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MICROECONOMICS

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Indifference Curves & Budget Lines

Consumers’ budgets are modelled using budget lines

Consumer preferences are modelled using indifference curves and indifference maps

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U1

U2

Indifference Map: Goods

Food (units)

Clothing

(units)

U0

E

A

G

Indifference maps: • Comprise a set

of indifference curvesE is preferred to

A.A is preferred to G.

Direction of ___________ satisfactionincreasing

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Recap Key Concepts from Week 1: Slope of Indifference Curve

Food (units)2 3 4 51

Clothing (units)

2

4

6

8

10

12

14

16 A

B

D

EG

-2-1

1

-6

1

1

1

-4

MRSF for C = - C/F= 6

MRSF for C = - C/F = 2

SLOPE OF INDIFFERENCE CURVE

So MRS is represented by the absolute value of slope of the indifference curve

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L1

An increase in the price of food rotates the budget line inward.

L3

L2

A decrease in the price of food rotates the budget line outward.

Food(units)

Clothing(units)

Effects of Price Changes

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Effects of Income Changes

An increase in income is shown by a parallel outward shift in the budget

line

Food(units)

Clothing(units)

80 120 16040

20

40

60

80

0

L2L1L3

A decrease in income is shown by a parallel inward shift in the budget line

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Recap Key Concepts from Week 1:Slope of Budget Line Assume income of $80/week, price per unit of

food is $1 and price per unit of clothing is $2o I = $80o PF = $1o PC = $2

Budget line is PFF + PCC = I Using the formula 1F + 2C = 80

Slope= C/F or - PF/PC = -1/2

So Relative Price is represented by the slope of the budget line

Ratio of Price of F to Price of C; OR Relative Price of F to C

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Recap Key Concepts from Week 1: Indifference Curves & Budget Lines

Consumer preferences are modelled using indifference curves

MRS (F for C) = Absolute value of slope of indifference= -C/F

Consumers’ budgets are modelled using budget lines

Relative Price of F to C = Slope of budget line = -PF/PC

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Recap Key Concepts from Week 1: Consumer Choice Theory

Different consumers prefer different goods

Consumers have limited incomes to spend

Consumers’ choices about consumption reflect both their preferences and their budget constraints

Consumer preferences

Budget constraint

Consumer choice

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Understand the traditional theory’s explanation of how consumers make choices

Trace the effects of price changes from consumer choice to the demand curve

Trace the effects of income changes from consumer choice to the demand curve

Gain an understanding of different types of goods demanded by consumers

Examine the effects of price changes in terms of substitution and income effects

This Week’s Learning Outcomes

Traditional theory assumes that consumers are rational, self-interested maximisers.

Consumers are assumed to choose combinations of goods and services (market baskets) that:

maximise their satisfaction (utility); & make full use of their budgets

For example, suppose I have $500 and I get to choose among 3 market baskets:

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Consumer Choice: Maximising Consumer Satisfaction

Basket Food Clothing Price of basket

A 100 units 100 units $1000

B 20 units 20 units $200

D 50 units 50 units $500

A is unaffordable

B is affordable but does not make full use of budget

The rational consumer chooses D over A & B.

D is affordable & makes full use of budget

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Consumer Choice: Maximising Consumer Satisfaction

Food (units)40 8020

Clothing(units)

20

30

40

0

U1

60

10

U3

U2

PLUS, D is on higher indifference curve than G or H

A

However, A is unaffordable (ABOVE budget line).

U1 gives the greatest satisfaction, followed by U2, and then U3

B is affordable but does not make full use of budget (BELOW budget line)

B

G

H

D

D, G & H are all affordable & make full use of budget (ON budget line)

Rational consumer chooses D

Question on Maximising Consumer Satisfaction

French fries4 11

Big Mac

4

7

11

0 7

The diagram brings together Grace’s budget line and indifference map. The two goods are Big Macs and orders of french fries. Which point maximizes Grace’s satisfaction?A. 11 orders of french friesB. 11 Big MacsC. 7 Big Macs & 4 orders of friesD. 4 Big Macs & 7 orders of fries E. None of the above

Easy question from a past year test which most students got right.

B

A

C

D

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Consumer Choice: Maximising Consumer Satisfaction

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• To fully understand the traditional theory, we need to delve more deeply into the meaning of MRS and the significance of the tangency point shown on the last diagram

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Consumer Choice:Maximising Consumer Satisfaction

Food (units)40 8020

Clothing(units)

20

30

40

0 60

10

U2

D

Consumer satisfaction is maximised at D, where the Slope of indifference curve = Slope of budget line

Recall MRS is represented by the slope of indifference curve

Recall RELATIVE PRICE is represented by the slope of budget line

Consumer satisfaction is maximised at D when:MRS = RELATIVE PRICE

Point of tangency

MRS (F for C) = PF/PC

MRS (C for F) = PC/PF

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Now for some more details on MRS Recall all market baskets on the same

indifference curve give the same level of utility Also recall that the slope of indifference curves

conveys information on the amount of value (utility) consumers get from the different goods

A utility function gives a numerical interpretation of these ideas If a person’s utility function is

U(F,C) = F + 2C 8 units of F & 3 units of C gives her utility of

U(F,C) = 8 + 2(3) = 14

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Marginal utility (MU) measures the additional (marginal) satisfaction obtained from consuming 1 additional unit of a good.

