Indifference Curve Approach

7/28/2019 Indifference Curve Approach

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The Indifference

Curve Approach


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A. An economic agent behaves rationally.

Significance:Thus, economic investigation is

possible and meaningful.

Meaning:Behaviour of an economic agent

has objectives and involves a prudentchoice among alternative means. In other words,

consumer behaviour is not random or arbitrary.

It has patterns and can be explained.

What are the basic postulates of consumer behaviour?


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Then how does an individual make his choice?

B. Postulate of constrained maximization / self -

interest / self ishness

Meaning:An economic agent always chooses the

option that maximizesthe achievement of his goals

among the options allowed by existing constraints.Significance:Without a postulate on economic choice,

there is no economics. Without a confirmed postulate

on economic choice, economics might not have

survived.

Note: This isthe most important & most useful postulate in

economics.


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C. Each individual has many wants.

Significance:Hence choice and exchange may

arise.D. To each individual, some goods are scarce.

Significance:Hence competition and choice are

inevitable. They constitute the main content of

economics.

Competition Choice

Scarcity


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E. Scarce goods are substi tutable

Meaning:One is willingto forgosomethingto getmore of the scarce goodsubstitution,provided that the value got is larger than the

cost paid.

Significance:Exchangeis possible.


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F. The law of diminishing MRS

Marginal rate of substitution (MRS): is the

maximumamountof good Y that an individual is

wil l ing to forgoforan additional uni tof good X.

It is equal to marginal use value (MUV)of goodX in terms of good Y.

The law states that MRS or MUV of a good

declinesas moreunits of the good are obtained,

ceteris paribus.

Significance:(Both interior and corner solutions are

possible.)


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Good, Bad and Neuter


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A goodis something desired,

i.e., _________ is preferred to _________.nonesome


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Goods

Free goods Scarce goods

(economic goods)

Types of goods:


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Free good: Features

its amount availableis ______ than its

amount desiredat zero price,

i.e., ________ is preferred.

something desired

no more

more


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Scarce good(economic good):Features

something desired

its amount availableis _____ than its amountdesiredat zero price,

i.e., ______ is preferred to _____.

less

more less


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Depends on situationsrather than kinds.

Any examples?

Distinction between free goods and scarce goods:


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Distinction between free goods and goods free-of-charge:

A free goodmust bea good free-of-charge. Why?

A good free-of-chargemay not bea free good. Why?

its amount available is more than its amount desired.

no one desires to have more of it

no production nor exchange takes place zero-priced.

a scarce good can also be free-of-charge if someone

pays the cost for you. Any examples?


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Is sickness bad ?

more

A badis something undesired,

i.e., _________ is preferred to _________.less


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A neuteris something neither

desirednorundesired,

i.e., the quantitydoes not matter.

Any examples?


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Utility


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What is utility?

Utilityis a number

arbitrar i ly assignedto entities to rankthem

according to ones preference.

a criterion ofmaximizationto rank options for makingchoice.

the higherthe utility, the moreone prefersthe entity.


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What is uti l i ty?

Utilityreflects preference

social welfare happiness / satisfaction

Why?


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Measurement ofutility

Ordinal utility

only reflects an

order

but the difference

betweenthe numbersassigned ismeaningless

Cardinal utility

can also reflect

an order

and the differencebetween

the numbersassigned ismeaningful


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Measurement of uti l i ty

Which measurement of utility is used

in the indifference curve approach?

Ordinal measure of uti l i ty


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Indifference Curve


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What is an indifferencecurve?

U=10

An indifference curve(IC, is a line

joining all the points (representing

different baskets of goods) giving the

same utility to an individual.

Good X

Good Y

0


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What is an indifference

map?An indifference mapis a set

of ICs showing the

__preference_______of anindividual.

U=10U=20

U=30

Good Y

Good X0


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Properties of IndifferenceCurves of Two Goods


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1. ICs of two goods are negativelysloped

U=10

Good Y

Good X0

+X

-Y

Keeping utility constant, along an IC,a basket with more units of good X

must have _____ units of good Y.fewer

negative

(Options: more / fewer /

positive / negative)

Slope of an IC of two goods (=Y/ X)must be ________.


