indifference curve.pdf

7/28/2019 indifference curve.pdf

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Chapter 3 12005 Pearson Education, Inc.

Indifference Curves:

An Example (pp. 65 - 79)

4010H

2010G

4030E

2040D

5010B

3020A

Units of ClothingUnits of FoodMarket Basket


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Graph the points with one good on the x-axis and one good on the y-axis

Plotting the points, we can make some

immediate observations aboutpreferences

The more, the better


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The consumer prefersA to all combinations

in the yellow box, whileall those in the pink

box are preferred to A.



Food

10

20

30

40

10 20 30 40

Clothing 50

G

A

EH

B

D


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Points such as B & D have more of onegood but less of another compared to ANeed more information about consumer

ranking

Consumermaydecide they areindifferent between B, A and DWe can then connect those points with an

indifference curve


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Indifferent

between points B,

A, & D

E is preferred toany points on the

indifference curve

U1

Points on U1arepreferred to H & G



Food

10

20

30

40

10 20 30 40

Clothing50

U1G

D

A

EH

B


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Indifference Curves (pp. 65 - 79)

Any market basket lying northeast of anindifference curve is preferred to anymarket basket that lies on theindifference curve

Points on the curve are preferred topoints southwest of the curve


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Indifference curves slope downward tothe right

If they sloped upward, they would violate theassumption that more is preferred to less


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To describe preferences for allcombinations of goods/services, we havea set of indifference curves anindifference map

Each indifference curve in the map showsthe market baskets among which the personis indifferent


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U2

U3

Indifference Map (pp. 65 - 79)

Food

Clothing

U1

AB

D

Market basketAis preferred to B.

Market basket B is

preferred to D.


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Indifference Maps (pp. 65 - 79)

Indifference maps give more informationabout shapes of indifference curves

Indifference curves cannot cross

Violates assumption that more is better

Why? What if we assume they can cross?


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Indifference Maps (pp. 65 - 79)

Food

Clothing

B is preferred to D

A is indifferent to B & D

B must be indifferent toD but that cant be if B is

preferred to D. A

contradiction

Other example:On a map, two

contours never cross

each other.

U1

U1

U2

U2

A

B

D


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The shapes of indifference curvesdescribe how a consumer is willing tosubstitute one good for another

A to B, give up 6 clothing to get 1 food

D to E, give up 2 clothing to get 1 food

The more clothing and less food a person

has, the more clothing they will give up toget more food


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A

B

D

E G-1

-6

1

1

-4

-21

1

Observation: The amount

of clothing given up for

1 unit of food decreases

from 6 to 1


Food

Clothing

2 3 4 51

2

4

6

8

10

12

14

16


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We measure how a person trades onegood for another using the marginal rateof substitution (MRS)

It quantifies the amount of one good aconsumer will give up to obtain more ofanother good, orthe individual terms of trade

From a geometric viewpoint, it is measured

by the slope of the indifference curve


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Marginal Rate of Substitution (pp. 65- 79)

Food2 3 4 51

Clothing

2

4

6

8

10

12

14

16 A

B

D

EG

-6

1

1

1

1

-4

-2

-1

MRS = 6

MRS = 2

FCMRS =


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From A to B, give up 6 clothing to get 1 food.

That is,

F=2-1=1, C=10-16 =-6; MRS=- C /F=6

From D to E, , give up 2 clothing to get 1 food;

F=4-3=1, C=4-6 =-2; MRS =- C /F= 2


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Indifference curves are convexAs more of one good is consumed, a consumer would

prefer to give up fewer units of a second good to getadditional units of the first one. As food becomes lessscarce, he/she would give up less of clothing for an

additional food.

Consumers generally prefer a balanced marketbasket (preference for varieties; the Doctrine of

the Mean in a Chinese classic)


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The MRS decreases as we move downthe indifference curve

Along an indifference curve there is adiminishing marginal rate of substitution.

The MRS went from 6 to 4 to 1


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Indifference curves with different shapesimply a different willingness to substitute

[That is, an indifference map is a concept

to represent ones preference for marketbaskets.]

Two polar cases are of interest

Perfect substitutesPerfect complements


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Perfect Substitutes

Two goods are perfect substitutes when themarginal rate of substitution of one good forthe other is constant

Example: a person might consider applejuice and orange juice perfect substitutes

They would always trade 1 glass of OJ for 1

glass of Apple Juice Find your own examples.


