INDIFFERENCE CURVES
Reveals consumer preferences
= illustrates the different
combinations of 2 goods that yields
equal satisfaction to a consumer,
ie utility is fixed along this line
Slope: represents the extent to (or
rate at) which consumer is happy to
substitute one good for another
- The steeper the slope, the more
willing the consumer is to give up
units of good A for units of good B.
= marginal rate of substitution
= negative of the ratio of the
marginal utility of X over the
marginal utility of Y.
Slope = -
𝑀𝑈𝑥
𝑀𝑈𝑦
INDIFFERENCE CURVES
Reveals consumer preferences
EFFECT OF A CHANGE IN INCOME
For an increase in income: indifference curve shifts upward
For a decrease in income: indifference curve shifts down
COMBINE THE BUDGET LINE & INDIFFERENCE
CURVE TO FIND THE CONSUMER EQUILIBRIUM:
EFFECT OF A CHANGE IN INCOME
Initially, I1 and B1  consumer equilibrium
at E1 (where B1 and I1 are tangent to one
another)
Income increases, BL shifts from B1 to B2.
This also causes the IC to shift up from I1 to
I2.
Final effect: consumer equilibrium at E2
where all budget is spent and the highest
possible satisfaction is yielded
What would it look like for an inferior
good?
INCOME AND SUBSTITUTION EFFECTS:
A CHANGE IN PRICE
These effects can be illustrated with indifference curves (IC) + budget lines (BL)
Substitution effect = movement along original indifference curve (shown by
shadow BL)
Income effect = movement from hypothetical to new budget line (shown by IC)
These effects can work in the same or in opposite directions.
Normal goods: https://www.youtube.com/watch?v=vQsDCo-xVZY
Inferior goods: https://www.youtube.com/watch?v=eSBiFdqaj8U
Giffen goods: https://www.youtube.com/watch?v=PkS-G40CtzQ
THE INCOME AND SUBSTITUTION EFFECTS OF A
PRICE CHANGE (CONT.)
Page 146 – 147: NORMAL GOODS
A price change will cause the budget line to pivot, but look closely at how to explain the income &
substitution effects.
Fall in the price:
- The price of product B has fallen, so ceteris paribus (income unchanged), consumers will substitute
B for A. = substitution effect
- The price change means consumers’ real income have increased (can purchase more units with
same amount of money), meaning more of product B can be purchased. = income effect
Rise in the price:
- The price of product B has increased, so ceteris paribus (income unchanged), consumers will
substitute A for B = substitution effect
- The price change means the consumers’ real income have decreased (can purchase less units with
the same amount of money), meaning less of product B will be purchased. (The price change has
reduced the purchasing power of the consumer).
THE INCOME AND SUBSTITUTION EFFECTS OF A
PRICE CHANGE (CONT.)
INFERIOR GOODS:
A price change will cause the budget line to pivot, but look closely at how to explain the income & substitution
effects. *A price change has an effect on the real income of the consumer.
Fall in the price:
- The price of product B has fallen, so ceteris paribus (income unchanged), consumers will substitute B for A. =
substitution effect
- The price change means consumers’ real income have increased (can purchase more units with same amount
of money), meaning less of product B is purchased due to its inferiority = income effect (IN OPPOSITE
DIRECTIONS)
Rise in the price:
- The price of product B has increased, so ceteris paribus (income unchanged), consumers will substitute A for B
= substitution effect
- The price change means the consumers’ real income have decreased (can purchase less units with the same
amount of money), meaning more of product B will be purchased due to its inferiority. (The price change has
reduced the purchasing power of the consumer, so he is forced to buy more of the inferior good).
GIFFEN GOODS (EXAMINABLE; NOT IN TEXTBOOK)
Definition: “A good with an upward sloping demand curve; i.e. as the price increases, the quantity
demand increases”
Explanation: a Giffen good is a highly inferior good, with few close substitutes
RISE IN PRICE:
When the price of a Giffen good increases, consumers will substitute away from the good towards
other relatively cheaper goods (substitution effect).
But the decrease in their real income will cause them to buy more of the inferior Giffen good (income
effect).
Giffen goods are so inferior that the income effect will outweigh the substitution effect, and the
net result of the price increase will be an increase in the quantity demanded.
Possible examples: Staples like rice or potatoes – when the price of these goods increases, people
can’t afford to switch consumption to meat/dairy products, but still need to eat – they therefore buy
more rice/potatoes.
PRACTICE QUESTION
BUDGET LINES – EXAMPLE
A gorilla consumes only apples and bananas. If apples cost R2 and bananas cost
R3, and the gorilla has a budget of R60, draw the gorilla’s budget line.
Put apples on the x axis.
 On this budget line, illustrate (A) a point that is attainable, but doesn’t use the entire
budget, (B) a point that uses the entire budget, and (C) a point that is outside of the
budget.
 What does this remind you of?
PAGES 145-147: QUESTIONS
What are the income and substitution effects?
When will the income effect be negative for a decrease in the price of
a good (i.e. an increase in real income)?
- normal goods
- inferior goods
- giffen goods
Self-assessment task 7.2
EXERCISE
As before, a gorilla consumes only apples and bananas. Apples cost R2 and
bananas cost R3, and the gorilla has a budget of R60. Put apples on the x axis.
 For each of the following, draw the original budget line (based on the above
information), as well as the new budget line after the price/income changes:
1.
2.
3.
4.
The price of apples rises to R3, and the price of bananas remains at R3
The price of bananas drops to R1 and the price of apples remains at R2
The price of both apples and bananas doubles (to R4 and R6, respectively)
The gorilla’s budget decreases to R45, but apples and bananas still cost R2 and R3,
respectively
5. The gorilla’s budget increases to R90, but apples and bananas still cost R2 and R3,
respectively
EXERCISE (CONT.)
Based on your previous answers, summarise what happens to the initial budget
line if:
A. The price of one good increases/decreases
B. The price of both goods increases/decreases by equal proportions (i.e.
relative prices remain the same)
C. Income increases/decreases
PRACTICE QUESTION: ESSAY
Nov 17 p43
BUDGET LINES – MATHS [NOT EXAMINABLE]
Budget constraint:
px qx  p y q y  Y
Where the two sides are equal, the entire budget is being spent, and we call this
the budget line.
px qx  p y q y  Y
 p y q y  Y  px qx
Y
py
Y px
 qy 
 qx
py py
Y / px