.
 The indifference curves for perfect complements are L-shaped. Utility increases (the consumer
moves to a higher indifference curve) only if the quantity of both goods x and y increases.
Perfect substitutes or just substitutes? Students will remember discussions of substitutes and complements
in consumption from Chapter 3, and often don’t see how “perfect” substitutes or complements are any
different. Be sure to use examples to show how, even for most goods that are considered substitutes (or
complements), the MRS will still be diminishing. Only when a consumer’s willingness to trade one good for
the other is constant (i.e., MRS is linear) are two goods considered “perfect” substitutes. Similarly, you may
drink cream in your coffee, implying coffee and cream are complements, but they’re not likely to be
“perfect” complements. A cup of coffee without cream may still be better (increase your utility) than no
coffee at all.

© 2019 Pearson Education Ltd.

 POSSIBILITIES, PREFERENCES, AND CHOICES 101

III. Predicting Consumer Choices

Best Affordable Choice
 The consumer will select his or her best affordable
point. This point:
 is on the budget line,
 is on the highest attainable indifference curve,
 has a marginal rate of substitution between the
two goods equal to the relative price of the two
goods.
 The figure shows the best affordable point, 2 pizzas
and 3 books. This combination is on the budget, and
hence is “affordable.” It also is on the highest
indifference curve so that the marginal rate of
substitution equals the relative price of the two
goods, and hence the point is “best.”
The meaning of tangency. Emphasize to your students the meaning behind the tangency point between the
indifference curve and the budget line. In particular, the marginal rate of substitution (MRS) shows the
consumer’s willingness to give up one good to get more of the other good. The relative price of the two
goods shows what the consumer must give up one good to get more of the other good. When a consumer
equates the marginal rate of substitution (MRS) to the relative price ratio, the consumer is just willing to give
up what he or she must give up, and there are no unrealized gains from substituting one good for another.

A Change In Price
 The price effect shows how a change in the price of a good affects the quantity consumed of that
good.
 When the price of the good on the x-axis falls, the budget line rotates around the y-axis intercept and
becomes flatter. The person moves to a new consumption point. The new consumption bundle
satisfies all three properties: It is on the new budget line, it is on the highest attainable indifference
curve, and the MRS equals the slope of the new budget line.
 When the price of a good changes, tracking the change in the quantity of the good consumed reveals
the demand curve for that good.
The Economics in Action case study considers how the best affordable combination of movies, DVD rentals,
and video streaming have changed over time, largely due to changes in prices, first in the DVD rental market
and now with Netflix and video streaming. Have students illustrate this result for themselves, shifting the
budget line between movies and streaming and seeing what the new equilibrium might look like.

A Change In Income
 The income effect shows how a change in income affects the buying plans of consumers.
 When the price of the goods remains constant, a change in income shifts the budget line. This shift
changes which indifference curve is highest attainable indifference curve. The person moves to a
new consumption point. The new consumption bundle satisfies all three properties: it is on the new
budget line; it is on the highest attainable indifference curve; and the MRS equals the slope of the
new budget line.
 A change in income shifts the demand curve, because a different quantity is consumed at the same
prices.
 If income rises and more is consumed at each price (or if income falls and less is consumed at each
price) the good is a normal good.

© 2019 Pearson Education Ltd.

