36385206 indifference-curve

Indifference curveIndifference curve

• Indifference curveIndifference curve – A curve that shows – A curve that shows combinations of goods which gives the combinations of goods which gives the same level o satisfaction to the consumers same level o satisfaction to the consumers so that an individual is indifferent.so that an individual is indifferent.

0

2

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0 2 4 6 8 10 12 14 16 18 20 22

aP

ear

s

Oranges

Pears

3024201410

86

Oranges

678

10131520

Point

abcdefg

Constructing an indifference curveConstructing an indifference curve

AssumptionAssumption

• More of a commodity is better than lessMore of a commodity is better than less

• Preference of a consumer are transitivePreference of a consumer are transitive

• Diminishing marginal rate of substitutionDiminishing marginal rate of substitution

More of a commodity is better than lessMore of a commodity is better than less

Preference of a consumer are transitivePreference of a consumer are transitive

Marginal rate of substitutionMarginal rate of substitution

• Marginal rate of substitutionMarginal rate of substitution – The rate at – The rate at which consumer is prepared to exchange which consumer is prepared to exchange goods X and Y is known as MRS ie the rate goods X and Y is known as MRS ie the rate at which one good must be added when the at which one good must be added when the other is taken away in order to keep the other is taken away in order to keep the individual indifferent between the two individual indifferent between the two combinations without changing total combinations without changing total satisfaction .satisfaction .

0

10

20

30

0 10 20

Deriving the marginal rate of substitution (Deriving the marginal rate of substitution (MRSMRS))a

b

Un

its o

f goo

d Y

Units of good X

26

6 7

0

10

20

30

0 10 20

a

b

Un

its o

f goo

d Y

Units of good X

26

6 7

Y = 4

X = 1

MRS = 4

Deriving the marginal rate of substitution (Deriving the marginal rate of substitution (MRSMRS))

0

10

20

30

0 10 20

a

b

Un

its o

f goo

d Y

Units of good X

26

6 7

cd

Y = 4

X = 1

Y = 1

X = 1

MRS = 1

MRS = 4

13 14

9

Deriving the marginal rate of substitution (Deriving the marginal rate of substitution (MRSMRS))

Indifference scheduleIndifference schedule

• Indifference scheduleIndifference schedule

CombinaCombinationtion

Good XGood X Good YGood Y MRSMRS

AA 11 1212

BB 22 88 44

CC 33 55 33

DD 44 33 22

EE 55 22 11

Marginal Rate of SubstitutionMarginal Rate of Substitution

• MRS declines as we move downward to the MRS declines as we move downward to the right along an indifference curve.right along an indifference curve.

• Indifference curves with diminishing MRS Indifference curves with diminishing MRS are thus convex.are thus convex.

• Convexity illustrates that people like Convexity illustrates that people like variety.variety.

Law of diminishing marginal rate of substitutionLaw of diminishing marginal rate of substitution

• Law of diminishing marginal rate of substitutionLaw of diminishing marginal rate of substitution – As you get more and more of a good X , – As you get more and more of a good X , one is prepared to forego less and less of one is prepared to forego less and less of Y that is MRS of X for Y diminishes as Y that is MRS of X for Y diminishes as more and more of good X is substituted for more and more of good X is substituted for good Y.good Y.

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10

20

30

0 10 20

Un

its o

f goo

d Y

Units of good X

I1

I2

I3

I4

I5

An indifference mapAn indifference map

Properties of Indifference CurveProperties of Indifference Curve

– Indifference curves are downward sloping to Indifference curves are downward sloping to the rightthe right

– Indifference curves are convex to the originIndifference curves are convex to the origin– Indifference curves cannot intersect each Indifference curves cannot intersect each

other other – A higher Indifference curves represents a A higher Indifference curves represents a

higher satisfactionhigher satisfaction

BUDGET LINEBUDGET LINE

• Budget line graphically shows the budget Budget line graphically shows the budget constraint.constraint.

• The combination of commodities lying to The combination of commodities lying to the right of the budget line are unattainable the right of the budget line are unattainable because the income of the consumer is because the income of the consumer is not sufficient to be able to buy those not sufficient to be able to buy those combinations.combinations.

• The combination of commodities lying to The combination of commodities lying to the left of the budget line are attainable the left of the budget line are attainable because the income of the consumer is because the income of the consumer is sufficient to be able to buy those sufficient to be able to buy those combinationscombinations

What is a Budget Constraint?What is a Budget Constraint?

• A budget constraint shows the A budget constraint shows the consumer’s purchase opportunities consumer’s purchase opportunities as every combination of two goods as every combination of two goods that can be bought at given prices that can be bought at given prices using a given amount of income.using a given amount of income.

