Indifference curve Indifference curve A curve that shows combinations of goods which gives the same level o satisfaction

on to the consumers so that an individual is indifferent.

Constructing an indifference curve

30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0 2 4 6

a
Pears Oranges 30 24 20 14 10 8 6 6 7 8 10 13 15 20 Point a b c d e f g

Pears

10

12

14

16

18

20

22

Oranges

Assumption More of a commodity is better than less Preference of a consumer are transitive Diminishing marginal rate of substitution

More of a commodity is better than less

Preference of a consumer are transitive

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

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

30
26

a b

Units of good Y

20

10

0 0
67

10

20

Units of good X

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

30

a (Y = 4 MRS = 4 b

26

(X = 1 Units of good Y
20

10

0 0
67

10

20

Units of good X

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

30

a (Y = 4 MRS = 4 b

26

(X = 1 Units of good Y
20

10 9

c (Y = 1 (X = 1

MRS = 1 d

0 0
67

10

13 14

20

Units of good X

Indifference schedule

Indifference schedule
Combina Good X tion A 1 B 2 C D E 3 4 5 Good Y 12 8 5 3 2 MRS

4 3 2 1

Marginal Rate of Substitution MRS declines as we move downward to the right along an indifference curve. Indifference curves with diminishing MRS are thus convex. Convexity illustrates that people like variety.

Law of diminishing marginal rate of substitution

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

An indifference map
30

Units of good Y

20

10

I5 I2
20

I3

I4

0 0 10

I1 Units of good X

Properties of Indifference Curve

Indifference curves are downward sloping to the right Indifference curves are convex to the origin Indifference curves cannot intersect each other A higher Indifference curves represents a higher satisfaction

BUDGET LINE Budget line graphically shows the budget constraint. The combination of commodities lying to the right of the budget line are unattainable because the income of the consumer is not sufficient to be able to buy those combinations. The combination of commodities lying to the left of the budget line are attainable because the income of the consumer is sufficient to be able to buy those combinations

What is a Budget Constraint? A budget constraint shows the consumers purchase opportunities as every combination of two goods that can be bought at given prices using a given amount of income. The budget constraint measures the combinations of purchases that a person can afford to make with a given amount of monetary income.

A budget line
30

a
Units of good X Units of Point on good Y budget line 30 20 10 0 a b

Units of good Y

20

0 5 10 15

10

Assumptions PX = 2 PY = 1 Budget = 30

0 0 5 10 15 20

Units of good X

Effect of an increase in income on the budget line

40
Assumptions PX = 2 PY = 1 Budget = 40

30

Units of good Y

20
16

n m

10

Budget = 40 Budget = 30
0 5
7

0 10

15

20

Units of good X

Effect on the budget line of a fall in the price of good X

30

a
Assumptions PX = 1 PY = 1 Budget = 30

Units of good Y

20

10

B1
0 0 5 10

B2 b c
20 25 30

15

Units of good X

The Best Feasible Bundle Tools needed to determine how consumers should allocate their income between 2 goods :
Budget Constraint Indifference Curves

Consumers strategy is to keep moving to higher and higher indifference curves until he reaches the highest one that is still affordable.

How to Find the Best Combination

Utility is maximized when: the indifference curve is just tangent to the budget line.

The Best Affordable Bundle

Finding the optimum consumption

Units of good Y

Budget line

I5 I2 I3 I4

I1 O Units of good X

indifference curve and budget line

r s Units of good Y

Y1

u v I1 O X1 Units of good X I2 I3

I5 I4

Effect on consumption of a change in income

Units of good Y

B1 O Units of good X

I1

Effect on consumption of a change in income

Units of good Y

B1 O

B2

I1

I2

Units of good X

Effect on consumption of a change in income

Units of good Y

I4 I3 B1 O Units of good X B2 B3 B4 I1 I2

Effect on consumption of a change in income

Units of good Y

Incomeconsumption curve

I4 I3 B1 O Units of good X B2 B3 B4 I1 I2

The Engel curve The Engel curve

Shows the relationship between the quantity of the good consumed and income

Normal and inferior goods

Normal goods upward sloping Engel curve Inferior goods downward sloping Engel curve

Deriving an Engel curve from an incomeconsumption curve income

Bread

Qb3 Qb2 Qb1

Income-consumption c curve I3 B1 B2 I1 I2 B3

Qcd1Qcd2 Qcd3

CDs

Income ()

Y3 Y2 Y1

c b a

Qcd1Qcd2Qcd3

CDs

Deriving an Engel curve from an incomeconsumption curve income

Bread

Qb3 Qb2 Qb1

Income-consumption c curve I3 B1 B2 I1 I2 B3

Qcd1Qcd2 Qcd3

CDs
Engel curve

Income ()

Y3 Y2 Y1

c b a

Qcd1Qcd2Qcd3

CDs

Engel Curves
Income ($ per month) 30

20

Engel curve slopes upward for a normal good.

