Consumer Behavior

Indifference curve
(Ordinal Approach))
 Indifference curve (Ordinal Approach)

Fundamentals of ordinal approach:

Indifference curve
Marginal Rate of Substitution (MRS)
Budget line/ budget constraint/ price line
 indifference curve

An indifference curve is a line that shows combinations of

goods among which a consumer is indifferent. All
combinations on an IC are equally preferred.

pairs Good x Good Y MRSxy

A 1 15 -----

B 2 10 1:5

C 3 6 1:4

D 4 3 1:3

E 5 1 1:2
Preferences and Indifference Curves

All the points above

the indifference curve
are preferred to the
points on the curve.

And all the points on

the indifference curve
are preferred to the
points below the
curve.
Marginal Rate of Substitution (MRS)

The marginal rate of substitution, (MRS) measures the rate at

which a person is willing to give up good y, (the good measured
on the y-axis) to get an additional unit of good x (the good
measured on the x-axis) and 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.
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, and at the same time remain
indifferent, as the quantity of good x increases.
Properties of indifference:

 Convex to origin & negatively sloped

 Map of indifference curve
 Higher gives higher satisfaction
 Never intersect to each other
 Never intersect to axes
 Budget line/ budget constraint/ price line

The Budget line shows all those combinations of two goods

which the consumer can buy by spending his given money
income on two goods(goodx & goody) at their given prices.
The budget line describes the limits to the household’s
consumption choices.
 The Budget Equation

The budget equation states that

Expenditure = Income
Call the price of soda PS, the quantity of soda QS, the
price of a movie PM, the quantity of movies QM, and
income Y.
Lisa’s budget equation is:
PSQS + PMQM = Y.
 The Budget Equation

PSQS + PMQM = Y
Divide both sides of this equation by PS, to give:
QS + (PM/PS)QM = Y/PS
Then subtract (PM/PS)QM from both sides of the
equation to give:
QS = Y/PS – (PM/PS)QM
The term Y/PS is Lisa’s real income in terms of soda.
The term PM/PS is the relative price of a movie in
terms of soda.
 SHIFTING

A rise in the price of

the good on the x-axis
decreases the
affordable quantity of
that good and
increases the slope of
the budget line.
Figure 8.2(a) shows
the rotation of a
budget line after a
change in the relative
price of movies.
A Change in Income

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.
Figure 8.2(b) shows the effect of a fall in income.
 Consumer Equilibrium

Conditions:
 At equilibrium slope of IC & slope Budget line are equal
 Above condition is satisfied at highest possible IC
Predicting …

A Change in Price
The effect of a change in the
price of a good on the
quantity of the good
consumed is called the price
effect.
Figure illustrates the price
effect and shows how the
consumer’s demand curve is
generated.
Initially, the price of a movie
is $6 and Lisa consumes at
point C in part (a) and at
Derivation of Demand Curve

A Change in Income
The effect of a change in
income on the quantity of
a good consumed is called
the income effect.
Figure illustrates the
effect of a decrease in
income.
Initially, Lisa consumes at
point J in part (a) and at
point B on demand curve
D0 in part (b).
Predicting …

The price of a movie

then falls to $3.
The budget line rotates
outward.
best affordable point is now J
in part (a).
In part (b), Lisa moves to point
B, which is a movement along
her demand curve for movies.
Predicting …

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 & Income Effects

When price changes, total change in quantity

demanded is composed of two parts
Substitution effect
Income effect

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Substitution & Income Effects

Substitution effect
Change in consumption of a good after a change in
its price, when the consumer is forced by a change
in money income to consume at some point on the
original indifference curve
Income effect
Change in consumption of a good resulting strictly
from a change in purchasing power

5-18
 Income & Substitution Effects:
A Decrease in Px
Total effect of price = + Income
Substitution effect
decrease effect
3 = 5 + (-2)

5-19
 Income & Substitution Effects:
A Decrease in Px
Total effect of price decrease = Substitution effect + Income effect
9 = 5 + 4

5-20
 Income & Substitution Effects:
A Decrease in Px
Total effect of = Substitution + Income Total effect of = Substitution+ Income
price decrease effect effect price effect effect
9 = 5 + 4 decrease 3 = 5 + (-2)

5-21
Derivation of Demand Curve