102 CHAPTER 9

Substitution Effect and Income Effect

 For a normal good, a rise in price always decreases the quantity consumed. This result is shown by
breaking the price effect into two parts, as illustrated in the figure in which the price of movies rise:
 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.
The substitution effect is showing by moving
the new budget line (with its new slope) so that
it is tangent to the initial indifference curve.
This procedure creates a (hypothetical) new
best affordable point using the initial
indifference curve and the hypothetical budget
line. Comparing the initial best affordable point
to this new one captures the substitution effect.
In the figure this compares point a to point b.
The substitution effect of a rise in price always
leads to a decrease in the quantity consumed.
 The income effect is the effect on the quantity
bought of a change in income sufficient to shift
the hypothetical budget line used to measure the substitution effect, so that it is the same as the
actual new budget line. This process is the movement from point b to point d in the figure. For
a rise in price, this change requires a decrease in income. For a normal good, the decrease in
income decreases the quantity consumed. So for a normal good, the substitution effect and the
income effect reinforce each other: both demonstrate that the quantity consumed decreases. For
an inferior good, the decrease in income increases the quantity consumed. So for an inferior
good, the substitution effect and the income effect have opposite effects on the quantity
consumed. It is theoretically possible for the income effect to be large enough that the rise in
the price of the good results in an increase in the quantity demanded. But such a case has not
been observed in reality.
Income and substitution effects: two separate influences over demand. Income and substitution effects are
typically difficult concepts for students to grasp. Be sure that the students understand how a change in a
good’s price causes two separate influences on a consumer’s purchase decision: i) a higher (lower) price
raises (lowers) the opportunity cost of that good, making that good less (more) attractive than all other
goods; and ii) a higher (lower) price means less (more) of all goods and services is affordable, causing the
quantity demanded for all normal goods to decrease (increase). A consumer may not think of each effect
individually when making consumption decisions, but both effects will have an impact.

Can the income effect for an inferior good ever dominate the substitution effect? Many economists have
studied the infamous potato famine in Ireland in the mid-19th century in search of the elusive “upward-
sloping demand curve” associated with strongly inferior goods. Indeed, when food became even scarcer than
usual in that poverty-stricken country, historical records indicate that Irish families consumed a greater
quantity of potatoes as the market price of potatoes increased. Many economists were misled into thinking
they had found historical evidence of the world’s first recorded positively-sloped demand curve! However,
they failed to remember their basic economics: it is the relative price of potatoes that is tracked on the
demand curve for potatoes, not the money price. The money price of potatoes rose more slowly than the
prices of other foods. This change lowered the relative price of potatoes to Irish families and so the quantity
they consumed increased, in accord with the law of demand. Although some experimental evidence exists to
show that demand curves with a positive slope might exist, there are no good real-world examples.

© 2019 Pearson Education Ltd.

 POSSIBILITIES, PREFERENCES, AND CHOICES 103

An Addendum: Relationship between MRS and MU ratios: If you’ve covered both the marginal utility
theory (from Chapter 8) and indifference curve theory of consumer choice in this chapter--and you’re
teaching an honors section of economics majors--you might want to spend a bit of time demonstrating the
equivalence of the two sets of results. The basic analysis that you might cover is the following: In marginal
utility theory, total utility is maximized when
MUM /PM = MUS/PS. (the subscript M stands for movies and the subscript S stands for sodas to be consistent
with the textbook example)
In indifference curve theory, the consumer is at the best affordable point when the marginal rate of
substitution of movies for soda equals the relative price of movies in terms of soda. That is:
MRS = PM /PS
These two propositions are equivalent. To see why, there are a couple of ways to explain this. If your
students are particularly good at math, begin with the fact that the change in total utility can be written as:
Change in Total Utility = MUM  QM + MUS  QS
where  means “change in” and QM and QS are the quantities of movies and soda.
Because a consumer is indifferent between any pair of points along an indifference curve, you can think of
an indifference curve as a constant utility curve. So along an indifference curve, the change in total utility is
zero. When the change in total utility is zero,
0 = MUM QM + MUS  QS,
And so
MUM  QM = –MUS  QS.
Now divide both sides of this equation by QM and also divide both sides by MUS to obtain:
QS /QM = -MUM /MUS
Notice that the left-hand side of the last equation is the change in soda divided by the change in movies
along an indifference curve, which is the slope of the indifference curve. But the magnitude of the slope of
an indifference curve is the marginal rate of substitution. So,
MRS = MUM /MUS
That is, the marginal rate of substitution of movies for soda is the ratio of the marginal utilities of movies
and soda.
Alternatively (or even in addition), many students appreciate an intuitive explanation of the relationship
between the MRS and MUM /MUS. Simply start with the marginal utility of a movie equal to some number
(20, for example). If the consumer would like a soda half as much as a movie, then the marginal utility of a
soda would be 10 in that example. In that case, MUM /MUS = 20/10 = 2.
Then ask students if they could answer the following question: “How many sodas would the consumer be
willing to give up for a movie?” Most students will see that the movie is worth 2 sodas. This is simply the
definition of the marginal rate of substitution, and it will always be the case that the ratio of marginal
utilities will be equal to the marginal rate of substitution.
Regardless of the method you use to show that MRS = MUM /MUS, the main point is that the consumer
chooses the best affordable point by making the MRS equal the relative price. But that is the same as
MUM /MUS = PM /PS.
Multiply both sides of this equation by MUS and divide both sides by PM to obtain the marginal utility theory
proposition:
MUM /PM = MUS /PS.