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2. Indifference curves arecontinuous

If quantities of good X and good Y can be

increased or decreased by infinitesimal amounts,

the ICs are continuous. Why?

U=10

Good Y

Good X0


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3. Indifference curves can neverintersect

Along U2: point A = point C = U2

Along U1: point A = point B = U1

What is the uti l i ty ofpoint A, =U1orU2?

U of the intersection pointlogical contradiction

A

B

C


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4. Full

coverage

U1U2

U3

Good Y

Good X0

The higher the IC ,

the higher the utility

(U3 > U2 > U1). Why?

If a consumerknows hispreference on every

basket of commodities, the commodity plane

will be fully covered by ICs. Why?


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5. Indifference curves of twogoods are convex to the origin

U1

ood Y

Good X0

+1X

-Y

As the consumption of good X rises,

MRS (the slope)falls. Why?

convex

As the IC becomes

f latter & flatter, its shape is

_______ to the origin.

The numerical value of the slopeof an IC

(+1X -?Y) is equal to the MRS. Why?


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Other Shapes of

Indifference Curves


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1. X is a neuter and Y is agood

Y (A good)

X(A neuter)0

U2

U1

U3

U3>U2>U1Any increase or

decrease in the quantity

of X makes no difference

to the consumer.

Why?

ICs are___________.horizontal


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ICs are _________slopingwith a/an _________slope.

2. X is a bad and Y is a good

U3>U2>U1

U1U2

U3

0

Y (A good)

X (A bad)

Why?

upwardincreasing

+X

+Y

To keep U constant,

in a bad (+X) requires

in a good (+Y) as a compensation.


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3. X is a commodity with a satiation threshold

(beyond which X turns from a good to a bad)

0

Good Y

X

U1

U2

U3

U3>U2>U1

X becomes a badX is a good

ICs are__________.

Why?

U-shaped


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4. X and Y are perfect substi tutes

Good X (pack of 5 kg rice)

Good Y (pack of 8 kg rice)

0 U1 U2 U3

U3>U2>U1

ICs are _________ sloping

_______ lines.

Why?

downward

straight


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5. X and Y are perfect complements

Good Y (left shoes)

Good X (right shoes)0

ICs are__________.

45o U3>U2>U1

U1

U2

U3Why?

right-angled


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Budget Line


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It is also called the budget constraint.

What is a budget line?

Budget l ine (BL )orconsumption possibil i ty curveisa

boundary showing the largest possible combinations of

goods that a consumer can buyin a market,givenhis money income and market pr ices of the goods.


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Y

X0

Given I = Rs.100, PX

= Rs.20 & PY

= Rs.25 The maxi.amount of X one can buy = Rs.100/Rs.20 = 5

Rs.100/Rs.25= 4

Rs.20/Rs.25=.8

4

5

+1X

-0.8Y

Derivation of a BL:

To buy 1 more unit of X, one

forgoes = unit of Y.

The maxi. amount of Y one can buy

=

The BL is a downwardsloping straight line.

The slope of BL = costof

consuming an additional unit ogood X in terms of good Y.


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Features:

Y

X0

A

CB

Point A:Expenditure ____ Income

Point B:Expenditure ____ IncomePoint C:Expenditure ____ Income

(Options: > = < )


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Equation of budget line

X PX+ Y PY= I

Expenditure

on good X

Expenditure

on good Y

Money income

of the consumer


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Changes in budget constraints

1. Changes in income

When ones income

increases, the budgetline will shift ______

in a parallel manner,

and vice versa.

Y

0 X

outward

Why?

in income

in income


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2. Proportionate changes in

prices

Y

0X

When prices of both

goodsrise

by the sameproportion, the budget

line will shift _______

in a parallel manner,

and vice versa.

inward

Why?

