MICRO ECONOMICS

Group Members: Alka Singh Mahak Arora PARAS HANDA PRIMAL SHARMAINDIFFERENCE CURVESCourse: Seminar on Micro Economics1Cardinal versus ordinal utilityEarly economists assumed that people are able to assign meaningful utilitynumbers(utils) to their satisfaction in one situation vis--vis their satisfaction in an alternative situation. For example, the utils generated by each brownie you eat or book you read would be recorded as if you have utilometer imbedded in your system.Cardinal measurement of utilitySatisfaction, like temperature or distance, is assumed measurable in meaningful, absolute numbers.

2Ordinal Utility GenesisCardinal measures are possible when incremental units are constant and reasonably objective, but utility is roughly measurable at best. As there is no one born equipped with a utilometer to precisely measure satisfaction.In the 1930s, Nobel prize-winner Sir John Hicks followed the leads of Vilfredo Pareto and Francis Y. Edgeworth to developindifference analysis, an underpinning for the theory of consumer behavior that dispenses with cardinally-measured utility. Hicks argued that ranking our preferences is the best we can do.3INDIFFERENCE CURVESThe technique of indifference curves was originated by Francis Y. Edgeworth in England in 1881. It was then refined by Vilfredo Pareto, an Italian economist in 1906. This technique attained perfection and systematic application in demand analysis at the hands of Prof. John Richard Hicks and R.G.D. Allen in 1934.

Hicks discarded the Marshallian assumption of cardinal measurement of utility and suggested ordinal measurement which implies comparison and ranking without quantification of the magnitude of satisfaction enjoyed by the consumer .

4Assumptions:Rational behavior of the consumerUtility is ordinalDiminishing marginal rate of substitutionConsistency in choiceTransitivity in choice makingGoods consumed are substitutable

5Axioms of rational choiceCompletenessif A and B are any two situations, an individual can always specify exactly one of these possibilities:A is preferred to BB is preferred to AA and B are equally attractive

6Axioms of rational choiceTransitivityif A is preferred to B, and B is preferred to C, then A is preferred to Cassumes that the individuals choices are internally consistent

7Axioms of rational choiceContinuityif A is preferred to B, then situations suitably close to A must also be preferred to Bused to analyze individuals responses to relatively small changes in income and prices

8DefinitionAn indifference curve is the locus of points representing all the different combinations of two goods which yield equal level of utility to the consumer.Indifference schedule is a list of various combinations of commodities which are equally satisfactory to the consumer concerned.

9Two Indifference SchedulesSCHEDULE 1SCHEDULE2Good XGood YGood XGood Y11221428310354743555264In Schedule 2,consumer has initially 2 units of goods X and 14 units of Y.So questions arises how much of Y would consumer be ready to abandon for succesive additions of X in his stock so that satisfaction remains equal as compared to his intial one i.e 2X+14Y.10Schedule 1 or Schedule 2?Any combination in schedule 2 will give consumer more satisfaction than in schedule 1.The reason for this is that more of a commodity is preferable to less of it.In simple terms, greater quantity of a good gives an individual more satisfaction than the smaller quantity of it,the quantity of other goods with him remaining the same.11Indifference CurvesAn indifference curve shows a set of consumption among which the individual is indifferentQuantity of XQuantity of YX1Y1Y2X2U1Combinations (X1, Y1) and (X2, Y2)provide the same level of utility12

Shape of Indifference CurveIndifference curve slope down and to the right, and the slope becomes less steep the farther right you go (this shape is sometimes described asconvexorconvex to the origin). Why?The curves slope down to the right because any combination on the curve would yield equal satisfaction.13Indifference CurveAn indifference curve shows various combinations of goods that yield the same utility, but different indifference curves show different levels of utility.For instance, the green indifference curve on the graph below indicates a higher level of utility than the red or the blue indifference curves. Economists assume that people want to attain the highest level of utility possible (I3is better thanI2which is better thanI1)There are an infinite number of indifference curves in the indifference map, and each persons indifference map is unique to that person.

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Indifference Curve Map15Indifference Curve MapEach point must have an indifference curve through itQuantity of xQuantity of yU1 < U2 < U3U1U2U3Increasing utility16UtilityGiven these assumptions, it is possible to show that people are able to rank in order all possible situations from least desirable to mostEconomists call this ranking utilityif A is preferred to B, then the utility assigned to A exceeds the utility assigned to BU(A) > U(B)17Utility is affected by the consumption of physical commodities, psychological attitudes, peer group pressures, personal experiences, and the general cultural environmentEconomists generally devote attention to quantifiable options while holding constant the other things that affect utilityceteris paribus assumption

18Preferences and UtilityMarginal Rate of Substitution, MRSyx : The rate at which a consumer is willing to sacrifice one good (y) in return for more of another good (x).

