Given a resource we see how we can use the resource. Resource could be time. How could one use time- Entertainment/ WorkWithin work- Amount of time spent on Economics/ FinanceEach commodity is measured in different way. To be consistent we use the number of units of the commodity as a measure
Each point in the space represents a combination of the two goods.
The two bundles- A and B can be either equally preferred (indifferent), A is more preferred than B, or visa versa. There is no comment on the cost or affordability of the two bundles. One may be preferred to the other but not affordable.There may be bads where more of some good leads to lower utilityBuying on impulse and ignoring other factors. They may not be able to rank all bundles.
Convexity implies that the slope of the curve decreases with increase in quantity. Which implies that slope of the IC decreases with increase in quantity. Which implies that there is a decrease in MRS with increase in quantity
The higher the slope, less willingness to substitute. Even if willingness to substitute is constant throughout.
Consumer Choice• Consumers decide on what to consume and how much• This decision can be translated into the demand of a product• How do consumers allocate income to the purchase of different goods?
Consumer TheoryTheory of consumer behavior The explanation of how consumers allocate income to the purchase of different goods and services
Aspects of Consumer Choice• Consumer Preferences: To describe how and why people prefer one good to another(Unlimited Wants)• Budget Constraints : Representation of Resource constraints (Limited Resources)• Consumer Choice : What combination of goods will consumers buy to maximize their satisfaction? Maximizing Preferences subject to Budget Constraint.• Consumer Choice is Individual demand at that price
Consumption• What does a typical purchase at a grocery store look like?• One purchases many goods.• How to rank preferences over different groups /bundles of products.
Bundles• Bundle/ Market Basket : Group of items and their quantity• Bundle may be different food products. Meat and Vegetables• Individuals can choose between market baskets containing different goods• Measure each good in terms of the units of commodity
Commodity SpaceY (units) B 10 3 A 2 10 X (Units)
Consumer Preferences• What can you say about your preference for the two bundles?• Can you make a generic assumption about the preferences of consumers?
Assumptions• Completeness: Any consumer can compare and rank any two given bundles• More is Better: More of any good is always better than less.• Transitivity: If a consumer prefer bundle A over B, Bundle B over C. Then it must prefer bundle A over C.
Indifference CurveA curve that represents all bundles that give the individual the same level of satisfaction.Given our assumptions of preferences, how does the indifference curve look like?
Indifference Curves: An ExampleMarket Basket Units of Food Units of Clothing A 20 30 B 10 50 D 40 20 E 30 40 G 10 20 H 10 40 12
Indifference Curves: An ExampleClothin 50 B The consumer prefers A to all combinations g in the yellow box, while 40 all those in the pink H E box are preferred to A. 30 A 20 D G 10 Food 10 20 30 40 13 .
Indifference Curves: An Example• Points such as B & D have more of one good but less of another compared to A – Need more information about consumer ranking• Consumer may decide they are indifferent between B, A and D – We can then connect those points with an indifference curve 14
Indifference Curves: An Example •Indifferent 50 B between pointsClothin B, A, & D g H •E is preferred 40 E to points on U1 •Points on U1 A are preferred to 30 H&G D 20 G U1 10 Food 10 20 30 40 15
Indifference Curves• Any market basket lying northeast of an indifference curve is preferred to any market basket that lies on the indifference curve• Points on the curve are preferred to points southwest of the curve 16
Properties of ICs1. Slope downward to the right – If they sloped upward, they would violate the assumption that more is preferred to less • Some points that had more of both goods would be indifferent to a basket with less of both goods 17
Indifference Maps• An indifference curve only represents limited preferences• It represents bundles that give same utility for “some” bundles.• How to represent preferences over other bundles.
Indifference Maps• To describe preferences for all combinations of goods/services, we have a set of indifference curves – an indifference map • Each indifference curve in the map shows the market baskets among which the person is indifferent • An indifference Map will have thousand of such curves. Representing an indifference curve for each point 19
Indifference MapClothing Market basket A is preferred to B. Market basket B is D preferred to D. B A U3 U2 U1 Food 20
Properties of Indifference Curve1. Downward Sloping: More is better2. Never Crosses:
Indifference Maps U1 U •B is preferred to DClothing 2 •A is indifferent to B & D •B must be indifferent to D but that can’t be if B is preferred to D A B U2 D U1 Food 22
Indifference Curve• How does the indifference curve of two goods that are perfect substitute look like?• How does the indifference curve of two goods that are perfect compliment look like?
