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# Indifference curve | Microeconomics | Expertsmind.com

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### Indifference curve | Microeconomics | Expertsmind.com

1. 1. MICROECONOMICSwww.expertsmind.com 1
2. 2. Indifference Curves & Budget Lines Consumers’ budgets are modelled using budget lines Consumer preferences are modelled using indifference curves and indifference maps 2
3. 3. Indifference Map: GoodsClothing (units) Direction of increasing ___________ satisfaction E Indifference maps: A • Comprise a set of U2 indifference curves G U1 E is preferred to A. A is preferred to G. U0 Food (units) 3
4. 4. Recap Key Concepts from Week 1:Slope of Indifference CurveClothing (units) 16 A MRSF for C SLOPE OF 14 = - C/F INDIFFERENCE =6 CURVE 12 -6 10 B So MRS is 1 8 -4 MRSF for C represented by = - C/F D the absolute 6 =2 1 E value of slope of -2 4 G the indifference 1 -1 2 1 curve 1 2 3 4 5 Food (units) 4
5. 5. Effects of Price Changes A decrease in the price of food rotates the Clothing budget line outward. (units) An increase in the price of food rotates the budget line inward. L1 L2 L3 Food (units) 5
6. 6. Effects of Income Changes An increase in income is shown by aClothing (units) parallel outward shift in the budget line 80 A decrease in income is shown by a parallel inward shift in the budget line 60 40 20 L1 L2 Food 0 40 80 120 160 (units) 6
7. 7. Recap Key Concepts from Week 1:Slope of Budget Line Assume income of \$80/week, price per unit of food is \$1 and price per unit of clothing is \$2 o I = \$80 o PF = \$1 o PC = \$2 Budget line is PFF + PCC = I Using the formula 1F + 2C = 80 Slope = C/F or - PF/PC = -1/2 Ratio of Price of F to Price of C; OR Relative Price of F to C So Relative Price is represented by the slope of the budget line 7
8. 8. Recap Key Concepts from Week 1: Indifference Curves & Budget Lines Consumer preferences are modelled using indifference curves  MRS (F for C) = Absolute value of slope of indifference= -C/F Consumers’ budgets are modelled using budget lines  Relative Price of F to C = Slope of budget line = -PF/PC 8
9. 9. Recap Key Concepts from Week 1:Consumer Choice Theory Different consumers prefer different goods  Consumer preferences Consumers have limited incomes to spend  Budget constraint Consumers’ choices about consumption reflect both their preferences and their budget constraints Consumer choice 9
10. 10. This Week’s Learning Outcomes Understand the traditional theory’s explanation of how consumers make choices Trace the effects of price changes from consumer choice to the demand curve Trace the effects of income changes from consumer choice to the demand curve Gain an understanding of different types of goods demanded by consumers Examine the effects of price changes in terms of substitution and income effects 10
11. 11. Consumer Choice: Maximising Consumer Satisfaction  Traditional theory assumes that consumers are rational, self-interested maximisers.  Consumers are assumed to choose combinations of goods and services (market baskets) that:  maximise their satisfaction (utility); &  make full use of their budgets  For example, suppose I have \$500 and I get to choose among 3 market baskets: Basket Food Clothing Price of A is unaffordable basket B is affordable but does not make full A 100 units 100 units \$1000 use of budget B 20 units 20 units \$200 D is affordable & D 50 units 50 units \$500 makes full use of budgetThe rational consumer chooses D over A & B. 11
12. 12. Consumer Choice:Maximising Consumer Satisfaction U1 gives the greatest satisfaction, followed by U2,Clothing and then U3 (units) However, A is unaffordable (ABOVE budget line). B is affordable but does not make full 40 use of budget (BELOW budget line) G D, G & H are all affordable & make full use of budget (ON budget line) 30 A PLUS, D is on higher indifference curve than G or H 20 D B Rational consumer 10 U1 chooses D H U3 0 20 40 60 80 Food (units) 12