It is the key measure of the consumer’s valuation of different commodities

Consumer Choice & Marginal Utility

Food Clothing Utility = F+2C MU

2 3 2 + 2(3) = 8

2 4 2 + 2(4) = 10

2 5 2 + 2(5) = 1222

Using the example of U(F,C) = F + 2C

Another really important concept!

Consumer Choice & Marginal Utility

MUF/MUC = 5

If I derive 5 times as much utility from an extra unit of food as I do from an extra unit of clothing,

then I should be willing to give up 5 units of clothing to get an

additional unit of food.

MRS (F for C) = 5

Comparing the MU of two different goods gives us MRS

MUF/MUC = MRS (F for C)

Logic: The more utility I get from a good, The more I’m willing to give up to get

more of it

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Consumer Choice: 4 Formulas

Food (units)40 8020

Clothing(units)

20

30

40

0 60

10U2

D

Point of tangency

MRS (F for C) = PF/PC

ThereforeMUF/MUC = PF/PC

Consumer satisfaction is maximised at D, where

ThereforeMUF/PF = MUC /PC

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Consumer Choice: Understanding the Key Formula

MUF/PF = MUC /PC MUF/MUC = PF/PCor

This tells us the extra value the

consumer will get from spending $1

extra on food

This tells us the extra value the

consumer will get from spending $1 extra on clothing

When the ratios are equal (i.e. At the point of tangency) the consumer won’t

increase her utility by spending more on clothing and less on food or vice versa

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Consumer Choice: Understanding the Key Formula

Food (units)40 8020

Clothing(units)

20

30

40

0 60

10U2

D

MRS (F for C) ≠ PF/PC

ThereforeMUF/MUC ≠ PF/PC

Consumer satisfaction is NOT maximised at C, because

ThereforeMUF/PF ≠ MUC /PC

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Consumer Choice: Understanding the Key Formula

At point C the IC is flatter than the budget line, so

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orF F

C C

CF

F C

MU P

MU P

MUMU

P P

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Effects of Price Changes in MILK …on Consumer Choice

“Coles instigated a price war in January by slashing the price of its no-name milk to $1 a litre, forcing Woolworths, Aldi and Franklins to also reduce prices.…. The no-name milk now accounts for 51 per cent of all milk sales and 72 per cent of full-cream milk sold in the country's supermarkets, according to the group. That is up from 25 per cent in the late 1990s.”

Annabel Hepworth, Milk wars 'could cost suppliers $730m‘, The Australian March 04, 2011

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Consumer Choice: Understanding the Key Formula

MUF/PF <MUC /PC MUF/MUC < PF/PCor

This tells us the extra value the

consumer will get from spending $1

extra on food

This tells us the extra value the

consumer will get from spending $1 extra on clothing

When the ratios are NOT equal the consumer CAN

increase her utility by spending more on

clothing and less on food or vice versa.

Suppose at point C I’m getting 4 units of value for each $1 I’m spending on clothing and 1 unit of value from each $1 I’m spending on food.

If I spend $1 less on food and $1 more on

clothing my U will

increase by 3 ☺☺☺

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Effects of Price Changes …. on Consumer Choice

U3

D

U2

B

Assume: I = $50, PM = $2.50, $2, $1

Milk (cartons)

Othergoods (units)

A

U1

PM=$2.50

PM=$2

PM=$1

2. One utility-maximisation point per budget line.

1. PM decreases: Budget line rotates outwards along milk axis

3. Trace utility-maximising basket at each price of milk to get Price consumption curve (PCC)

Price Consumption Curve

This joins up the utility maximising points as one price changes while holding income and the other price constant.