Economics in the News at the end of the chapter considers why it is taking students longer to finish college
and focuses especially on the impact of higher college costs on students’ behavior.

© 2019 Pearson Education Ltd.

104 CHAPTER 9

Additional Problems
1. Marc has an income of $20 per week. Root beer
costs $5 a can and CDs cost $10 each. Figure 9.1
illustrates his preferences.
a. What are the quantities of root beer and CDs that
Marc buys?
b. What is Marc’s marginal rate of substitution of
CDs for root beer at the point at which he
consumes?
2. Now suppose that in the situation described in
problem 1, the price of a CD falls to $5 and the
price of root beer and Marc’s income remain
constant.
a. Find the new quantities of root beer and CDs that
Marc buys.
b. Find two points on Marc’s demand curve for
CDs.
c. Find the substitution effect of the price change.
d. Find the income effect of the price change.
e. Are CDs a normal good or an inferior good for Marc?
3. Pete buys tuna and golf balls. The price of tuna is $2 a can, and the price of a golf ball is $1.
Each month, Pete spends all of his income and buys 20 cans of tuna and 40 golf balls. Next
month, the price of tuna will rise to $3 a can and the price of a golf ball will fall to 50¢.
Assume that Pete’s preference map shows indifference curves have a bowed in shape so that
they show a diminishing marginal rate of substitution.
a. Will Pete be able to buy 20 cans of tuna and 40 golf balls next month?
b. Will Pete want to buy 20 cans of tuna and 40 golf balls?
c. Which situation does Pete prefer: tuna at $2 a can and golf balls at $1 each or tuna at $3 a
can and golf balls at 50¢ each?
d. If Pete changes the quantities that he buys, which good will he buy more of and which less
of?
e. When the prices change next month, will there be an income effect and a substitution effect
at work or just one of them?
4. The sales tax is a tax on goods. Some people say that a consumption tax, a tax on both goods
and services, would be better. Explain and illustrate with a graph what would happen if we
replaced the sales tax with a consumption tax to
a. The relative price of books and haircuts.
b. The budget line showing the quantities of books and haircuts you can afford to buy.
c. Your purchases of books and haircuts.

© 2019 Pearson Education Ltd.

