Economics 111.3 Winter 14
February 24th, 2014
Lecture 15
Ch. 8 and Ch. 9
The Budget Line : a recap
Good “A”
We use the following symbols:
PA = price of good A, PB = price of
good B, QA = quantity of good
A, QB = quantity of good B, y
(or M or I) = income.
The budget line can be written as:
PA QA + PB QB = y
or,
$4.00 QA + $8 QB = $40
We can choose any combination
of goods that satisfies this
equation.
Good “B”
The slope of Budget Line: a recap
The Budget Line
Price of A rises
10
Quantity of A
Price changes
cause
a change in the
quantity
demanded of the
items
12
8
6
4
2
0
2
4
6
8
Quantity of B
10
12
Income increases
10
Quantity of A
An increase in
income
makes the
purchase of
more of either or
both
items possible
12
8
6
4
2
0
2
4
6
8
Quantity of B
10
12
Study question
Consumer’s Choice:
Ordinal Utility:
Indifference Curve Analysis
Indifference Curves
An indifference curve represents all the combinations of the two goods amongst which
an individual is indifferent.
An indifference curve shows consumption bundles that give the consumer the same
level of satisfaction.
Marginal utility theory assumes utility is numerically measurable
Indifference curve approach requires only that a consumer specify if a particular
combination of products yields more or less utility than another
NB!
• more of a good is better than
less of it
• good: commodity for
which more is preferred to
less at least at some levels
of consumption
• bad: something for which
less is preferred to more,
such as pollution
• consumers are not satiated
Indifference Curves
Units of A
Units of B
12
j
12
2
10
k
6
4
l
4
6
m
3
8
Quantity of A
combination
j
8
k
l
6
m
4
2
0
I
2
4
6
8
Quantity of B
10
12
Study question
• Does this individual receive satisfaction from
consuming good B? Good A?
Good B
Good A
(a) Perfect Substitutes
Nickels
6
4
2
0
I1
1
I2
2
I3
3
Dimes
Copyright©2004 South-Western
Study question
• Molly loves hamburgers and soft drinks,
but insists on consuming exactly one soft
drink for every two hamburgers that she
eats.
• Draw an indifference curve that is
consistent with her preferences.
Study question
Draw a set of indifference curves for
the following pair of goods:
• Ice cream and pie if these are goods
that you like, but if you consume
enough of either, you get sick of them.
If you are sick of a good, consuming
more of it lowers your utility.
Study question
• Jocasta loves to dance and hates
housecleaning. She prefers dancing to any
other activity and never gets tired of
dancing, but the more time she spends
cleaning house, the less happy she is.
• Draw an indifference curve that is
consistent with her preferences.
Study question
In the field of financial management it has been
observed that there is a trade-off between the rate of
return that one earns on investments and the amount
of risk that one must bear to earn that return.
A. Draw a set of indifference curves between risk and
return for a person that is risk averse (a person that
does not like risk).
B. Draw a set of indifference curves for a person that is
risk neutral (a person that does not care about risk one
way or the other).
C. Draw a set of indifference curves for a person that likes
risk.
Properties of well-behaved
Indifferent Curves
•
•
•
•
•
Higher indifference curves
are preferred to lower ones.
Indifference curves do not
cross.
Indifference curves are
“thin”
Indifference curves are
bowed inward (convex to
the origin).
Indifference curves are
downward sloping.
The Impossibility of Intersecting Indifference Curves
Quantity
of Pepsi
C
A
B
0
Quantity
of Pizza
Copyright©2004 South-Western
Indifference Curves are “THIN”!
Thick
B, Burritos
per semester
b
a
I
Z, Pizzas per semester
Indifference curves are convex to the
origin
Well-behaved indifference
curves are downward sloping
• Overall, the slope of the
indifference curve is called
the marginal rate of
substitution (MRS)
• MRS is the amount of the
good on the vertical axis that
the consumer is willing to
give up to obtain one extra
unit of the good measured
on the horizontal axis.
Convex vs. Concave
Diminishing MRS: Rationale
• People are more willing
to trade away goods that
they have in abundance
and less willing to trade
away goods of which they
have little.
• These differences in a
consumer’s marginal
substitution rates cause
his or her indifference
curve to bow inward.
Combining Indifference
Curves and Budget Line
• The goal for a consumer is to
get as high on an indifference
curve as possible, given her
income constraint.
Equilibrium at Tangency
12
10
Quantity of A
Point X represents
the optimal
attainable
combination of
products A & B
8
X
6
I4
4
2
0
2
4
6
8
Quantity of B
10
12