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Effects of Price Changes …. on Individual Demand for Milk

Individual Demand Schedule for MILK

Price ($)

$2.50

$2

$1U3

D

U2

B

Milk(cartons)

Othergoods(units)

A

U1

PM=$2

PM=$1

4. Derive demand schedule for MILK using PCC

Quantity (units)

2

10

15

PM=$2.50

7

15

6

10

9

2

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Effects of Price Changes …. on Individual Demand for Milk

Individual Demand Curve

Milk (cartons)

Priceof MILK

$2.50A

2

B

10

$2

D

15

$1

Individual Demand Schedule for MILK

Price ($)Quantity (units)

$2.50 2

$2 10

$1 15

5. Draw demand curve for MILK using demand schedule

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Effects of Price Changes …. on Individual Demand for Milk

Increase in price = Movement up demand curve

Decrease in price = Movement down demand curve

Milk (cartons)

Priceof MILK

D

A

B

$2.50

2 10 15

$2

$1

Income Consumption Curve

This joins up the utility maximizing points as income changes, while holding all prices constant.

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Effects of Income Changes …. on Consumer Choice

Food (units)

Clothing(units)

A U1

DU3

I=$10 BU2

I=$20

I=$30

Assume: PC = $2, PF = $1, I = $10, $20, $30

1. Income increases: Budget line shifts outwards in a parallel manner2. One utility-maximisation point per budget line

3. Trace utility-maximising basket at each income level to get Income consumption curve (ICC)

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BU2

Effects of Income Changes …. on Individual Demand for Food

Individual Demand Schedule for FOOD

Price ($)

(fixed)

$1.00

$1.00

$1.00

Food (units)

Clothing(units)

A U1

DU3

I=$10

4

3

10

5

16

7

I=$20

I=$30

4.Derive demand schedule for FOOD Using ICC

Quantity (units)

4

10

16

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Effects of Income Changes …. on Individual Demand for Food

Food (units)

Priceof

food

$1.00

D1

4

A

D2

10

B

D3

5. Draw demand curve for FOOD using demand schedule

Individual Demand Schedule for FOOD

Price ($) (fixed)

Quantity (units)

$1.00 4

$1.00 10

$1.00 16

16

D

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Effects of Income Changes …. on Individual Demand for Food

Food (units)

Priceof

food

$1.00

4

D1

A

10

D2

B

16

D3

D

Increase in income = Shift to the right by demand curve

Decrease in income = Shift to the left by demand curve

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Consumer wants more steak as income increases: Steak is a normal good

Consumer also wants more designer clothes as income increases: Designer clothes are normal goods

Normal good: You buy more when your income increases.

Normal goods

Designer clothes(units)

Steak(units)

10

10

4

5

ICC

16

15

U1

U3

U2

A

C

B

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Inferior goodsBetween A & B: Both steak & hamburger are

normal goods. You buy more of both as your income increases.

Between B & C: Steak is still a normal good. Hamburgers become an

inferior good – consumer wants less hamburgers (106) as income increases.

ICC: upward-sloping between

A & B, backward-bending between B & C.

Hamburger(units)

Steak(units)

104

AU1

B

U25

9

15

U3

C

6

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Engel Curves

Steak (unitsper month)

30

10

Income($ per

month)

20

4 8 12 16

Engel curves slopeupward for

normal goods.

Engel curves relate the quantity of a good to INCOME.

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Engel Curves

Engel curves arebackward bending for inferior goods.

Inferior

Normal

Hamburger (unitsper month)

30

10

Income($ per

month)

20

4 8 12 16

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Income and Substitution Effects

A change in price can be broken down into 2 effects: Substitution Effect Income Effect

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Substitution Effect

Occurs because the RELATIVE PRICE of a good changes

Example: when the price of apples increases, apples become more expensive relative to pears

You buy fewer apples but more pears, that is, you SUBSTITUTE pears for apples to keep your UTILITY CONSTANT

Definition: The substitution effect is the change in a good’s consumption associated with a change in the __________________ of the good, with the level of ____________________.RELATIVE PRICE

UTILITY CONSTANT

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Finding the Substitution Effect

Following a price change, move the budget line back until it is just tangent to the original IC. The SUBSTITUTION EFFECT is the movement around the original IC.

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Substitution Effect When Price Falls: Graphical Representation

Food (units)

Clothing(units)

A

U1

Recall Substitution effect: Change in relative price; Utility constant

L1 L2

The substitution is F1E (move from A to D).

D

Change in relative price Change in slope of original budget line L1

Utility constant Stay at original indifference curve U1

Substitutioneffect

E

Price of food decreases: Budget line rotates outward from L1 to L2.

U2

B

F1

Total effectF2

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Income Effect

Occurs because consumers experience a change in REAL PURCHASING POWER when price changes

Example: when the price of apples increases, your overall ability to purchase goods decreases.

Definition: The income effect is the change in a good’s consumption brought about by a change in ___________________________.REAL PURCHASING POWER

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Finding the Income Effect

The Income effect is the movement between the ARTIFICIAL optimum used to find the Substitution effect, and the consumer’s new utility maximising position.