Perfect SubstitutesY (units) IC3 IC2 A IC1 B X (Units)
Perfect ComplimentsY (units) IC2 IC1 A X (Units)
Consumer Preferences• The theory of consumer behavior does not require assigning a numerical value to the level of satisfaction• Although ranking of market baskets is good, sometimes numerical value is useful 26
Utility– A numerical score representing the satisfaction that a consumer gets from a given market basket– If buying 3 copies of Microeconomics makes you happier than buying one shirt, then we say that the books give you more utility than the shirt 27
Utility Function– Formula that assigns a level of utility to individual market baskets– If the utility function is U(F,C) = F + 2C A market basket with 8 units of food and 3 units of clothing gives a utility of 18 = 8 + 2(5) 28
Utility• Although we numerically rank baskets , numbers are ONLY for ranking• There are two types of rankings – Ordinal ranking – Cardinal ranking 30
Utility• Ordinal Utility Function – Places market baskets in the order of most preferred to least preferred, but it does not indicate how much one market basket is preferred to another• Cardinal Utility Function – Utility function describing the extent to which one market basket is preferred to another 31
Utility• The actual unit of measurement for utility is not important• An ordinal ranking is sufficient to explain how most individual decisions are made 32
Utility - Example• Baskets for each level of utility can be plotted to get an indifference curve – To find the indifference curve for a utility of 14, we can change the combinations of food and clothing that give us a utility of 14 33
Utility -Example• Can you find out points on the indifference curve which represents utility function, U=FC and gives utility 25?
Utility - ExampleClothing Basket U = FC C 25 = 2.5(10) 15 A 25 = 5(5) B 25 = 10(2.5) C 10 A U3 = 100 5 B U2 = 50 U1 = 25 Food 0 5 10 15 35
Marginal Utility• Volunteer who is hungry• Rate your level of satisfaction for every unit of candy that you consume• How does your happiness level change with every unit of candy?• How does your change in happiness change with every unit of candy?
Marginal UtilityUnits Total Utility Change in Utility
Marginal Utility• Marginal Utility : Change in total happiness or utility with a unit change in consumption• Marginal Utility is for one good, keeping all other things constant• What can you say about the sign of MU with an increase in consumption?
Marginal Utility• As consumption increases, Total Utility always increases, from our assumption More is Better.• Thus, MUX >0
Law of Diminishing Marginal UtilityLaw of Diminishing Marginal Utility : With an increase in consumption of a good, Marginal Utility from consuming one more unit of that product, decreases.• An assumption on preferences of consumers.• Which goods do not follow Law of DMU?
Indifference Curves AClothing 16 14 Observation: The amount -6 of clothing given up for 12 1 unit of food decreases from 6 to 1 10 B 1 8 -4 D 6 1 -2 E 4 G 1 -1 1 2 Food 1 2 3 4 5 41
Indifference Curves• The shapes of indifference curves describe how a consumer is willing to substitute one good for another – A to B, give up 6 clothing to get 1 food – D to E, give up 2 clothing to get 1 food• The more clothing and less food a person has, the more clothing they will give up to get more food 42
Indifference Curves• Marginal rate of substitution (MRS): – It quantifies the amount of one good a consumer will give up to obtain more of another good – It is measured by the slope of the indifference curve 43
Marginal Rate of SubstitutionClothing 16 A MRS = 6 MRS C 14 F 12 -6 10 B 1 8 -4 MRS = 2 D 6 1 -2 E 4 G 1 -1 2 1 Food 1 2 3 4 5 44
Indifference Curve• How does utility change when you move along the IC? U ( X ,Y )• When one moves along the IC curve: U 0 MU X X MUY Y 0 Y MU X ( ) X MUY
Indifference CurvesMarginal rate of substitution (MRS): Y MU X ( ) MRS XY X MU Y 46
Marginal Rate of SubstitutionClothing 16 A MRS = 6 MRS C 14 F 12 -6 10 B 1 8 -4 MRS = 2 D 6 1 -2 E 4 G 1 -1 2 1 Food 1 2 3 4 5 47
Marginal Rate of Substitution• Compare the MRS at point B and D B Y MU B X B ( ) B MRS XY X MU Y D Y MU D X ( ) D MRS D XY X MU Y
Marginal Rate of Substitution MU B X MU D X B D MU Y MU Y B D MRS XY MRS XY
Properties of Indifference Curve1. Downward Sloping: More is better2. Never Crosses:3. Indifference Curves are ConvexAs more of one good is consumed, a consumer would prefer to give up fewer units of a second good to get additional units of the first one
Law of Diminishing Marginal Rate of Substitution• The MRS decreases as we move down the indifference curve – Along an indifference curve there is a diminishing marginal rate of substitution. – The MRS went from 6 to 4 to 1 51
Polar Cases• Indifference curves with different shapes imply a different willingness to substitute• Two polar cases are of interest – Perfect substitutes – Perfect complements 52
Consumer Preferences Apple 4 Juice(glasses) Perfect 3 Substitutes 2 1 Orange Juice 0 1 2 3 4 (glasses) 53
