indifference curves

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INDIFFERENCE CURVES AND UTILITY INDIFFERENCE CURVES AND UTILITY MAXIMIZATION MAXIMIZATION Indifference curve Indifference curve – A curve that shows – A curve that shows combinations of goods which gives combinations of goods which gives the same level of satisfaction to the same level of satisfaction to the consumers so that an the consumers so that an individual is indifferent. individual is indifferent.

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Page 1: Indifference curves

INDIFFERENCE CURVES AND UTILITY INDIFFERENCE CURVES AND UTILITY MAXIMIZATIONMAXIMIZATION

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

Page 2: Indifference curves

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0 2 4 6 8 10 12 14 16 18 20 22

aP

ear

s

Oranges

Pears

3024201410

86

Oranges

678

10131520

Point

abcdefg

Constructing an indifference curveConstructing an indifference curve

Page 3: Indifference curves

AssumptionAssumption

• More of a commodity is better than lessMore of a commodity is better than less

• Preference of a consumer are transitivePreference of a consumer are transitive

• Diminishing marginal rate of substitutionDiminishing marginal rate of substitution

Page 4: Indifference curves

More of a commodity is better than lessMore of a commodity is better than less

Page 5: Indifference curves

Preference of a consumer are transitivePreference of a consumer are transitive

Page 6: Indifference curves
Page 7: Indifference curves

Marginal rate of substitutionMarginal rate of substitution

• Marginal rate of substitutionMarginal rate of substitution – The rate at – The rate at which consumer is prepared to exchange which consumer is prepared to exchange goods X and Y is known as MRS ie the rate goods X and Y is known as MRS ie the rate at which one good must be added when the at which one good must be added when the other is taken away in order to keep the other is taken away in order to keep the individual indifferent between the two individual indifferent between the two combinations without changing total combinations without changing total satisfaction .satisfaction .

Page 8: Indifference curves

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Deriving the marginal rate of substitution (Deriving the marginal rate of substitution (MRSMRS))a

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its o

f goo

d Y

Units of good X

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6 7

Page 9: Indifference curves

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a

b

Un

its o

f goo

d Y

Units of good X

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6 7

Y = 4

X = 1

MRS = 4

Deriving the marginal rate of substitution (Deriving the marginal rate of substitution (MRSMRS))

Page 10: Indifference curves

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0 10 20

a

b

Un

its o

f goo

d Y

Units of good X

26

6 7

cd

Y = 4

X = 1

Y = 1

X = 1

MRS = 1

MRS = 4

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Deriving the marginal rate of substitution (Deriving the marginal rate of substitution (MRSMRS))

Page 11: Indifference curves

Indifference scheduleIndifference schedule

• Indifference scheduleIndifference 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

Page 12: Indifference curves

Marginal Rate of SubstitutionMarginal Rate of Substitution

• MRS declines as we move downward to the MRS declines as we move downward to the right along an indifference curve.right along an indifference curve.

• Indifference curves with diminishing MRS Indifference curves with diminishing MRS are thus convex.are thus convex.

• Convexity illustrates that people like Convexity illustrates that people like variety.variety.

Page 13: Indifference curves

Law of diminishing marginal rate of substitutionLaw of diminishing marginal rate of substitution

• Law of diminishing marginal rate of substitutionLaw of diminishing marginal rate of substitution – As you get more and more of a good X , – As you get more and more of a good X , one is prepared to forego less and less of one is prepared to forego less and less of Y, that is MRS of X for Y diminishes as Y, that is MRS of X for Y diminishes as more and more of good X is substituted for more and more of good X is substituted for good Y.good Y.

