1 indifference curve and consumer choice. 2 overview illustrated using example of choices on movies...
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Indifference Curve and Consumer Choice
Indifference Curve and Consumer Choice
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OverviewOverview
Illustrated using example of choices on movies and concerts
Assumptions of preference– ______________________– ______________________– ______________________
Indifference curve Consumer choice
– maximize utility with constraint of budget
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Assumption 3: More is better
No. of movies per month
No. of concerts per month
A
D?
E?C?
B?
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Assumption 3: Nonsatiation-- More is
better
No. of movies per month
No. of concerts per month
A
more preferred
less preferred
?
?C
B
B preferred to A
A preferred to C
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Assumption 1: Can rank any two bundles
No. of movies per month
No. of concerts per month
A
B
C
‘More is better’ means that as we go northeast from C to B, utility increases
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Indifference Curve:All Combinations of two Goods that yield the same level of utility (Make the consumers equally well off.)
No. of movies per Month
No. of concerts per month
A
B
C
D
E
U0
After giving you an additional concert, how many movies could we take away from you and leave you no better or worse off than D?
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Two things about the Indifference curveTwo things about the Indifference curve
First, it slopes _____. This follows the assumption about preferences _________.
Second, notice the curvature about the indifference curve. As we move downward and rightward along it, the curve becomes _________. Why?
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Diminishing Marginal Utility:As No. of concert increases, takes away decreasing amounts of movies to leave utility unchanged
No. of movies per month
No. of concerts per month
U0
ΔM1
ΔM2
ΔM3
Along an indifference curve,
As No. of movies decreases and No. of concerts increases, Marginal utility from an additional movie ____ and Marginal utility from an additional concert _______.
ΔC ΔC ΔC
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Marginal Rate of Substitution– the absolute value of the slope of the indifference curve.
No. of movies per month
No. of concerts per month
U0
ΔM1
ΔM2
ΔM3
ΔC ΔC ΔC
What does the slope (without the minus sign) of indifference Curve mean?The maximum amount of movie Max would willingly trade for one more concert.
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Marginal Rate of Substitution
No. of movies per month
No. of concerts per month
U0
ΔM1
ΔM2
ΔM3
ΔC ΔC ΔC
Along the indifference curve,the slope _______in absolute value;the MRS _______ when No. of movies decreases and No. of concert increases.
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Indifference Map -Ranking Indifference Curves
No. of movies per month
No. of concerts per month
A
B
CU0
U1
U-1
Any point on a higher indifference curve is preferred to any point on a lower one.
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Budget Set: All combinations of goods that lie on or inside the budget line
No. of movies per month
No. of concerts per month
15
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Not affordable
affordable
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Combine budget line with indifference curve
No. of movies per month
No. of concerts per month
15
5
U0U1
U2
A
BC
The optimal combination of Goods for a consumer is thePoint on the budget line wherean indifference curve is tangentto the budget line.
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Combine budget line with indifference curve
No. of movies per month
No. of concerts per month
15
5
U0U1
U2
A
BC
The absolute value of the slope of the budget line=__________The absolute value of the slope of the indifference curve =______The optimal decision-making rule is _________________
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Changes in income
No. of movies per month
No. of concerts per month
15
5
U0U1
U2
A
BC
A rise in income, with no change in prices, leads to a new quantity demanded for each good. Whether a particular good is normal (quantity demanded increases) or inferior (quantity demanded decreases) depends on the individual’s __________, as represented by his ____________.
10
30
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Changes in Price
No. of movies per month
No. of concerts per month
15
5
U0U1
U2
A
BC
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The drop in the price of concert rotates Max’s budget line ______. Based on his difference curves, he will choose___. What if we droppedthe price of concert again?How can we derive Max’s individual demandcurve for concert?
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Income and Substitution EffectsIncome and Substitution Effects
Demand curve actually summarizes impact of two separate effects of price change on quantity demanded
Substitution effects– As the price of concert falls, its relative price
( relative to movies) _____.– Max substitutes concerts in place of movies whose
prices have not changed.– It always moves quantity demanded in the opposite
direction to the price changeWhen price decreases (increases), substitution
effect works to _______ (_______) quantity demanded.
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The Income EffectThe Income Effect
When the price of concert drops, Max’s budget line rotates rightward. The price decline of concert ____ his total purchasing power over both goods.
Income effect can work to either increase or decrease the quantity of a good demanded, depending on whether the good is normal or inferior.
If concert is a normal good, the income effect of a price cut will lead Max to consume _____ of them.
If concert is an inferior good, the income effect of a price cut will lead Max to consume _______ of them.
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Figure 7: Combining Income and Substitution EffectsFigure 7: Combining Income and Substitution EffectsPrice Decrease:
P
Purchasing Power
QD
QD
QD
if normalif inferior
Substitution Effect
UltimateEffect
(Almost Always)
QD
Price Increase:
P QD
QD
QD
if normal
if inferior
Substitution Effect
QDPurchasing
Power