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Chapter 1 Appendix
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Indifference Curve Analysis Market Baskets are combinations of
various goods.
Indifference Curves are curves connecting various market basket combinations of goods that make an individual equally happy.
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Assumptions about Preferences Persons can rank market baskets. Rankings are transitive. More is preferred to less. The marginal rate of substitution is
diminishing.
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Figure 1A.1 Indifference Curves
60
40
B1
50
50
B2
U1 U2
U3
Exp
end
itu
re o
n O
ther
Go
od
s p
er M
on
th (
Do
llar
s)
0 Gasoline per Month (Gallons)
Qx
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The amount of expenditure on other goods that a person will give up in order to get an additional unit of one good is called the marginal rate of substitution or the marginal benefit of a good.
The Marginal Rate of Substitution
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The Budget ConstraintThe budget constraint is the combination of goods that a person can afford.
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The Budget Constraint in Algebraic Terms
I = PxQx + PiQi
Where: I is income
Pi is the price of good i
Qi is the amount of good i purchased
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Figure 1A.2 The Budget Constraint
Exp
endi
ture
on
Gas
olin
e pe
r M
onth
Exp
endi
ture
on
All
O
ther
Goo
ds E
xcep
t G
asol
ine
per
Mon
th
C
60
40
F D
100
100
A
B Exp
end
itu
re o
n O
ther
Go
od
s p
er M
on
th (
Do
llars
)
Gasoline per Month (Gallons) 0 Qx
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Figure 1A.3 Consumer Equilibrium
U1
U3 U2
E 40
60
Exp
end
itu
re o
n O
ther
Go
od
s p
er M
on
th (
Do
llar
s)
Gasoline per Month (Gallons) 0 Qx
A
B
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Equilibrium Condition
PX = MBX
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Figure 1A.4 Changes in Income
A
B
Exp
end
itu
re o
n O
ther
Go
od
s p
er M
on
th (
Do
llars
)
Qx per Month 0
A'
B'
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Figure 1A.5 Changes in the Price of Good X
A
B '' B ' B
Exp
end
itu
re o
n O
ther
Go
od
s p
er M
on
th (
Do
llars
)
0
Qx per Month
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Income and Substitution Effects The income effect is the change in the monthly
(or other period) consumption of a good due to changing purchasing power of fixed income caused by the good’s price change.
The substitution effect is the change in the monthly (or other period) consumption of the good due to the change in its price relative to other goods.
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Figure 1A.6 Income and Substitution Effects
Qx
100
The Substitution Effect
Exp
end
itu
re o
n O
ther
Go
od
s p
er M
on
th (
Do
llar
s)
Gasoline per Month
(Gallons)The Income Effect
50
150
U2
U1
E'
45
E1
60 40
20 E2
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The Law of Demand The demand curve slopes downward. As the price rises, the quantity
demanded falls.
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Figure 1A.7 The Law of Demand
D = MB
Pri
ce
Qx per Month 0
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Price Elasticity of Demand
% Change in Quantity Demanded
% Change in PriceED =
QD/QD
P/P=
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Consumer Surplus Net benefit that consumers obtain from
a good Total benefit to consumers from obtaining
a good, less the money they give up to get the good.
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Figure 1A.8 Consumer Surplus
Consumer Surplus
A
D = MB
Pri
ce
Gasoline per Month 0 1 Q
P B Market Price
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Figure 1A.9 The Work Leisure Choice
U3 U2
U1
E 40
16
A
B
24Leisure Hours per Day
Inco
me
per
Day
0
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Budget line for time allocation
I = w(24 – L)
Where: I is income
W is wage
L is the amount of time devoted to leisure
