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♪ [music] ♪

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To get a better understanding
of how we make choices,

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we first need to understand 
the elements

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that go into making a decision.

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And not all of them
are within our control.

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The world is constantly, 
invisibly determining the prices

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of goods and services.

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Take the price of a cup of coffee.

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It depends on so many variables.

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Think culture, demographics, 
the cost of beans, the weather,

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the supply and demand for oil,

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even the high rent at your hip 
neighborhood coffee shop.

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You get the idea.

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All of this economic activity
is magically being simplified

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into a price for a cup of coffee.

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How about your salary -- the price 
of one hour of your labor?

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It depends on you, of course,
on your skills and effort,

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but it also depends on many factors
outside of your control --

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for example, 
the demand for your services,

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nearby competition, 
even how fun your job is.

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Every day you make decision 
after decision about what to buy,

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comparing hundreds 
of different goods and services.

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There are so many choices.

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To simplify things, let's think 
about what you would do

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if you had a weekly budget of $50
to spend on just two goods:

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coffee and pizza.

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Coffee costs $5,
and pizza costs $10.

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So pizza is twice 
as expensive as coffee.

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There are several different 
combinations of coffee and pizza

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you could buy with this money.

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Let's plot a few 
of your options on a graph.

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On the x-axis, we have the number
of pizzas per week.

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And on the y-axis, we have
the cups of coffee per week.

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You could buy two cups of coffee
and four pizzas,

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four cups of coffee 
and three pizzas,

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five pizzas but no coffee,

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or 10 cups of coffee but no pizza.

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When you connect 
to different options that represent

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the ways you can spend your $50,
you get a straight line.

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This is your budget constraint.

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And it represents all possible 
combinations of coffee and pizza

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you can buy, given your budget
and the prices of coffee and pizza.

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This budget line also separates 
what you can afford

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from what you cannot afford.

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Maybe you wish you could buy
two cups of coffee and six pizzas,

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or four cups of coffee 
and 10 pizzas.

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But these are not in your budget.

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Sorry.

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All these different combinations
cost more than you have.

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So they're unaffordable,

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given your budget
and the prices of these two goods.

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Combinations of coffee and pizza
below the budget line,

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on the other hand, 
are within your means.

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So they're affordable,

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and you could buy them
if you wanted.

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The budget constraint also reflects
how the market substitutes

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between the two goods.

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Remember, pizzas are twice
as expensive as coffee.

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And this simply means 
that the relative price

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of one pizza is two cups of coffee.

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You see this on the slope
of the budget constraint,

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which is 2.

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Well, actually it's -2,
but we're less concerned

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about the sign.

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Although, it does remind us that
having more of one good requires

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giving up some of the other.

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When coffee costs $5,
and pizzas cost $10,

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if you want an additional pizza,

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you have to give up
two cups of coffee.

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If this made you think 
about opportunity cost,

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you're right!

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The slope of the budget constraint 
is the opportunity cost of pizza.

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Will this tradeoff change
if your budget increases --

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say, if you find a $20 bill
in the pocket of your winter jacket

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and now have $70 to spend
on these two goods?

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No -- the tradeoff is given 
by the market's prices.

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So changes in your income 
do not affect

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the relative price of goods.

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Sure -- you'll be able
to afford and choose

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between all of the consumption
combinations that total $70.

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And you can see how this makes 
your budget constraint

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shift outward.

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But, the two cups of coffee

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for one pizza tradeoff
remains the same.

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And that is because the market
still values these two goods

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relative to one another
just like it did before.

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This tradeoff does change

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if the relative price
of the two goods changes.

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Think of what will happen if,

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maybe because
of unusually good weather,

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the price of coffee falls
from $5 to $2.50.

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Does the market tradeoff 
remain the same?

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No.

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Pizza's just became four times 
more expensive than coffee.

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So you're able to buy
four cups of coffee

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when you give up eating one pizza.

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This will make your budget 
constraint rotate outward.

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Notice how because nothing
happened to the price of pizza,

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the number of pizzas you can buy

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when you don't buy coffee
hasn't changed.

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You can still only buy five pizzas.

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But, if you spend 
all of your budget on coffee,

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just look at how many more 
cups of coffee you can buy.

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You can now buy 
20 cups of coffee per week.

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That's a lot of coffee.

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You see -- the new higher 
relative price of pizza,

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in terms of coffee,

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in the slope
of the new budget constraint,

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which is now 4.

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We make choices every day.

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The reality of what we can afford,

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given by our incomes and the prices
of goods and services,

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are all very important elements
that affect our decisions.

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But there are other elements
equally important,

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and those are our preferences.

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We'll examine these next.

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[Narrator] You're on your way
to mastering economics.

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Make sure this video sticks

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by taking a few
quick practice questions.

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Or, if you're ready
for more microeconomics,

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click for the next video.

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Still here?

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Check out Marginal 
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♪ [music] ♪