10

12

16

Food (units per month)

Engel Curves
Income ($ per month) 30

Inferior 20
Engel curve is backward bending for inferior goods.

Normal 10

12

16

Food (units per month)

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

Units of good Y (normal good)

a B O
1

I1

Units of good X (inferior good)

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

Units of good Y (normal good)

I2

a B O
1

I1

B
2

Units of good X (inferior good)

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

Incomeconsumption curve
Units of good Y (normal good) b

I2

a B O
1

I1

B
2

Units of good X (inferior good)

Effect of a fall in the price of good X

30
Assumptions PX = 2 PY = 1 Budget = 30

Units of good Y

20

10

0 0 5 10

B1
15 20 25

I1
30

Units of good X

Effect of a fall in the price of good X

30

a
Assumptions PX = 1 PY = 1 Budget = 30

Units of good Y

20

k j

10

I2

0 0 5 10

B1
15 20 25

I1

B2
30

Units of good X

Effect of a fall in the price of good X

30

Priceconsumption curve Units of good Y

20

k j

10

I2

0 0 5 10

B1
15 20 25

I1

B2
30

Units of good X

Deriving a demand curve from a priceconsumption curve price

Further falls in the price of X a b c d

Expenditure on all other goods

B1

B2

B3

I1

I2 B4

I3

I4

Units of good X

Deriving a demand curve from a priceconsumption curve price

Expenditure on all other goods

Price-consumption curve
I4

B1

B2

B3

I1

I2 B4

I3

Units of good X

Deriving a demand curve from a priceconsumption curve price

Expenditure on all other goods

Price-consumption curve
I4

B1

B2

B3

I1

I2 B4

I3

Units of good X Price of good X P1 a

P2

Q1 Q2

Units of good X

Deriving a demand curve from a priceconsumption curve price

Expenditure on all other goods

Price-consumption curve
I4

B1

B2

B3

I1

I2 B4

I3

Units of good X Price of good X P1 a

P2 P3 P4

b c d Q1 Q2 Q3 Q4

Units of good X

Deriving a demand curve from a priceconsumption curve price

Expenditure on all other goods

Price-consumption curve
I4

B1

B2

B3

I1

I2 B4

I3

Units of good X Price of good X P1 a

P2 P3 P4

b c d Demand Q1 Q2 Q3 Q4 Units of good X

Income and Substitution Effects of a Price Change Income effect A change in the quantity purchased of a good by a consumer as result of a change in his income, prices remaining constant. Substitution effect Substitution effect means the change in the quantity purchased of a good by a consumer as result of a change in relative prices alone , real income remaining constant.

Income and Substitution Effects

A fall in the price of a good has two effects: Substitution & Income

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

Income and Substitution Effects

A fall in the price of a good has two effects: Substitution & Income

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

Response to an income increase: both goods normal

C 100

U1 20 35 F

Income effects

C Normal; F inferior

C 100 Both F and C Normal

F Normal; C inferior U1 20 35 F

Decomposing the price change

Prices Drop

Income and Substitution Effects Illustrated: The Normal-Good Case Normal[Figure 4.3]

 Price effect =substitution effect + Income effect The movement from W W =Price effect The movement from W J = substitution effect The movement from JW =Income effect J

Income and Substitution Effects: Normal Good

Clothing (units per month) R
When the price of food falls, consumption increases by F1F2 as the consumer moves from A to B. The substitution effect,F1E, (from point A to D), changes the A relative prices but keeps real income (satisfaction) constant. The income effect, EF2, ( from D to B) keeps relative prices constant but increases purchasing power.

C1

D C2
Substitution Effect

U2 U1
E S F2
Income Effect

F1

Total Effect

Food (units per month)