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Household consumption choices are constrained by its income and the prices of the goods and services available. The budget line describes the limits to the household’s consumption choices.

Lisa has an income of $40; the price of movies is $8 and the price of pop is $4 a case. How many cases of pop can she consume if she goes to zero movies? How many movies can she attend if she buys no pop? What is the rate at which she can trade off pop for movies? 2 cases of pop will buy her one movie – slope = 2/1 =

The budget line is a constraint on Lisa’s choices. Lisa can afford any point on her budget line or inside it. Lisa cannot afford any point outside her budget line.

The Budget Equation The budget equation states that Expenditure = Income

Call the price of pop PP, the quantity of pop QP, the price of a movie PM, the quantity of movies QM, and income Y. Lisa’s budget equation is:

PPQP + PMQM = Y

PPQP = Y - PMQM

QP = Y/PP – (PM /PP)QM

A rise in the price of movies PM makes the budget line steeper.

The ―movies‖ intercept

Y/PM gets smaller

The budget line rotates inward

QP = Y/PP – (PM /PP)QM An change in money income brings a parallel shift of the budget line. The slope of the budget line doesn’t change because the relative price doesn’t change.

An indifference curve is a line that shows combinations of goods among which a consumer is indifferent.

At point C, Lisa sees 2 movies and drinks 6 cases of pop a month.

Lisa can sort all possible combinations of goods into three groups: preferred, not preferred, and just as good as point C. An indifference curve joins all those points that Lisa says are just as good as C. G is such a point. Lisa is indifferent between point C and point G.

All the points on the indifference curve are preferred to all the points below the indifference curve.

And all the points above the indifference curve are preferred to all the points on the indifference curve.

A preference map is a series of indifference curves. Call the indifference curve that we’ve just seen I1.

I0 is an indifference curve below I1. Lisa prefers any point on I1 to any point on I0 .

I2 is an indifference curve above I1.

Lisa prefers any point on I2 to any point on I1 .

For example, Lisa prefers point J to either point C or point G.

Marginal Rate of Substitution The marginal rate of substitution, (MRS) measures the rate at which a person is willing to give up good y to get an additional unit of good x while at the same time remain indifferent (remain on the same indifference curve). The magnitude of the slope of the indifference curve measures the marginal rate of substitution.

. If the indifference curve is relatively steep, the MRS is high. In this case, the person is willing to give up a large quantity of y to get a bit more x. . If the indifference curve is relatively flat, the MRS is low. In this case, the person is willing to give up a small quantity of y to get more x.

A diminishing marginal rate of substitution is the key assumption of consumer theory. 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 remain indifferent as the quantity of good x increases.

At point C, Lisa is willing to give up 2 cases of pop to see one more movie—her MRS is 2.

At point G, Lisa is willing to give up 1/2 case of pop to see one more movie—her MRS is 1/2.

Best Affordable Choice The consumer’s best affordable choice is

 On the highest attainable indifference curve

 On the budget line

The highest possible indifference curve that is attainable given the budget line, is at point C. Point C is at a tangency between the budget line and an indifference curve – the slopes are equal.

At point C, MRS = PM/PP

At point F, Lisa’s MRS is greater than the relative price. She is willing to give up more pop for an additional movie than she is required to.

At point H, Lisa’s MRS is less than the relative price. She is willing to give up less pop for an additional movie than she was required to.

When movies cost $8, she goes to 2 movies. This is a point on her demand curve. Now, the price of a movie falls to $4. The budget line rotates outward.

Lisa’s best affordable point is now J.

Lisa moves to point B, which is a movement along her demand curve for movies.

A Change in Income The effect of a change in income on the quantity of a good consumed is called the income effect.

Initially, Lisa consumes at point J in part (a) and at point B on demand curve D0 in part (b).

Lisa’s income decreases and her budget line shifts leftward in part (a). Her new best affordable point is K in part (a). Her demand for movies decreases, shown by a leftward shift of her demand curve for movies in part (b).

Substitution Effect and Income Effect For a normal good, a fall in price always increases the quantity consumed. We can prove this assertion by dividing the price effect in two parts:

 Substitution effect

 Income effect

Initially, Lisa has an income of $40, the price of a movie is $8, and she consumes at point C. The price of a movie falls from $8 to $4 and her budget line rotates outward.