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Consumer Preferences (pp. 65 - 79)

Orange Juice

(glasses)

Apple

Juice(glasses)

2 3 41

1

2

3

4

0

Perfect

Substitutes


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Perfect Complements

Two goods are perfect complements whenthe indifference curves for the goods areshaped as right angles

Example: If you have 1 left shoe and 1 rightshoe, you are indifferent between havingmore left shoes only

Must have one right for one left. Thats why wealways get apairof shoes, not one by one.

Find your own examples.


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Consumer Preferences:

An Application (pp. 65 - 79)

In designing new cars, automobileexecutives must determine how muchtime and money to invest in restylingversus increased performance

Higher demand for car with better styling andperformance

Both cost more to improve


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Consumer Preferences:

An Application (pp. 65 - 79)

An analysis of consumer preferences

would help to determine where to spendmore on change: performance or styling

Some consumers will prefer better styling

and some will prefer better performance In recent years we have seen more and

more SUVs on our roads. Certainly more

owners/drivers prefer SUVs to otherstyles.


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The theory of consumer behavior doesnot required assigning a numerical valueto the level of satisfaction. Can you tellthe level of satisfaction from your monthlybasket?

Although ranking of market baskets is

good, sometimes numerical value isuseful


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Utility

A numerical score (concept) representing thesatisfaction that a consumer gets from agiven market basket. The concept of utility was

born before that of consumer preference.If buying 3 copies ofMicroeconomics makes

you happier than buying one shirt, then we

say that the books give you more utility thanthe shirt


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Utility (pp. 65 - 79)

Utility function

Formula that assigns a level of utility toindividual market baskets

If the utility function is

U(F,C) = F + 2CA market basket with 8 units of food and 3 units of

clothing gives a utility of

14 = 8 + 2(3)


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Utility - Example (pp. 65 - 79)

4 + 2(4) = 1244C

6 + 2(4) = 1446B

8 + 2(3) = 1438A

UtilityClothingFoodMarket

Basket

Consumer is indifferent between A & B andprefers both to C.


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Utility - Example (pp. 65 - 79)

Baskets for each level of utility can beplotted to get an indifference curveTo find the indifference curve for a utility of

14, we can change the combinations of food

and clothing that give us a utility of 14


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Utility - Another Example (pp. 65 - 79)

Food10 155

5

10

15

0

Clothing

U1 = 25

U2 = 50

U3 = 100A

B

C

Basket U = FC

C 25 = 2.5(10)A 25 = 5(5)

B 25 = 10(2.5)


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Utility (pp. 65 - 79)

Although we numerically rank baskets and

indifference curves, numbers are ONLY forranking

A utility of 4 is not necessarily twice as good asa utility of 2. A umber assigned to a utility levelDOES NOT have any meaning.

There are two types of rankingsOrdinal ranking; Ordinal Utility Function

Think of a number on your ticket when you are in awaiting line.

Cardinal ranking; Cardinal Utility Function

Think of the total number of students in this class.


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Budget Constraints (pp. 79 - 83)

Preferences do not explain all of

consumer behavior

Budget constraints limit an individualsability to consume in light of the pricesthey must pay for various goods andservices


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The Budget Line (Constraint)

Indicates all combinations of twocommodities for which total money spentequals total income

We assume only 2 goods are consumed, sowe do not consider savings


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The Budget Line (pp. 79 - 83)

Let F equal the amount of food

purchased, and C is the amount ofclothing

Price of food = PF and price of

clothing = PC Then PFF is the amount of money spent

on food, and PCC is the amount of money

spent on clothing


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ICPFPCF

=+


The budget line then can be written:

All income is allocated to food (F) and/or clothing

(C)


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The Budget Line(pp. 79 - 83)

Different choices of food and clothing can

be calculated that use all incomeThese choices can be graphed as the budget

line

Example:

Assume income of $80/week, PF = $1 and PC= $2


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$80080G$801060E

$802040D

$803020B

$80400A

IncomeI = PFF + PCC

Clothing

PC = $2

Food

PF = $1

MarketBasket


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C

F

P

P

F

CSlope -2

1- ==

=


10

20

A

B

D

E

G

(I/PC) = 40

Food40 60 80 = (I/PF)20

10

20

30

0

Clothing


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As consumption moves along a budget

line from the intercept, the consumerspends less on one item and more on theother

The slope of the line measures therelative cost of food and clothing

The slope is the negative of the ratio of

the prices of the two goods


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The slope indicates the rate at which the

two goods can be substituted withoutchanging the amount of money spent

It represents exchange ratio or terms oftrade in market places.

We can rearrange the budget line

equation to make this more clear


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YXP

P

P

I

YPXPI

YPXPI

Y

X

Y

YX

YX

=

=

+=

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indifference curve.pdf