Page 14: Indifference curves

DMRSDMRS

Page 15: Indifference curves

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Units of good X

I1

I2

I3

I4

I5

An indifference mapAn indifference map

Page 16: Indifference curves

Properties of Indifference CurveProperties of Indifference Curve

– Indifference curves are downward sloping to Indifference curves are downward sloping to the rightthe right

– Indifference curves are convex to the originIndifference curves are convex to the origin– Indifference curves cannot intersect each Indifference curves cannot intersect each

other other – A higher Indifference curves represents a A higher Indifference curves represents a

higher satisfactionhigher satisfaction

Page 17: Indifference curves

BUDGET LINEBUDGET LINE

• Budget line graphically shows the budget Budget line graphically shows the budget constraint.constraint.

• The combination of commodities lying to The combination of commodities lying to the right of the budget line are unattainable the right of the budget line are unattainable because the income of the consumer is because the income of the consumer is not sufficient to be able to buy those not sufficient to be able to buy those combinations.combinations.

• The combination of commodities lying to The combination of commodities lying to the left of the budget line are attainable the left of the budget line are attainable because the income of the consumer is because the income of the consumer is sufficient to be able to buy those sufficient to be able to buy those combinationscombinations

Page 18: Indifference curves

What is a Budget Constraint?What is a Budget Constraint?

• A budget constraint shows the A budget constraint shows the consumer’s purchase opportunities consumer’s purchase opportunities as every combination of two goods as every combination of two goods that can be bought at given prices that can be bought at given prices using a given amount of income.using a given amount of income.

• The budget constraint measures the The budget constraint measures the combinations of purchases that a combinations of purchases that a person can afford to make with a person can afford to make with a given amount of monetary income.given amount of monetary income.

Page 19: Indifference curves

Un

its o

f goo

d Y

Units of good X

a

b

Units ofgood X

0 51015

Units ofgood Y

302010 0

Point onbudget line

ab

Assumptions

PX = £2PY = £1

Budget = £30

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0 5 10 15 20

A budget lineA budget line

Page 20: Indifference curves

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0 5 10 15 20

Un

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d Y

Units of good X

Assumptions

PX = £2PY = £1

Budget = £40

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Budget = £40

Budget = £30

Effect of an increase in income on the budget lineEffect of an increase in income on the budget line

Page 21: Indifference curves

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Effect on the budget line of a fall in the price of good XEffect on the budget line of a fall in the price of good XU

nits

of g

ood

Y

Units of good X

Assumptions

PX = £1PY = £1

Budget = £30

B1B2

a

b c

Page 22: Indifference curves

The Best Feasible BundleThe Best Feasible Bundle

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

• Consumer’s strategy is to keep moving to Consumer’s strategy is to keep moving to higher and higher indifference curves until higher and higher indifference curves until he reaches the highest one that is still he reaches the highest one that is still affordable.affordable.

Page 23: Indifference curves

How to Find the Best CombinationHow to Find the Best Combination

• Utility is maximized when:Utility is maximized when:

– the indifference curve is just the indifference curve is just tangent to the budget line. tangent to the budget line.

Page 24: Indifference curves

Consumer EquilibriumConsumer Equilibrium

Page 25: Indifference curves

The Best Affordable BundleThe Best Affordable Bundle

Page 26: Indifference curves

I1

I2

I3

I4

I5

Un

its o

f goo

d Y

O

Units of good X

Budget line

Finding the optimum consumptionFinding the optimum consumption

Page 27: Indifference curves

I1

I2

I3

I4

I5

Un

its o

f goo

d Y

O

Units of good X

r

s

tY1

X1

v

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indifference curve and budget lineindifference curve and budget line

Page 28: Indifference curves

Un

its o

f goo

d Y

O

Units of good X

B1

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

I1

Page 29: Indifference curves

I2

Un

its o

f goo

d Y

O

Units of good X

B1 B2 I1

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

Page 30: Indifference curves

I2

Un

its o

f goo

d Y

O

Units of good X

B1 B2 B3 B4 I1

I3

I4

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

Page 31: Indifference curves

I2

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f goo

d Y

O

Units of good X

B1 B2 B3 B4 I1

I3

I4

Income–consumption curve

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

Page 32: Indifference curves

Utility MaximizationUtility Maximization