Marginal Rate of Substitution• Perfect Substitutes – Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant – Example: a person might consider apple juice and orange juice perfect substitutes • They would always trade 1 glass of OJ for 1 glass of Apple Juice 54
Consumer Preferences• Perfect Complements – Two goods are perfect complements when the indifference curves for the goods are shaped as right angles – Example: If you have 1 left shoe and 1 right shoe, you are indifferent between having more left shoes only • Must have one right for one left 56
Bads• We have assumed all our commodities are “goods”• There are commodities we don’t want more of - bads – Things for which less is preferred to more• Examples – Air pollution – Asbestos 57
Budget Constraints• Preferences do not explain all of consumer behavior• Budget constraints also limit an individual’s ability to consume in light of the prices they must pay for various goods and services 59
Budget Constraints• The Budget Line – Indicates all combinations of two commodities for which total money spent equals total income – We assume only 2 goods are consumed, so we do not consider savings 60
The Budget Line• Let F equal the amount of food purchased, and C is the amount of clothing• Price of food = PF and price of clothing = PC• Then PFF is the amount of money spent on food, and PCC is the amount of money spent on clothing 61
The Budget Line• The budget line then can be written: PF F PC C IAll income is allocated to food (F) and/or clothing(C) 62
The Budget Line• Different choices of food and clothing can be calculated that use all income – These choices can be graphed as the budget line• Example: – Assume income of $80/week, PF = $1 and PC = $2 63
Budget ConstraintsMarket Food Clothing IncomeBasket PF = $1 PC = $2 I = PFF + PCC A 0 40 $80 B 20 30 $80 D 40 20 $80 E 60 10 $80 G 80 0 $80 Chapter 3
The Budget LineClothing A(I/PC) = 40 C 1 PF Slope - - B F 2 PC 30 10 D 20 20 E 10 G Food 0 20 40 60 80 = (I/PF) 65
The Budget Line• As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other• The slope of the line measures the relative cost of food and clothing 66
The Budget Line• What does the Y axis of the budget line represent?• What does the X axis of the budget line represent?
Budget Constraints• The Budget Line – The vertical intercept, I/PC, illustrates the maximum amount of C that can be purchased with income I – The horizontal intercept, I/PF, illustrates the maximum amount of F that can be purchased with income I 68
The Budget Line• As we know, income and prices can change• As incomes and prices change, there are changes in budget lines• How does budget line change with a change in Income? 69
The Budget Line - Changes Clothing (unitsper week) An increase in income shifts 80 the budget line outward 60 A decrease in 40 income shifts the budget line inward 20 L3 (I = L1 L2 $40) (I = $80) (I = $160) Food 0 40 80 120 160 (units per week) 70
The Budget Line - Changes• The Effects of Changes in Income – An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant). – Can buy more of both goods with more income 71
The Budget Line - Changes• The Effects of Changes in Income – A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant) – Can buy less of both goods with less income 72
The Budget Line• As we know, income and prices can change• As incomes and prices change, there are changes in budget lines• How does budget line change with a change in Price? 73
The Budget Line - Changes• The Effects of Changes in Prices – If the price of one good increases, the budget line shifts inward, pivoting from the other good’s intercept. – If the price of food increases and you buy only food (x-intercept), then you can’t buy as much food. The x-intercept shifts in. – If you buy only clothing (y-intercept), you can buy the same amount. No change in y-intercept. 74
The Budget Line - Changes• The Effects of Changes in Prices – If the price of one good decreases, the budget line shifts outward, pivoting from the other good’s intercept. – If the price of food decreases and you buy only food (x-intercept), then you can buy more food. The x-intercept shifts out. – If you buy only clothing (y-intercept), you can buy the same amount. No change in y-intercept. 75
The Budget Line - Changes Clothing (units A decrease in theper week) price of food to Rs.50 changes the slope of the budget line and rotates it outward. An increase in the 40 price of food to Rs2.00 changes the slope of the budget line and rotates it inward. L3 L1 L2 (PF = 1) (PF = 1/2) (PF = 2) Food 40 80 120 160 (units per week) 76
The Budget Line - Changes• The Effects of Changes in Prices – If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change – However, the budget line will shift inward parallel to the original budget line 77
The Budget Line - Changes• The Effects of Changes in Prices – If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change – However, the budget line will shift outward parallel to the original budget line 78