13. 13. Question on Maximising Consumer Satisfaction The diagram brings together Grace’sBig Mac budget line and indifference map. The two goods are Big Macs and orders of french fries. Which point maximizes11 B Grace’s satisfaction? A. 11 orders of french fries B. 11 Big Macs 7 D C. 7 Big Macs & 4 orders of fries D. 4 Big Macs & 7 orders of fries E. None of the above 4 C Easy question from a past A year test which most 0 4 7 11 students got right. 13 French fries
14. 14. Consumer Choice:Maximising Consumer Satisfaction•To fully understand the traditional theory, we need todelve more deeply into the meaning of MRS and thesignificance of the tangency point shown on the lastdiagram 14
15. 15. Consumer Choice: Maximising Consumer Satisfaction Consumer satisfaction is maximised at D, whereClothing the Slope of indifference curve = Slope of budget (units) line Recall MRS is represented by the slope of indifference curve 40 Recall RELATIVE PRICE is represented by the slope of budget line 30 Consumer satisfaction is maximised at D when: 20 D MRS = RELATIVE PRICE Point of MRS (F for C) = PF/PC 10 tangency MRS (C for F) = PC/PF 0 20 40 60 80 Food (units) 15
16. 16. Now for some more details on MRS Recall all market baskets on the same indifference curve give the same level of utility Also recall that the slope of indifference curves conveys information on the amount of value (utility) consumers get from the different goods A utility function gives a numerical interpretation of these ideas  If a person’s utility function is U(F,C) = F + 2C 8 units of F & 3 units of C gives her utility of U(F,C) = 8 + 2(3) = 14 16
17. 17. Another really important concept!Consumer Choice & Marginal Utility Marginal utility (MU) measures the additional (marginal) satisfaction obtained from consuming 1 additional unit of a good. It is the key measure of the consumer’s valuation of different commodities Using the example of U(F,C) = F + 2C Food Clothing Utility = F+2C MU 2 3 2 + 2(3) = 8 2 4 2 + 2(4) = 10 2 2 5 2 + 2(5) = 12 2 17
18. 18. Consumer Choice & Marginal UtilityComparing the MU of two different goods gives us MRS MUF/MUC = MRS (F for C) Logic: The more utility I get from a good,The more I’m willing to give up to get more of itIf I derive 5 times as much utilityfrom an extra unit of food as I do MUF/MUC = 5from an extra unit of clothing, then I should be willing to give up 5 units of clothing to get an MRS (F for C) = 5 additional unit of food.
19. 19. Consumer Choice: 4 FormulasClothing (units) Consumer satisfaction is maximised at D, where 40 MRS (F for C) = PF/PC30 Therefore MUF/MUC = PF/PC20 D Therefore Point of MUF/PF = MUC /PC10 tangency 0 20 40 60 80 Food (units) 19
20. 20. Consumer Choice: Understanding theKey Formula MUF/PF = MUC /PC or MUF/MUC = PF/PC This tells us the extra value the This tells us theconsumer will get extra value thefrom spending \$1 consumer will get extra on food from spending \$1 extra on clothing When the ratios are equal (i.e. At the point of tangency) the consumer won’t increase her utility by spending more on clothing and less on food or vice versa 20
21. 21. Consumer Choice: Understanding the Key FormulaClothing (units) Consumer satisfaction is NOT maximised at C, because 40 MRS (F for C) ≠ PF/PC30 Therefore MUF/MUC ≠ PF/PC20 D Therefore MUF/PF ≠ MUC /PC10 C 0 20 40 60 80 Food (units) 21
22. 22. Consumer Choice: Understanding theKey Formula At point C the IC is flatter than the budget line, so MU F PF  or MU C PC MU F MU C  PF PC 22
23. 23. Effects of Price Changes in MILK … on Consumer Choice “Coles instigated a price war in January by slashing the price of its no-name milk to \$1 a litre, forcing Woolworths, Aldi and Franklins to also reduce prices.…. The no-name milk now accounts for 51 per cent of all milk sales and 72 per cent of full-cream milk sold in the countrys supermarkets, according to the group. That is up from 25 per cent in the late 1990s.” Annabel Hepworth, Milk wars could cost suppliers \$730m‘, The Australian March 04, 2011 23
