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♪ [music] ♪

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[Joana] To get a better understanding[br]of how we make choices,

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we first need to understand [br]the elements

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that go into making a decision.

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And not all of them[br]are within our control.

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The world is constantly, [br]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, [br]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 [br]neighborhood coffee shop.

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You get the idea.

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All of this economic activity[br]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 [br]of one hour of your labor?

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It depends on you, of course --[br]on your skills and effort.

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But it also depends on many factors[br]outside of your control.

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For example --[br]the demand for your services,

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nearby competition, [br]even how fun your job is.

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Every day you make decision [br]after decision about what to buy,

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comparing hundreds [br]of different goods and services.

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There are so many choices.

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

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

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coffee and pizza.

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Coffee costs $5,[br]and pizza costs $10.

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So pizza is twice [br]as expensive as coffee.

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There are several different [br]combinations of coffee and pizza

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you could buy with this money.

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

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

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

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You could buy two cups of coffee[br]and four pizzas,

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four cups of coffee [br]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 [br]the different options

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that represent the ways[br]you can spend your $50,

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you get a straight line.

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This is your budget constraint.

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And it represents[br]all possible combinations

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of coffee and pizza you can buy

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given your budget[br]and the prices of coffee and pizza.

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This budget line also separates [br]what you can afford

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from what you cannot afford.

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

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or four cups of coffee [br]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[br]cost more than you have.

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So they're unaffordable,

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given your budget[br]and the prices of these two goods.

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Combinations of coffee and pizza[br]below the budget line,

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on the other hand, [br]are within your means.

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So they're affordable,

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and you could buy them[br]if you wanted.

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The budget constraint also reflects[br]how the market substitutes

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between the two goods.

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Remember, pizzas are twice[br]as expensive as coffee.

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And this simply means [br]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[br]of the budget constraint,

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which is 2.

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Well, actually it's -2,

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but we're less concerned[br]about the sign.

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

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giving up some of the other.

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When coffee costs $5,[br]and pizzas cost $10,

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if you want an additional pizza,

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you have to give up[br]two cups of coffee.

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If this made you think [br]about opportunity cost,

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you're right!

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The slope of the budget constraint [br]is the opportunity cost of pizza.

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Will this tradeoff change[br]if your budget increases --

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

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

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

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So changes in your income [br]do not affect

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the relative price of goods.

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Sure, you'll be able to afford[br]and choose between

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all of the consumption combinations[br]that total $70.

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And you can see how this makes

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your budget constraint[br]shift outward.

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But, the two cups of coffee

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for one pizza tradeoff[br]remains the same.

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And that is because the market[br]still values these two goods

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relative to one another[br]just like it did before.

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This tradeoff does change

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if the relative price[br]of the two goods changes.

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Think of what will happen if,

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maybe because[br]of unusually good weather,

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the price of coffee falls[br]from $5 to $2.50.

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Does the market tradeoff [br]remain the same?

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No.

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Pizzas just became four times [br]more expensive than coffee.

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So you're able to buy[br]four cups of coffee

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when you give up eating one pizza.

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This will make your budget [br]constraint rotate outward.

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Notice how, because nothing[br]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[br]hasn't changed.

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You can still only buy five pizzas.

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But, if you spend [br]all of your budget on coffee,

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

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You can now buy [br]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 [br]relative price of pizza,

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in terms of coffee,

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in the slope[br]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[br]of goods and services,

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are all very important elements[br]that affect our decisions.

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But there are other elements[br]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[br]to mastering economics.

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Make sure this video sticks

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by taking a few[br]quick practice questions.

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Or, if you're ready[br]for more microeconomics,

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click for the next video.

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♪ [music] ♪