Economics 111.3 Winter 14
February 28th, 2014
Lecture 17
Ch. 9
Ordinal Utility:
Indifference Curve Analysis
MRS
• MRS stands for Marginal Rate of
Substitution
Combining Indifference Curves and
Budget Line: Equilibrium at Tangency
• The goal for a
consumer is to get as
high on an
indifference curve as
possible, given her
income constraint.
Which one of the following
statements about
Figure 9.3.2 is true?
Which one of the following
statements about
Figure 9.3.2 is true?
Consumer’s Equilibrium: a recap
• The utility-maximizing rule: a consumer
with a fixed income and facing given
market prices of goods will achieve
maximum satisfaction (utility) when the
marginal utility of the last dollar spent on
each good is exactly the same as the
marginal utility of the last dollar spent on
any other good.
In Equilibrium, at point X, MRS = -PB/PA
If we move along I3,
-A/B =MRS=MUB/MUA
Memo:
UA/ A =MUA
UB/ B =MUB
Thus,
UA=A*MUA
UB=B*MUB
UA + UB = 0
𝑴𝑼𝒙
𝑴𝑹𝑺 =
𝑴𝑼𝒚
In Equilibrium, at point X, MRS = -PB/PA
𝑴𝑹𝑺 =
Y
𝑰𝒏 𝒆𝒒𝒖𝒊𝒍𝒊𝒃𝒓𝒊𝒖𝒎, 𝑴𝑹𝑺 =
X
𝑴𝑼𝒙
𝑴𝑼𝒚
𝑴𝑼𝒙 𝑷𝒙
=
𝑴𝑼𝒚 𝑷𝒚
Study Question
• A consumer decides not to buy a VCR when
her income is $20,000. However, when her
income rises to $30,000, she decides to buy
one. In a single diagram, draw the budget
lines and indifference curves to illustrate this
situation (assume the VCR costs $300 in both
time periods). Be sure to label your diagram
completely.
Derivation of the Demand Curve, Income: $12
12
10
Quantity of A
What happens if
the price of B
increases to
$1.50?
8
X
6
I4
4
2
0
2
4
6
8
Quantity of B
10
12
Derivation of the Demand Curve
12
10
Quantity of A
New budget
line reflects
the price
change
8
X
6
I4
4
PB=$1.50
2
0
2
4
6
8
Quantity of B
10
12
Derivation of the Demand Curve
12
10
Quantity of A
New budget line
reflects the price
change
PB=$1.00
8
X
6
I4
4
PB=$1.50
2
0
2
4
6
8
Quantity of B
10
12
Derivation of the Demand Curve
12
10
Quantity of A
New equilibrium
point is X'
PB=$1.00
8
X'
6
X
I4
4
PB=$1.50
2
0
2
4
6
8
Quantity of B
10
12
Derivation of the Demand Curve
12
10
Quantity of A
A consumer’s demand
curve can be viewed as a
summary of the optimal
decisions that arise from
his or her budget
constraint and
indifference curves.
8
X'
6
X
I4
4
2
0
2
4
6
8
Quantity of B
10
12
Quantity of A
12
10
8
6
4
2
X'
PB
QB
$1.00
6
$1.50
3
Price of B
2
X
4
6
I4
8
10 12
Quantity of B
$1.50
$1.00
$0.50
DB
2
4
6
8
10 12
Quantity of B
The Effect of Price Change
The Effect of Price Change
•
A fall in the price of a good has
two effects:
1. Consumers will tend to buy
more of the good that has
become cheaper and less of
those goods that are now
relatively more expensive.
2. Because one of the goods is
now cheaper, consumers
enjoy an increase in real
purchasing power.
INCOME AND SUBSTITUTION EFFECTS
• Substitution effect
Change in consumption
of a good associated with
a change in its price, with
the level of utility held
constant.
• Income effect
• Change in consumption
of a good resulting from
an increase in purchasing
power, with relative
prices held constant.
The Substitution Effect of Price
Change
– The substitution effect is
the effect of a change in
price on the quantity
bought when the
consumer remains on the
same indifferent curve.
– When the relative price
falls, the consumer always
substitutes more of that
good for other goods.
– The substitution effect is
the first reason why the
demand curve slopes
downward.
The total effect of a change in price is given theoretically
by the sum of the substitution effect and the income effect