24. 24. Consumer Choice: Understanding theKey Formula MUF/PF <MU C /PC or MUF/MUC < PF/PC Suppose at point C This tells us the This tells us the I’m getting 4 units of extra value the extra value the value for each \$1consumer will get consumer will get I’m spending onfrom spending \$1 from spending \$1 clothing and 1 unit extra on food extra on clothing of value from each \$1 I’m spending on When the ratios are NOT food. equal the consumer CAN If I spend \$1 less on increase her utility by food and \$1 more spending more on on clothing my U will clothing and less on food increase by 3 or vice versa. 24
25. 25. Effects of Price Changes …. on Consumer Choice Other Assume: I = \$50, PM = \$2.50, \$2, \$1 goods (units) 1. PM decreases: Budget line rotates outwards along milk axis 2. One utility-maximisation point per A budget line. D U1 3. Trace utility- B U3 maximising basket at each price of milk to get Price PM=\$1 consumption curvePM=\$2.50 U2 (PCC) PM=\$2 Milk (cartons) 25
26. 26. Price Consumption Curve This joins up the utility maximising points as one price changes while holding income and the other price constant. 26
27. 27. Effects of Price Changes …. on Individual Demand for Milk 4. Derive demand schedule for MILK using PCC Other goods Individual Demand Schedule (units) for MILK Price (\$) Quantity (units) 9 A \$2.50 2 U1 D \$2 10 7 \$1 15 B U3 6 PM=\$1PM=\$2.50 U2 PM=\$2 2 Milk 10 15 (cartons) 27
28. 28. Effects of Price Changes …. on Individual Demand for Milk Price 5. Draw demand curve for MILK using demandof MILK schedule A \$2.50 Individual Demand Schedule for MILK Price (\$) Quantity (units) B \$2.50 2 \$2 \$2 10 \$1 15 \$1 D Individual Demand Curve Milk (cartons) 2 10 15 28
29. 29. Effects of Price Changes ….on Individual Demand for Milk Price of MILK A Increase in price = \$2.50 Movement up demand curve Decrease in price = Movement down demand curve \$2 B \$1 D Milk (cartons) 2 10 15 29
30. 30. Income Consumption Curve This joins up the utility maximizing points as income changes, while holding all prices constant. 30
31. 31. Effects of Income Changes …. on Consumer Choice Assume: PC = \$2, PF = \$1, I = \$10, \$20, \$30 Clothing (units) 1. Income increases: Budget line shifts I=\$30 outwards in a parallel manner 2. One utility-maximisation point per budget line I=\$20 3. Trace utility- maximising basket D at each income level U3 to get IncomeI=\$10 U2 consumption curve (ICC) B A U1 Food (units) 31
32. 32. Effects of Income Changes …. on Individual Demand for Food 4.Derive demand schedule for FOOD Clothing (units) Using ICC I=\$30 Individual Demand Schedule for FOOD Price (\$) Quantity (units) I=\$20 (fixed) \$1.00 4 7 D U3 \$1.00 10 5 B U2 \$1.00 16I=\$10 3 A U1 4 10 16 Food (units) 32
33. 33. Effects of Income Changes …. on Individual Demand for Food 5. Draw demand curve for FOOD using Price of demand schedule food Individual Demand Schedule for FOOD Price (\$) Quantity (fixed) (units) A B D\$1.00 \$1.00 4 \$1.00 10 \$1.00 16 D3 D2 D1 4 10 16 Food (units) 33
34. 34. Effects of Income Changes …. on Individual Demand for Food Price of food Increase in income = Shift to the right by demand curve Decrease in income = Shift to the left by A B D demand curve\$1.00 D3 D2 D1 4 10 16 Food (units) 34
35. 35. Normal goods Steak(units)  Consumer wants more steak as income increases: Steak is a normal good  Consumer also wants ICC more designer clothes as C 15 income increases: 10 U3 Designer clothes are B U2 normal goods 5 A  Normal good: You buy U1 more when your income increases. 4 10 16 Designer clothes (units) 35