A proportionate

in all money prices

A proportionate

in all money prices


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3. Disproportionate changes inprices

Y

0X

A rise in Px

A fall in Px

til t inward

til t outward

When PX, the budget line

will _________ and become

steeper. Why?

When PX, the budget

line will __________ and

become _______. Why?flatter


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What is a consumer

equilibrium?

Optimumorequilibrium is the best choiceof

an economic agent in achieving his objective.

Optimali ty conditionsorequi l ibr ium Conditions

are descriptions on the defining featuresof the

optimum or the equilibrium.


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I nter ior solution

When a consumerbuys both goodsX & Y,

i.e., the equilibrium is not one of the _________on the budget l ine, the equilibrium is called

an inter ior solution.

intercepts


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It is the tangency

point, the only point on

the budget line reaching

the highest IC attainable.U1

U3

Y

X0

U3>U2>U1

X*

Y*

From observation, the

best choice achievable is

_____________.

Equi l ibr ium: From observation

E*

U2

E* (X* , Y* )

Why?


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Equi l ibr ium conditions:

U1U2

U3

Y

X0

U3>U2>U1

E*

X*

Y*

1. The consumer

equilibrium mustlie____the BL.

2. The consumer

equilibrium is the____________at which

the slope of IC equals

the slope of BL.

on

tangency point


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Slope of indifference curve Slope of budget line

1. =Y/X, holding util ityconstant

=Y/X, holding expenditureor income constant

2. = Marginal rate of substitution

in consumption, MRSc

= Marginal rate of substitution

in exchange, MRSe

Meaning of the slopes

3. = The maximum amountof Y

one is wil l ing to payfor an

additional unit of X

= The actual amountof Y one

is requi red to payfor an

additional unit of X in exchange

4. = Cost / Value?of an

additional unit of X in terms

of Y (=MUV)

=Cost / Value?of consuming

an additional unit of X in terms

of Y (= Px/Py)

Value Cost


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How is the consumer equilibriumreached?

Buy X

At point A, MRSc>MRSe (_______of an

additional X >its ________), utility can be

raised if the consumer _________ units of X.

U2

U1

Y

X0

A

buys more

(Options: buys more /

sells some /

value / cost )

value

cost


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Sell XU2

U1

Y

X0

At point B,MRSc


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U2

U1

Y

X0

MRSc=MRSe (value = cost),

utility is maximized &

the equilibrium is attained.

E*

How is the consumer equi l ibrium reached?


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Changes in

Consumer Equilibriumin Response toChanges in Constraints


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A. Changes in

income

When income with PX and PY unchanged,

the BL will shift in a parallel manner.

The effect of income on the consumption of a

consumer can be shown by 2 curves:

1. I ncome consumption curve

2. Engel curve

outward


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1. Income consumptioncurve

I ncome consumption

curve(ICC) is a line

joining all the

equilibrium(X,Y) of aconsumer when ones

incomechanges, holding

PX and PY constant.

ICCY

0 X


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Engel curveis

a line showing the

consumptionof agoodat different

incomelevels,

holding PX and PY

constant.

X

0Income

Engel

curve

2. Engel curve

I1 I2 I3

X3

X2

X1


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Y

X

ICC

A. Super ior good:

I ts consumption ispositively relatedto income.X

Income

Engel

curve

X1 X2 X3

X3

X2

X1

I1 I2 I3


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ICC

Y

X

B. I nfer ior good:

I ts consumption isnegatively relatedto income.X

I

Engel curve

X3X2X1

X1

X2

X3

I1 I2 I3


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B. Changes in price

The effect of price on the consumption of a

consumer can be shown by 2 curves:

1. Price consumption curve

2. Demand curve


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PCC

Price consumption

curveis a linejoining

all the equi l ibr iumofa consumerwhen PX

changes, holding I & PY

constant.