 POSSIBILITIES, PREFERENCES, AND CHOICES 105

Solutions to Additional Problems

1. a. Marc buys 2 cans of root beer and 1 CD. Marc buys the quantities of root beer and CDs that moves
him onto the highest indifference curve, given his income and the prices of root beer and CDs. The
graph shows Marc’s indifference curves. So draw Marc’s budget line on the graph. The budget line is
tangential to indifference curve I0 at 2 cans of root beer and 1 CD. The indifference curve I0 is the
highest indifference curve that Marc can get attain.
b. Marc’s marginal rate of substitution is 2. The marginal rate of substitution is the magnitude of the
slope of the indifference curve at Marc’s consumption point, which equals the magnitude of the
slope of the budget line. The slope of Marc’s budget line is 2, so the marginal rate of substitution is
2.
2. a. Marc buys 1 can of root beer and 3 CDs. Draw the new budget line on the graph with Marc’s
indifference curves. The budget line now runs from 4 CDs on the x-axis to 4 cans of root beer on the
y-axis. The new budget line is tangential to indifference curve I1 at 1 can of root beer and 3 CDs.
The indifference curve I1 is the highest indifference curve that Marc can now get attain.
b. Two points on Marc’s demand curve for CDs are the following: At $10 a CD, Marc buys 1 CD. At
$5 a CD, Marc buys 3 CDs.
c. The substitution effect is 1 CD. To divide the price effect into a substitution effect and an income
effect, take enough income away from Marc and gradually move his new budget line back toward
the origin until it just touches Marc’s indifference curve I0. The point at which this budget line just
touches indifference curve I0 is 2 CDs and 0.5 can of root beer. The substitution effect is the increase
in the quantity of CDs from 1 CD to 2 CDs along the indifference curve I0. The substitution effect is
1 CD.
d. The income effect is 1 CD. The income effect is the change in the quantity of CDs from the price
effect minus the change from the substitution effect. The price effect is 2 CDs (3 CDs minus the
initial 1 CD). The substitution effect is an increase in the quantity of CDs from 1 CD to 2 CDs. So
the income effect is 1 CD.
e. CDs are a normal good for Marc because the income effect is positive.
3. a. Pete can still buy 20 cans of tuna and 40 golf balls. When Pete buys 20 cans of tuna at $2 a can and
40 golf balls at $1 each, he spends $80 a month. Now that the price of a can of tuna is $3 and the
price of a golf ball is $0.50, 20 cans of tuna and 40 golf balls will cost $80. So Pete can still buy 20
cans of tuna and 40 golf balls.
b. Pete will not want to buy 20 cans of tuna and 40 golf balls because the marginal rate of substitution
does not equal the relative price of the goods. Pete will move to a point on the highest indifference
curve possible where the marginal rate of substitution equals the relative price.
c. Pete prefers tuna at $3 a can and golf balls at $0.50 each because he can get onto a higher
indifference curve than when tuna is $2 a can and golf balls are $1 each.
d. Pete will buy more golf balls and fewer cans of tuna. The new budget line and the old budget line
pass through the point at 20 cans of tuna and 40 golf balls. If cans of tuna are plotted on the x-axis,
the marginal rate of substitution at this point on Pete’s indifference curve is equal to the relative
price of a can of tuna at the original prices, which is 2. The new relative price of a can of tuna is
$3/50 cents, which is 6. That is, the budget line is steeper than the indifference curve at 20 cans of
tuna and 40 golf balls. Pete will buy more golf balls and fewer cans of tuna.
e. There will be a substitution effect and an income effect. A substitution effect arises when the relative
price changes and the consumer moves along the same indifference curve to a new point where the

© 2019 Pearson Education Ltd.

106 CHAPTER 9

marginal rate of substitution equals the new relative price. An income effect arises when the
consumer moves from one indifference curve to another, keeping the relative price constant.
4. a. Books are goods and so are taxed under both a sales tax and a consumption tax. Haircuts are services
and so are taxed only under a consumption tax. If the sales tax is replaced with a consumption tax,
the relative price of a haircut rises and the relative price of a book falls.
b. Assuming the sales tax and consumption tax are the
same rate, in the figure the budget line rotates
inward around a fixed book intercept. In Figure 9.2,
the new budget line is BL1. The price of a book does
not change but the price of a haircut rises.
c. In general, if the relative price of a haircut rises and
the relative price of a book falls, the substitution
effect leads consumers to buy more books and fewer
haircuts. There is, however, also an income effect.
The consumer’s real income falls, which decreases
the demand for normal goods. Assuming that both
books and haircuts are normal goods, then the
income effect offsets the substitution effect of
buying more books but reinforces the substitution
effect of buying fewer haircuts. In the figure, with
the sales tax and budget line BL0 the consumer is
initially at point A and buys 20 books per year and 4
haircuts per year. With the consumption tax and
budget line BL1 the consumer moves to point B and buys 15 books per year and 3 haircuts per year.