Principle of Diminishing Marginal Rate of Substitution : A rule stating that, for any convex indifference curve, when moving down the curve from the top (northwest) to the bottom (southeast), the absolute value of that curves slope must be continuously declining19Marginal Rate of SubstitutionMRS changes as x and y changereflects the individuals willingness to trade y for xQuantity of xQuantity of yx1y1y2x2U1At (x1, y1), the indifference curve is steeper.The person would be willing to give up morey to gain additional units of xAt (x2, y2), the indifference curveis flatter. The person would bewilling to give up less y to gainadditional units of x20Marginal Rate of SubstitutionThe negative of the slope of the indifference curve at any point is called the marginal rate of substitution (MRS)Quantity of xQuantity of yx1y1y2x2U1

21Properties of Indifference CurvesHigher indifference curves are preferred to lower ones.Indifference curves are downward sloping.Indifference curves do not cross.Indifference curves are bowed inward.22Property 1: Higher indifference curves are preferred to lower ones.Consumers usually prefer more of something to less of it. Higher indifference curves represent larger quantities of goods than do lower indifference curves.23Property 2: Indifference curves are downward sloping.A consumer is willing to give up one good only if he or she gets more of the other good in order to remain equally happy.If the quantity of one good is reduced, the quantity of the other good must increase.For this reason, most indifference curves slope downward.2422Property 3: Indifference curves do not cross.Quantityof PizzaQuantityof Pepsi0CAB251MRS = 183IndifferencecurveAProperty 4: Indifference curves are bowed inward.Quantityof PizzaQuantityof Pepsi014237B1 MRS = 646People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little.26Perfect SubstitutesDimes0Nickels2142I1I263I327Perfect ComplementsRight Shoes0LeftShoes7575I1I228Budget Line or Budget ConstraintEssential for understanding the theory of consumers equilibrium.The budget line shows all the different combinations of two goods that a consumer can purchase given his money income and price of two commoditiesWhen a consumer attempts to maximize his satisfaction, there are two constraints:Paying the prices for the goodsLimited money income29Budget EquationPx*X + Py*Y=M

M := Income of the consumerPx := Price of good XPy := Price of good YX := Quantity of good XY := Quantity of good Y30Units of good YUnits of good XabUnits ofgood X

0 51015Units ofgood Y

302010 0Point onbudget line

abAssumptions

PX = 2PY = 1Budget = 30

A budget line3131Budget Line ContinuedBudget line graphically shows the budget constraint. The combination of commodities lying to the right of the budget line are unattainable because income of the consumer is not sufficient to buy those combinations.The combinations of goods lying to the left of the budget line are attainable.

32Budget SpaceA set of all combinations of the two commodities that can be purchased by spending the whole or a part of the given income.

33Changes in Price and Shift in Budget LineAt the lower price of X, the given income purchases OL of X which is greater than OL.

At the higher price of X, the given income purchases OL of X which is less than OL.

34Changes in Income and Shift in Budget LineBL initial budget lineIf consumers income increases while prices of both X and Y remain unaltered, the price line shifts upwards i.e. BL and is parallel to BL.Similarly it will shift downward i.e. BL, if income decreases.

35Slope of Budget Line and Prices of two goodsSlope of budget line BL is equal to the ratio of prices of two goods.

Slope of budget line = OB/OL= Px / Py36Consumer EquilibriumIt refers to a situation in which a consumer with given income and given prices purchases such a combination of goods which gives him maximum satisfaction and he is not willing to make any change in it.

Assumptions:1) The consumer has a given indifference map exhibiting his scale of preferences for various combinations of two goods, X and Y.2) Fixed amount of money to spend and has to spend whole of his money on two goods.3) Prices of goods are given and constant for him. He cannot influence those prices.4) Goods are homogeneous and divisible.

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38There are three indifference curves IC1, IC2 and IC3. The price line PT is tangent to the indifference curve IC2 at point C. The consumer gets the maximum satisfaction or is in equilibrium at point C by purchasing OE units of good Y and OH units of good X with the given money income.

The consumer cannot be in equilibrium at any other point on indifference curves. For instance, point R and S lie on lower indifference curve IC1 but yield less satisfaction. As regards point U on indifference curve IC3, the consumer no doubt gets higher satisfaction but that is outside the budget line and hence not achievable to the consumer. 39ConditionsA given price line must be tangent to an indifference curve or marginal rate of satisfaction of good X for good Y (MRSxy) must be equal to the price ratio of the two goods. i.e. MRSxy = Px / Py

The second order condition is that indifference curve must be convex to the origin at the point of tangency.

40Income Effect : Income Consumption CurveThe income effect means the change in consumers preferences of the goods as a result of a change in his money income.Income consumption curve traces out the income effect on the quantity consumed of the goods.

Income effect for a good is said to be positive when with the increase in income of the consumer, his consumption of good also increases. (Normal Goods)Income effect for a good is said to be negative when with the increase in income of the consumer, his consumption of good decreases. (Inferior Goods)41Income Consumption Curve

42ContinuedWith the given budget line P1L1, the consumer is initially in equilibrium at point Q1 on the indifference curve IC1 and is having OM1 of X and ON1 of Y.As income increases budget line shifts upwards i.e. from P1L1 to P1L2 to P3L3 and so on.With budget line P2L2, equilibrium is at Q2 on IC2. Similarly it changes with next budget lines.If now various points Q1, Q2, Q3 and Q4 showing consumers equilibrium at various levels of income are joined together, we will gwt Income Consumption Curve.