• The budget constraint measures the The budget constraint measures the combinations of purchases that a combinations of purchases that a person can afford to make with a person can afford to make with a given amount of monetary income.given amount of monetary income.

Un

its o

f goo

d Y

Units of good X

a

b

Units ofgood X

0 51015

Units ofgood Y

302010 0

Point onbudget line

ab

Assumptions

PX = £2PY = £1

Budget = £30

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10

20

30

0 5 10 15 20

A budget lineA budget line

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40

0 5 10 15 20

Un

its o

f goo

d Y

Units of good X

Assumptions

PX = £2PY = £1

Budget = £40

16

7

m

n

Budget = £40

Budget = £30

Effect of an increase in income on the budget lineEffect of an increase in income on the budget line

0

10

20

30

0 5 10 15 20 25 30

Effect on the budget line of a fall in the price of good XEffect on the budget line of a fall in the price of good XU

nits

of g

ood

Y

Units of good X

Assumptions

PX = £1PY = £1

Budget = £30

B1B2

a

b c

The Best Feasible BundleThe Best Feasible Bundle

• Tools needed to determine how consumers Tools needed to determine how consumers should allocate their income between 2 should allocate their income between 2 goods :goods :– Budget ConstraintBudget Constraint– Indifference CurvesIndifference Curves

• Consumer’s strategy is to keep moving to Consumer’s strategy is to keep moving to higher and higher indifference curves until higher and higher indifference curves until he reaches the highest one that is still he reaches the highest one that is still affordable.affordable.

How to Find the Best CombinationHow to Find the Best Combination

• Utility is maximized when:Utility is maximized when:

– the indifference curve is just the indifference curve is just tangent to the budget line. tangent to the budget line.

The Best Affordable BundleThe Best Affordable Bundle

I1

I2

I3

I4

I5

Un

its o

f goo

d Y

O

Units of good X

Budget line

Finding the optimum consumptionFinding the optimum consumption

I1

I2

I3

I4

I5

Un

its o

f goo

d Y

O

Units of good X

r

s

tY1

X1

v

u

indifference curve and budget lineindifference curve and budget line

Un

its o

f goo

d Y

O

Units of good X

B1

Effect on consumption of a change in incomeEffect on consumption of a change in income

I1

I2

Un

its o

f goo

d Y

O

Units of good X

B1 B2 I1


I2

Un

its o

f goo

d Y

O

Units of good X

B1 B2 B3 B4 I1

I3

I4


I2

Un

its o

f goo

d Y

O

Units of good X

B1 B2 B3 B4 I1

I3

I4

Income–consumption curve


The Engel curveThe Engel curve

• The Engel curveThe Engel curve– Shows the relationship between the quantity of Shows the relationship between the quantity of

the good consumed and incomethe good consumed and income

• Normal and inferior goodsNormal and inferior goods– Normal goods – upward sloping Engel curveNormal goods – upward sloping Engel curve– Inferior goods – downward sloping Engel curveInferior goods – downward sloping Engel curve

B1 B2 B3

I3I2I1

Income-consumptioncurveB

read

Inco

me

(£)

CDs

CDs

Qb3

Qb2

Qb1

Y3

Y2

Y1

Qcd3Qcd2

Qcd1

Qcd3Qcd2

Qcd1

ab

c

ab

c

Deriving an Engel curve from an income–consumption curveDeriving an Engel curve from an income–consumption curve

B1 B2 B3

I3I2I1

Income-consumptioncurveB

read

Inco

me

(£)

CDs

CDs

Qb3

Qb2

Qb1

Y3

Y2

Y1

Qcd3Qcd2

Qcd1

Qcd3Qcd2

Qcd1

Engel curve

ab

c

ab

c

Deriving an Engel curve from an income–consumption curveDeriving an Engel curve from an income–consumption curve

Engel CurvesEngel Curves

Food (unitsper month)

30

4 8 12

10

Income($ per

month)

20

160

Engel curve slopesupward for anormal good.

Engel CurvesEngel Curves

Engel curve isbackward bending for inferior goods.