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Income Effect When Price Falls: Graphical Representation

Food (units)

Clothing(units)

A

U1

Recall Income effect: Change in overall real purchasing power

L1 L2

D

Change in real purchasing power Parallel shift from dotted red line to budget line L2

Substitutioneffect

E

U2

B

The income effect is EF2 (move from D to B).

Incomeeffect

TIP: The dotted red line must ALWAYS be PARALLEL to L2.

F1

Total effectF2

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Income Effect When Price Falls: Normal Good

Food (units)

Clothing(units)

A

U1L1 L2

D

Substitutioneffect

EF1

U2

B

Incomeeffect

F2

This graph shows that food is a NORMAL good.

Recall: A normal good is a good you buy MORE of as your income increases.

Consumer moves from D to B, so the units of food INCREASE from E to F2

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Income Effect When Price Falls: Inferior Good

Food (units)

Clothing(units)

A

U1L1 L2

D

Substitutioneffect

EF1

U2

B

F2

Incomeeffect

This graph shows that food is an INFERIOR good.

Recall: An inferior good is a good you buy LESS of as your income increases.

Consumer moves from D to B, so the units of food DECREASE from E to F2

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Income Effect When Price Falls: Giffen Good

Food (units)

Clothing(units)

A

U1L1 L2

D

Substitutioneffect

EF1

U2

B

F2

Incomeeffect

This graph shows that food is a GIFFEN good.

A Giffen good is a special case of an inferior good.

The income effect is so large that it is greater than the substitution effect.

Summary of Price Falls

1. Normal Good

Income effect reinforces Substitution effect.

2. Inferior Good, Not Giffen

Income effect offsets Substitution effect but does not dominate.

3. Inferior Good, Giffen

Income effect offsets Subsitution effect and dominates.

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Substitution & Income Effects When Price Rises

Food (units)

Clothing (units)

L1

U1

A

When the price of food rises, the budget line rotates inward from L1 to L2.

L2

F1E

The substitution effect is F1E (move from A to D).

U2

B

F2

The income effect is EF2 (move from D to B).

D

Incomeeffect

Substitutioneffect

Note we are assuming that food is a NORMAL good here. Why?

The income effect is going in the same direction as the substitution effect.

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Income Effect: Normal, Inferior and Giffen Goods

Substitutioneffect

Incomeeffect

When price decreases When price increases

Normal

Inferior

Substitutioneffect

Giffen

Substitutioneffect

Incomeeffect

Incomeeffect

Total effect

Total effect

Total effect

Substitutioneffect

Incomeeffect

Substitutioneffect

Substitutioneffect

Incomeeffect

Incomeeffect

Total effect

Total effect

Total effect

Question on Substitution & Income Effects

Assume that beer is an inferior good. If the price of beer falls, then the substitution effect results in the person buying ______ of the good and the income effect results in the person buying ________ of the good.A. more, moreB. less, lessC. less, moreD. more, less

Substitution effect: Price - buy more

Income effect: Inferior good – so the income effect must work in the opposite direction from the substitution effect - buy less

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Question on Substitution & Income EffectsYou have just won a cash award of $500 for academic excellence.A. The substitution effect of this award will be larger than its income effect.B. The income effect of this award will be larger than its substitution effect.C. The substitution and income effects will be of identical size.D. It is impossible to know whether the substitution effect is larger than the income effect or vice versa.

Almost everyone got this one wrong in a past year test!

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Assignment Tip: A cash award OR CASH BONUS is like giving ‘income’ to someone.

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The Australian government is proposing to tax carbon which will increase electricity prices

Substitution & Income Effects: Policy Application (Carbon Tax)

ElectricityO

All other goods

L1

U1

A

L2

F1E

Substitution effect is F1E (move from A to D).

U2

B

F2

The income effect is EF2 (move from D to B, implying that electricity is a NORMAL good).

D

Substitution effect

Income effect

NB the income effect also causes the demand for all other goods to fall

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Substitution & Income Effects: Policy Application (Carbon Tax)

ElectricityO

All other goods

L1

U1

A

U2F2

However, the government is also planning to compensate low income families by reduced their income tax.

L2

B

F1E

When the government reduces income tax, it is giving cash back to taxpayers.

DIf it fully compensates for the effects of tax this will cancel out the income effect resulting in budget line L3.

L3

Income effect

Substitution effect

NB the tax will still affect the use of electricity, due to the substitution effects

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Learning Outcomes

Understand how consumers maximise satisfaction Graphical representation and formula

Trace the effects of price changes from consumer choice to the demand curve Price consumption curve

Trace the effects of income changes from consumer choice to the demand curve Income consumption curve

Gain an understanding of different types of goods demanded by consumers Normal goods, inferior & Giffen goods Engel curve

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Learning Outcomes

Examine the effects of price changes in terms of substitution and income effects Substitution effects Income effects

Tip: Learn to draw the diagrams accurately! Practice … p

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