36. 36. Inferior goods Steak Between A & B:(units)  Both steak & hamburger are normal goods. You buy more of both as your income increases. C 15 Between B & C: U3  Steak is still a normal good.  Hamburgers become an B inferior good – consumer wants 9 less hamburgers (106) as income increases. U2 5  ICC: A U1  upward-sloping between A & Hamburger B, backward-bending 4 6 10 (units) between B & C. 36
37. 37. Engel CurvesEngel curves relate the quantity of a good to INCOME.Income 30 (\$ permonth) Engel curves slope 20 upward for normal goods. 10 Steak (units 4 8 12 16 per month) 37
38. 38. Engel CurvesIncome 30 (\$ permonth) Inferior Engel curves are 20 backward bending for inferior goods. Normal 10 Hamburger (units 4 8 12 16 per month) 38
39. 39. Income and Substitution Effects A change in price can be broken down into 2 effects:  Substitution Effect  Income Effect 39
40. 40. Substitution Effect Occurs because the RELATIVE PRICE of a good changes Example: when the price of apples increases, apples become more expensive relative to pears You buy fewer apples but more pears, that is, you SUBSTITUTE pears for apples to keep your UTILITY CONSTANT Definition: The substitution effect is the change in a good’s consumption associated with a change in the RELATIVE PRICE __________________ of the good, with the level of UTILITY CONSTANT ____________________. 40
41. 41. Finding the Substitution Effect Following a price change, move the budget line back until it is just tangent to the original IC. The SUBSTITUTION EFFECT is the movement around the original IC. 41
42. 42. Substitution Effect When Price Falls: Graphical RepresentationClothing Price of food decreases: Budget line rotates (units) outward from L1 to L2. Recall Substitution effect: Change in relative price; Utility constant Change in relative price  Change in slope of original budget line L1 A Utility constant  Stay at original indifference curve U1 D B The substitution is F1E (move from A to D). Substitution U2 effect U1 L1 L2 F1 E F2 Food (units) Total effect 42
43. 43. Income Effect Occurs because consumers experience a change in REAL PURCHASING POWER when price changes Example: when the price of apples increases, your overall ability to purchase goods decreases. Definition: The income effect is the change in a REAL PURCHASING POWER good’s consumption brought about by a change in ___________________________. 43
44. 44. Finding the Income Effect The Income effect is the movement between the ARTIFICIAL optimum used to find the Substitution effect, and the consumer’s new utility maximising position. 44
45. 45. Income Effect When Price Falls:Graphical RepresentationClothing Recall Income effect: (units) Change in overall real purchasing power Change in real purchasing power  Parallel shift from dotted red line to budget line L2 The income effect is EF2 (move from D to B). A TIP: The dotted red line must ALWAYS be D B PARALLEL to L2. Substitution Income U2 effect U1 effect L L2 1 F1 E F2 Food (units) Total effect 45
46. 46. Income Effect When Price Falls: Normal GoodClothing (units) This graph shows that food is a NORMAL good. Recall: A normal good is a good you buy MORE of as your income increases. A Consumer moves from D to B, so the units of food INCREASE from E to F2 D B Substitution Income U2 effect effect U1 L1 L2 F1 E F2 Food (units) 46
47. 47. Income Effect When Price Falls: Inferior GoodClothing This graph shows that food is an (units) INFERIOR good. Recall: An inferior good is a good you buy LESS of as your income increases. Consumer moves from D to A B, so the units of food B DECREASE from E to F2 U2 D Income Substitution effect effect U1 L 1 L2 F1 F2 E Food (units) 47
48. 48. Income Effect When Price Falls: Giffen GoodClothing (units) This graph shows that food is a GIFFEN good. A Giffen good is a special case of an inferior good. A U2 The income effect is so large that it is greater than D the substitution effect. Income effect Substitution U1 effect L1 L2 F2F1 E Food (units) 48