Inferior

Normal

Food (unitsper month)

30

4 8 12

10

Income($ per

month)

20

160

Effect of a rise in income on the demand for an inferior goodEffect of a rise in income on the demand for an inferior goodU

nits

of g

ood

Y(n

orm

al g

ood

)

Units of good X(inferior good)

O

I1B1

a


nits

of g

ood

Y(n

orm

al g

ood

)


O

I2

I1B1 B2

a

b


nits

of g

ood

Y(n

orm

al g

ood

)


O

Income–consumption curve

I2

I1B1 B2

a

b

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Effect of a fall in the price of good Effect of a fall in the price of good XXU

nits

of g

ood

Y

Units of good X

Assumptions

PX = £2PY = £1

Budget = £30

B1 I1

j

0

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0 5 10 15 20 25 30

Un

its o

f goo

d Y

Units of good X

Assumptions

PX = £1PY = £1

Budget = £30

B1 I1

j

I2

B2

k

Effect of a fall in the price of good Effect of a fall in the price of good XXa

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0 5 10 15 20 25 30

Un

its o

f goo

d Y

Units of good X

B1 I1

j

I2

B2

k

Price–consumption curve

Effect of a fall in the price of good Effect of a fall in the price of good XXa

B1 B2 B3

I3I2I1

I4

B4

Exp

endi

ture

on

all o

ther

goo

ds

Units of good X

a bc d

Further falls inthe price of X

Deriving a demand curve from a price–consumption curveDeriving a demand curve from a price–consumption curve

B1 B2 B3

I3I2I1

I4

B4

Exp

endi

ture

on

all o

ther

goo

ds

Units of good X

a Price-consumptioncurve

bc d


B1 B2 B3

I3I2I1

I4

B4

Exp

endi

ture

on

all o

ther

goo

ds

Units of good X


bc d

Pric

e of

goo

d X

Units of good X

a

b

P1

P2

Q1 Q2


B1 B2 B3

I3I2I1

I4

B4

Exp

endi

ture

on

all o

ther

goo

ds

Units of good X


bc d

Pric

e of

goo

d X

Units of good X

a

b

cd

P1

P2

P3

P4

Q1 Q2 Q3 Q4


B1 B2 B3

I3I2I1

I4

B4

Exp

endi

ture

on

all o

ther

goo

ds

Units of good X


bc d

Pric

e of

goo

d X

Units of good X

a

b

cd

Demand

P1

P2

P3

P4

Q1 Q2 Q3 Q4


Income and Substitution Effects of a Price Income and Substitution Effects of a Price ChangeChange

• Income effect – A change in the quantity Income effect – A change in the quantity purchased of a good by a consumer as purchased of a good by a consumer as result of a change in his income, prices result of a change in his income, prices remaining constant. remaining constant.

• Substitution effect – Substitution effect Substitution effect – Substitution effect means the change in the quantity means the change in the quantity purchased of a good by a consumer as purchased of a good by a consumer as result of a change in relative prices alone , result of a change in relative prices alone , real income remaining constant. real income remaining constant.

Income and Substitution EffectsIncome and Substitution Effects

• A fall in the price of a good has two effects: A fall in the price of a good has two effects: Substitution & IncomeSubstitution & Income– Substitution EffectSubstitution Effect

Consumers will tend to buy more of the good that Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good has become relatively cheaper, and less of the good that is now relatively more expensive.that is now relatively more expensive.

Income and Substitution EffectsIncome and Substitution Effects

• A fall in the price of a good has two effects: A fall in the price of a good has two effects: Substitution & IncomeSubstitution & Income– Income EffectIncome Effect

Consumers experience an increase in real Consumers experience an increase in real purchasing power when the price of one good falls.purchasing power when the price of one good falls.

Response to an income increase: both goods normalResponse to an income increase: both goods normal

C

F

100

20

U1

B

35

Income effectsIncome effects

C

F

100

20

U1

B

35

F Normal; C inferior

C Normal; F inferior

Both F and C Normal

Decomposing the price change

Prices Drop

Income and Substitution Effects Income and Substitution Effects Illustrated: The Normal-Good CaseIllustrated: The Normal-Good Case

[Figure 4.3][Figure 4.3]

• Price effect =substitution effect + Income Price effect =substitution effect + Income effecteffect

• The movement from W –W’ =Price effectThe movement from W –W’ =Price effect

• The movement from W –J = substitution The movement from W –J = substitution effecteffect

• The movement from J–W’ =Income effectThe movement from J–W’ =Income effect

Income and SubstitutionIncome and SubstitutionEffects: Normal GoodEffects: Normal Good

Food (units per month)O

Clothing(units per

month) R

F1 S

C1 A

U1

The income effect, EF2, ( from D to B) keeps relativeprices constant but increases purchasing power.

Income Effect

C2

F2 T

U2

B

When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B.

ETotal Effect

SubstitutionEffect

D

The substitution effect,F1E, (from point A to D), changes the relative prices but keeps real income(satisfaction) constant.

36385206 indifference-curve

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