View
17.611
Download
0
Category
Tags:
Preview:
DESCRIPTION
Citation preview
INDIFFERENCE CURVES AND UTILITY INDIFFERENCE CURVES AND UTILITY MAXIMIZATIONMAXIMIZATION
• 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 of satisfaction to the consumers same level of satisfaction to the consumers so that an individual is indifferent.so that an individual is indifferent.
0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
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.
DMRSDMRS
0
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
0
10
20
30
0 5 10 15 20
A budget lineA budget line
0
10
20
30
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.
Consumer EquilibriumConsumer Equilibrium
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
Effect on consumption of a change in incomeEffect on consumption of a change in income
I2
Un
its o
f goo
d Y
O
Units of good X
B1 B2 B3 B4 I1
I3
I4
Effect on consumption of a change in incomeEffect on consumption of a change in income
I2
Un
its o
f goo
d Y
O
Units of good X
B1 B2 B3 B4 I1
I3
I4
Income–consumption curve
Effect on consumption of a change in incomeEffect on consumption of a change in income
Utility MaximizationUtility Maximization
Recommended