FNB 108: MICROECONOMICS

Chapter 08: Possibility, Preference & Choices

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LEARNING OBJECTIVES
• After studying this chapter you will be able to -

• Describe a household’s budget line and show how it changes when prices or income change
• Make a map of preferences by using indifference curves and explain the principle of
diminishing marginal rate of substitution
• Predict the effects of changes in prices and income on consumption

Department of Finance & Banking, FBS-JU 11/03/2023

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INTRODUCTION

• Household consumption possibilities , preferences and choices:

a. Budget line.
b. Indifference curve.
c. Predicting consumer behavior.
d. Work-leisure choices.

Department of Finance & Banking, FBS-JU 11/03/2023

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BUDGET LINE
• Budget line shows the combination
of two products that a consumer
can afford to buy with a given
income.
• Two things determine budget line:
1. Income of household.
2. Price of goods.

Department of Finance & Banking, FBS-JU 11/03/2023

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DIVISIBLE & INDIVISIBLE GOODS

• DIVISIBLE GOODS
Some goods that can be bought in any
quantity desired are divisible goods.
• Divisible goods are goods that can be easily
divided into smaller parts, without losing
their value or functionality.
• Examples of divisible goods
include gasoline, food, clothes, and money.
• INDIVISIBLE GOODS
Those goods which can be sold in discrete
quantities are indivisible goods.
• Indivisible means unable to be divided or
separated.
• Example of indivisible public goods: public
roads, museums.

Department of Finance & Banking, FBS-JU 11/03/2023

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EXAMPLE

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BUDGET EQUATION
• Budget line can be described by the budget equation.
The budget equation starts by the fact that-

Expenditure = Income
Expenditure = ( Price of banana*Quantity of banana ) + ( Price of apple * Quantity of apple )
(PB)(QB) + (PA)(QA) = M
2QB + 4QA = 20
QB + 2QA = 10

Department of Finance & Banking, FBS-JU 11/03/2023

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REAL INCOME & RELATIVE PRICE

REAL INCOME: (Purchasing power)
• A real income is a income in terms of quantity of goods that a household can afford to buy.
Real Income = (M)Total income/(P)Price of goods
M/P Apple or P Banana
RELATIVE PRICE:
• Relative price is the price of one good divided by the price of another good.
Relative price = Price of Apple( PA) / Price of banana( PB)
PA/PB

Department of Finance & Banking, FBS-JU 11/03/2023

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A CHANGE IN PRICE

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A CHANGE IN INCOME

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PREFERENCES AND INDIFFERENCE CURVE

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INDIFFERENT CURVE
• An indifference curve is a
line that shows all possible
combinations of the
quantities of two goods that
gives the consumer same
level of satisfaction.

Department of Finance & Banking, FBS-JU 11/03/2023


PROPERTIES OF
INDIFFERENCE CURVES
The optimal consumption bundle is
the tangency condition between the
indifference curve and the budget
line.
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• The four properties of indifference curves are:
(1) indifference curves can never cross,
(2) the farther out an indifference curve lies, the higher
the utility it indicates,
(3) indifference curves always slope downwards, and
(4) indifference curves are convex.
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PREFERENCE MAP
• A preference map is the
indifference curves, which
illustrates a series of
bundled goods in which a
consumer is indifferent.

Department of Finance & Banking, FBS-JU 11/03/2023

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MARGINAL RATE OF SUBSTITUTE

The Marginal Rate of Substitution is a rate at which a person has to be given up amount of
goods to obtain an additional unit of another good while keeping the same level of satisfaction
or remain indifferent

Department of Finance & Banking, FBS-JU 11/03/2023

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LAW OF DIMINISHING MARGINAL UTILITY

Diminishing marginal rate of substitute: degree of Substitutability

Department of Finance & Banking, FBS-JU 11/03/2023

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PREDICTING CONSUMER CHOICE

Consumer choice and maximum utility can be predicted through utilizing these
major economic tools;
•Budget line
•Indifference curve
•Marginal substitute rate(MRS)

Department of Finance & Banking, FBS-JU 11/03/2023


• Suppose a consumer has a budget for fast-food
items of $20 per week and spends this money on
two goods, hamburgers and pizzas. Suppose
hamburgers cost $5 each and pizzas cost $10. Put
the quantity of hamburgers purchased per week on
the horizontal axis and the quantity of pizzas
purchased per week on the vertical axis. Draw the
budget line.
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PRACTICE PROBLEM
• Suppose the consumer in part (a) is indifferent
among the combinations of hamburgers and
pizzas shown. In the grid you used to draw the
budget lines, draw an indifference curve passing
through the combinations shown, and label the
corresponding points A, B, and C. Label this curve
I.
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THANK YOU ALL

Next discussion: Market and Its Structure