Additional Discussion Questions

1. How does an increase in the price of basic food staples affect real income in poor
countries? Illustrate this with a budget line and hypothetical consumption bundle. Where
money incomes are low, increases in food prices can devastate real incomes and the
achievable consumption bundle. The budget line, already close to the origin, shifts inward
even closer. Food riots returned to the global stage in 2008, and with the prices of many key
grains rising in 2010, we may see continued global dialogue about the negative impact of
higher food prices on the world’s poorest citizens.
2. How would the preference map shift if a consumer had a strong preference for one of the
products versus the other? How might that affect the tangency point? The map tilts to be
“long” on the axis of the non-preferred product. Basically to get the person give up a unit of
the preferred product, compensation in terms of units of the other product to maintain
indifference would be immense. The tangency is thus likely to be near the axis of the
preferred product, which means a large quantity of this good is consumed.
3. Will a low-income person’s optimal consumption bundle change if he or she receives food
stamps? Have the students apply a normal preference mapping between food and all other
goods for a low-income person. With food on the vertical axis, show that a person receiving
food stamps experiences a new, steeper budget line with a higher y-intercept. Show that the
person can now afford a greater total amount of food for any given level of other goods, but
the maximum amount of all other goods available remains unchanged. Have the students
locate the consumption combination that matches the slope of the new budget line with the
marginal rate of substitution of the highest indifference curve.
© 2019 Pearson Education Ltd.
 POSSIBILITIES, PREFERENCES, AND CHOICES 107

Could the low-income person be better off with an income subsidy of equal value to the
food stamp subsidy? Show that if the same level of income were given in place of food
stamps, this opens up even more combinations of goods and services than with food stamps.
It is impossible not find a higher indifference curve without a very unconventional
indifference curve map.
Could a low-income person be made equally as well off with a lower total income subsidy
than the initial food stamp subsidy? Ask them to consider why the government continues to
use food stamps instead of income assistance when the same quantity of extra income would
bring them even more utility. Ask them why the government doesn’t minimize total welfare
assistance expenditures by giving them just enough income to maintain a consumption bundle
on the same indifference curve as with the current food stamp expenditures. Students should
recognize that part of the government’s intention is to control the type of items purchased
with food stamps. If low-income households were simply given cash subsidies, the costs of
the welfare system would be lower, but not all low-income households would spend that cash
subsidy on food only.
4. Would the indifference curves of a preference map ever change shape when the prices of
goods change? Marketing managers for Ferrari claim that they would not consider a
significant price decrease in the face of falling demand. They worry that the decrease in the
perceived “exclusivity” of the brand would diminish the consumer perception of their product
and eventually decrease market demand. Ask the students to model this theory and show how
a sharp decline in the price of a Ferrari might causes a change in the consumer’s indifference
curves. (The answer is that if Ferraris were placed on the vertical axis, the indifference curves
are steeper.)
Would indifference curves ever move whenever the consumer’s income changes?
Consumers change their buying habits as they increase their income. They buy cars with
leather seats instead of cloth, designer dresses and purses, choose restaurants merely to “be
seen” dining there. Does this really represent a change in the preference mapping over
consumption possibilities when incomes increase? Does it change the slope of the
indifference curve?
5. Do perfect substitutes imply perfectly elastic demand? When indifference curves are straight
lines, the MRS is almost never equal to the relative price ratio, meaning the consumer selects
a “corner solution” (all of one good, or all of another, but not a mix of both). In the case of a
relative price change, the consumer immediately switches to consuming only the other good.
Ask the students if they have ever observed such peculiar consumer behavior in the real
world.
Do perfect complements imply perfectly inelastic demand? When the indifference curves are
90-degree angles, the consumer always purchases the product only in exact proportions. Ask
the students if there is any usefulness to separating out the two goods as separate items, or
whether it is more meaningful to consider them two necessary components of a single good.
For example, we rarely see single shoes being offered for sale, but surely the occasional
consumer loses a single shoe, or there are a small number of amputees that need only one
shoe. Why is there no market for single shoes? (As a counterexample, Lands’ End actually
sells single gloves or mittens to consumers who have lost one of a pair.)

© 2019 Pearson Education Ltd.