49. 49. Summary of Price Falls1. Normal Good Income effect reinforces Substitution effect.2. Inferior Good, Not Giffen Income effect offsets Substitution effect but does not dominate.3. Inferior Good, Giffen Income effect offsets Subsitution effect and dominates. 49
50. 50. Substitution & Income Effects When Price Rises When the price of food rises, the budget line rotates inward from L1 to L2.Clothing The substitution effect is F1E (units) (move from A to D). The income effect is EF2 (move from D to B). B D Note we are assuming that food is a NORMAL good here. Why? The income effect is A going in the same direction as the U2 substitution effect. Income Substitution U1 effect Leffect 2 L1 F2 E F1 Food (units) 50
51. 51. Income Effect: Normal, Inferior and Giffen Goods When price decreases When price increases Substitution Income Income Substitution effect effectNormal effect effect Total effect Total effect Substitution Substitution effect effectInferior Income Income effect effect Total effect Total effect Substitution Substitution effect effectGiffen Income Income effect effect Total effect Total effect 51
52. 52. Question on Substitution & IncomeEffectsAssume that beer is an inferior good. If the price ofbeer falls, then the substitution effect results in theperson buying ______ of the good and the incomeeffect results in the person buying ________ of thegood.A. more, more Substitution effect:B. less, less Price  - buy moreC. less, more Income effect:D. more, less Inferior good – so the income effect must work in the opposite direction from the substitution effect - buy less 52
53. 53. Question on Substitution & IncomeEffectsYou have just won a cashaward of \$500 for academicexcellence.A. The substitution effect ofthis award will be larger than Almost everyone got thisits income effect. one wrong in a past year test!B. The income effect of thisaward will be larger than itssubstitution effect.C. The substitution and Assignment Tip:income effects will be of A cash award ORidentical size. CASH BONUS is like giving ‘income’ toD. It is impossible to know someone.whether the substitutioneffect is larger than theincome effect or vice versa. 53
54. 54. Substitution & Income Effects: Policy Application (Carbon Tax)All other The Australian government is proposing goods to tax carbon which will increase electricity prices Substitution effect is F1E (move D from A to D). B The income effect is EF2 (move from D to B, implying that A electricity is a NORMAL good). U1 NB the income Income Substitution L2 effect also causes effect effect U2 L1 O F2 Electricity the demand for all E F1 other goods to fall 54
55. 55. Substitution & Income Effects: Policy Application (Carbon Tax) However, the government is also planning toAll other compensate low income families by reduced goods their income tax. When the government reduces income tax, it is giving cash back to taxpayers. D B If it fully compensates for the effects of tax this will cancel out the income effect resulting in budget line L3. A U1 NB the tax will still Income Substitution affect the use of L2 L3 effect effect U L1 electricity, due to 2 O F2 E F1 Electricity the substitution effects 55
56. 56. Learning Outcomes Understand how consumers maximise satisfaction  Graphical representation and formula Trace the effects of price changes from consumer choice to the demand curve  Price consumption curve Trace the effects of income changes from consumer choice to the demand curve  Income consumption curve Gain an understanding of different types of goods demanded by consumers  Normal goods, inferior & Giffen goods  Engel curve 56
57. 57. Learning Outcomes Examine the effects of price changes in terms of substitution and income effects  Substitution effects  Income effects Tip: Learn to draw the diagrams accurately! Practice … p Economics Assignments are prepared at Expertsmind.com Refer” http://www.expertsmind.com/economics- homework-assignment-help.aspx 57