43Income Consumption Curve in Case of Good X being Inferior Good

44Income Consumption Curve in Case of Good Y being Inferior Good

45Income Consumption Curves of Normal Goods

46Income Consumption Curves of Inferior Goods

47Engel curve

AnEngel curvedescribes how household expenditure on a particular good or service varies with household income.There are two varieties of Engel Curves. Budget share Engel Curves describe how the proportion of household income spent on a good varies with income. Alternatively, Engel curves can also describe how real expenditure varies with household income. They are named after the German statisticianErnst Engel(18211896) who was the first to investigate this relationship between goods expenditure and income systematically in 1857. The best-known single result from the article isEngels Lawwhich states that the poorer a family is, the larger the budget share it spends on nourishment.48The Shape of Engel Curves

The shape of Engel curves depend on many demographic variables and other consumer characteristics. A goods Engel curve reflects its income elasticity and indicates whether the good is an inferior, normal, or luxury good. Empirical Engel curves are close to linear for some goods, and highly nonlinear for others.Graphically, the Engel curve is represented in the first-quadrant of theCartesian coordinate system. Income is shown on the Y-axis and the quantity demanded for the selected good or service is shown on the X-axis.

49The Shape of Engel Curves(Contd.)Fornormal goods, the Engel curve has a positive gradient. That is, as income increases, the quantity demanded increases. Amongst normal goods, there are two possibilities. Although the Engel curve remains upward sloping in both cases, it bends toward the y-axis fornecessitiesand towards the x-axis forluxury goods.

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51The Shape of Engel Curves(Contd.)Forinferior goods, the Engel curve has a negative gradient. That means that as the consumer has more income, they will buy less of the inferior good because they are able to purchase better goods.

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Applications Of Engel Curves

In microeconomics Engel curves are used for equivalence scale calculations and related welfare comparisons, and determine properties of demand systems such as aggregability and rank.Engel curves have also been used to study how the changing industrial composition of growing economies are linked to the changes in the composition of household demandIn trade theory, one explanation inter-industry trade has been the hypothesis that countries with similar income levels possess similar preferences for goods and services (the Lindner hypothesis), which suggests that understanding how the composition of household demand changes with income may play an important role in determining global trade patterns.Engel curves are also of great relevance in the measurement of inflationand tax policy

54Substitution EffectIt is the change in the quantity of good. purchased due to change in their relative prices alone, while real income of the consumer remains the same.

55Substitution Effect(Contd.)

56Substitution Effect (Contd.)In this diagram the consumer with given money income and given prices of two goods represented by price line PL is in equilibrium at point Q on the indifference curve IC. He buys ON quantity of good Y and OM of good X.

We suppose now that the price of good X has fallen and the price of good Y remains the same. With the fall in the price line shifts from PL to PL/. Consumers real income is raised because commodity X is cheaper now. This increase in the real income of the consumer is to be wiped out for finding out the substitution effect. The reduction in the money income of the consumer is to be made by so much amount which keeps him on the same indifference curve IC.

57Indifference Curve Analysis - Price Effect

When there is no change in the income of the consumer, no change in the price of one commodity, and there is a change in the price of another commodity, there will be a change in the consumption made by the consumer. This change in consumption is known as the Price Effect. Though money income does not increase, the real income increases, generating more purchasing power.

58Indifference Curve Analysis - Price Effect (Contd.)Under the Price Effect, there will be a change in the equilibrium position of the consumer. This can be shown in the following diagram.

In this diagram PCC is the Price Consumption Curve. It is sloping downwards to the right. Any point on the Price Consumption Curve will indicate the equilibrium position of the consumer under the Price Effect. In this diagram when the price of X falls, the consumer purchases more of X and less of Y.

59Indifference Curve Analysis - Price Effect (Contd.)Shapes of Price Consumption CurveWith a fall in the price of one commodity there will be some extra income with the consumer. It can distribute this real extra income on the two commodities in different ways. So the Price Consumption Curve will have different shapes. Below we draw the different shapes of the Price Consumption Curve.

60Indifference Curve Analysis - Price Effect (Contd.)In the above diagram PCC is the price consumption curve. It is a horizontal straight line. It indicates that with a fall in the price of X, the consumer purchases more of X and the same quantity of Y

61Indifference Curve Analysis - Price Effect (Contd.)In the above diagram PCC, the price consumption curve, is sloping upwards to the right. This indicates that with a fall in the price of X the consumer purchases more of X and more of Y.

62Indifference Curve Analysis - Price Effect (Contd.)In this diagram the price consumption curve is sloping upwards to the left. This indicates that with a fall in the price of X, the consumer purchases less of X. This is applicable in case of Giffen goods.

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