Lisa’s best affordable point is now J.

The move from point C to point J is the price effect.

We’re going to break the move from point C to point J into two parts. The first part is the substitution effect and the second is the income effect.

Substitution Effect The substitution effect is the effect of a change in price on the quantity bought when the consumer remains on the same indifferent curve.

The direction of the substitution effect never varies: When the relative price falls, the consumer always substitutes more of that good for other goods. The substitution effect is the first reason why the demand curve slopes downward.

Income Effect To isolate the income effect, we reverse the hypothetical pay cut and restore Lisa’s income to its original level (its actual level). Lisa is now back on indifference curve I2 and her best affordable point is J. The move from K to J is the income effect.

For Lisa, movies are a normal good. With more income to spend, she sees more movies—the income effect is positive. For a normal good, the income effect reinforces the substitution effect and is the second reason why the demand curve slopes downward.

Inferior Goods For an inferior good, when income increases, the quantity bought decreases. The income effect is negative and works against the substitution effect. So long as the substitution effect dominates, the demand curve still slopes downward.

If the negative income effect is stronger than the substitution effect, a lower price for inferior goods brings a decrease in the quantity demanded—the demand curve slopes upward! This case does not appear to occur in the real world.

An externality is a cost or benefit that arises from production and falls on someone other than the producer, or a cost or benefit that arises from consumption and falls on someone other than the consumer. A negative externality imposes a cost and a positive externality creates a benefit.

The four types of externality are

 Negative production externalities

 Positive production externalities

 Negative consumption externalities

 Positive consumption externalities

Negative Production Externalities Negative production externalities are common. Some examples are noise from aircraft and trucks, polluted rivers and lakes, the destruction of animal habitat, and air pollution in major cities from auto exhaust.

Positive Production Externalities Positive production externalities are less common that negative externalities. Two examples arise in honey and fruit production. By locating honeybees next to a fruit orchard, fruit production gets an external benefit from the bees, which pollinate the fruit orchards and boost fruit output; and honey production gets an external benefit from the orchards.

Negative Consumption Externalities Negative consumption externalities are a common part of everyday life. Smoking in a confined space poses a health risk to others; noisy parties or loud car stereos disturb others.

Positive Consumption Externalities Positive consumption externalities are also common. When you get a flue vaccination, everyone you come into contact with benefits. When the owner of an historic building restores it, everyone who sees the building gets pleasure.

Private Costs and Social Costs A private cost of production is a cost that is borne by the producer, and marginal private cost (MC) is the private cost of producing one more unit of a good or service. An external cost of production is a cost that is not borne by the producer but is borne by others. Marginal external cost is the cost of producing one more unit of a good or service that falls on people other than the producer.

Marginal social cost is the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls—and is the sum of marginal private cost and marginal external cost. That is, MSC = MC + Marginal external cost. We express costs in dollars but must remember that the dollars represent the value of a forgone opportunity. Marginal private cost, marginal external cost, and marginal social cost increase with output.

Production and Pollution: How Much? In the market for a good with an externality that is unregulated, the amount of pollution created depends on the equilibrium quantity of the good produced.

Figure 16.2 shows the equilibrium in an unregulated market with an external cost. The quantity produced is where marginal private cost equals marginal social benefit.

At the market equilibrium, MSB is less than MSC, so the market produces an inefficient quantity. At the efficient quantity, marginal social cost equals marginal social benefit. With no regulation, the market overproduces and creates a deadweight loss.

Knowledge comes from education and research and creates external benefits. Private Benefits and Social Benefits A private benefit is a benefit that the consumer of a good or service receives, and marginal private benefit (MB) is the private benefit from consuming one more unit of a good or service. An external benefit is a benefit that someone other than the consumer receives. Marginal external benefit is the benefit from consuming one more unit of a good or service that people other than the consumer enjoy.

Marginal social benefit is the marginal benefit enjoyed by the entire society—by the consumer and by everyone else on whom the benefit falls. Marginal social benefit is the sum of marginal private benefit and marginal external benefit. That is: MSB = MB + Marginal external benefit.

Figure 16.5 illustrates the marginal private benefit, marginal external benefit, and marginal social benefit. It identifies marginal external benefit as the vertical distance between the MB and MSB curves.

Figure 16.6 shows how a private market underproduces an item that generates an external benefit and creates a deadweight loss.