1. Price consumption curveY

0 X


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Px1

Px3

Px2

Y

0Px

0 X

X

PCC

Demand

Curve

X1 X2 X3 X4

If price (Px) &

quantity demanded

(X) of the good are

negatively related.


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Px1

Px2

PCC

Y

0X

Px

0 X

DemandCurve

Giffen paradox

If price (Px) &

quantity demanded

(X) of a good are

_________ related,the good is calleda

Giffen good.

positively

X1X2


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Decomposition of

the Price Effect into

the Substitution Effect &

the Income Effect


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Price effect

Price effectis the overallchange

in the quantity demandedof a good

caused by achange in its price,holdingmoney income constant.

Price effect can be decomposed into___________ effectand__________ effect.substitution income


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PxOne will buy moregood X to substi tutegood Y

S.E.

L3X3

E3

Y

0 X

E1

L1X1

So substitution effect must be negative.

Substi tution effectis the change in the quantity

demanded of a good caused by a change in its price,

holding util i ty or real income constant.

New equi l ibr ium

L2


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I.E.

L2

X2

Y

0X

S.E.

E3

E1

L1 L3

X3X1

Using thesavedincome

The saved income will raise

the consumption of good X

if good X is a superior good.

E2

I ncome effectis the change in the quantitydemanded of a good as a result of a change in real

incomecaused by a change in its price.When Px, income is saved. Income

is further saved by the S.E. as the

consumption of an expensive good is

substituted by the consumption of

a cheaper good.


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Price effect of different kinds of goods

S.E.

Positive I.E.

Y

X

E1

L1 L2L3

E3

E2

2. I f good X isa super ior

good,what wil l be theincome effect?

3. And what wil l be the

price effect?

1. Thesubsti tution effect

must be negative.


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S.E.

L3 L2

Negative I.E.Y

0 XL1

E1

2. I f X isan infer ior good

with its-ve I .E.< S.E.,

what wi l l be the price effect?

E3

E2


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S.E.

L1 L3 L2

E3

Y

0 X

E1

Negative I.E. 3. I f X isan infer ior goodwith its-ve I .E.>S.E.,

(cal led Giffen good),what wi ll be the price effect?

E2


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Postulate of utility maximization

Ifthe utility and the cost of each option

can be measured or asserted beforehand

the postulate can generate refutable predictionsand

it isusefulif it is not refuted.

cannot be measured or asserted beforehand

the postulate cannot generate refutable predictions,

then it becomestautological and uselessin explanation

and prediction.


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When a consumerbuys one good only, i.e., the

equilibrium is one of the interceptson the budget line,

the equilibrium is called a corner solution.

There is a___________________ in consumption.specialization


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Possible reasons for a corner solution are:

3. MRS is not decreasing.

1. The good is too expensive.2. The entity is a bad.


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E*

Y (A good)

X (A good but

too expensive)

MRSc (= value)

MRSe (= cost)

U1

U3

U2

U3>U2>U1

1. The good is too expensive

>

1X


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Y (A good)

X (A bad)

U1

U3U2

E*

0

U3>U2>U1

2. The enti ty is a bad


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Y (A good)

X (A good)

U1

U3

U2

E*

0

I ncreasing MRS

U3>U2>U1

3. MRS is not decreasing

Constant MRS

Y (A good)

X (A good)

U1

U3

U2

E*

0

U3>U2>U1


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4. Uti l i ty of a good must be a positive number

and that of a bad must be negative.

5. Postulate of uti l i ty maximization is tautological.

6. A straight-l ine indifference curve denies

the postulate of substi tution.

Correcting M isconceptions:


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7. A concave indifference map cannot have

consumer equi l ibrium or can have an inter ior

solution.

8. A good with its price and quanti ty demanded

negatively related is a normal good.

9. Holding money income constant is the same asholding real income constant.



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10. Substitution effect is positive for super ior good

and negative for infer ior good.

11. Giffen good has no relation with infer ior good.


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Indifference Curve Approach