INDIFFERENCE CURVES AND UTILITY MAXIMIZATION

• Indifference curve – A curve that shows combinations of goods which gives the same level of satisfaction to the consumers so that an individual is indifferent.

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Constructing an indifference curve

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 .

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Deriving the marginal rate of substitution (MRS)a

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Deriving the marginal rate of substitution (MRS)

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Deriving the marginal rate of substitution (MRS)

Indifference schedule

• Indifference 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 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.

DMRS

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An indifference map

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 consumer’s

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.

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A budget line

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Effect of an increase in income on the budget line

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The Best Feasible Bundle

• Tools needed to determine how consumers should allocate their income between 2 goods :– Budget Constraint– Indifference Curves

• Consumer’s 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.

Consumer Equilibrium

The Best Affordable Bundle

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Budget line

Finding the optimum consumption

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indifference curve and budget line

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Effect on consumption of a change in incomeEffect on consumption of a change in income

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Effect on consumption of a change in incomeEffect on consumption of a change in income

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Effect on consumption of a change in incomeEffect on consumption of a change in income

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Income–consumption curve

Effect on consumption of a change in incomeEffect on consumption of a change in income