A more advanced explanation of consumer behavior and equilibrium is based on (1) budget lines and (2)so- called indifference curves.
A budget line (or, more technically, the budget constraint ) is a schedule or curve that shows various combinations of two products a consumer can purchase with a specific money income.
If the price of product A is $1.50 and the price of product B is $1, a consumer could purchase all the combinations of A and B shown in Table 1 with $12 of money income.
At one extreme, the consumer might spend all of his or her income on 8 units of A and have nothing left to spend on B. Or, by giving up 2 units of A and thereby “freeing” $3, the consumer could have 6 units of A and 3 of B. And so on to the other extreme, at which the consumer could buy 12 units of B at $1 each, spending his or her entire money income on B with nothing left to spend on A.
Income: $1,200 Price of X= $40 Price of Y= $30 Equation of the budget line 40good Y 35 30 25 20 15 10 5 5 10 15 20 25 30 35 40 good X
Effects of Changes in Income Effects of Changes in Prices
The location of the budget line varies with money income. An increase in money income shifts the budget line to the right; a decrease in money income shifts it to the left.
An indifference curve is the locus of points representing all the different combinations of two goods which yield equal level of utility to the consumer.
Indifference schedule is a list of various combinations of commodities which are equally satisfactory to the consumer concerned.
The marginal rate of substitution of X for Y (MRSxy) is defined as the amount of Y, the consumer is just willing to give up to get one more unit of X and maintain the same level of satisfaction.
As the consumer increases the consumption of apples, then for getting every additional unit of apples, he will give up less and less of oranges, that is, 8:1, 4:1, 2:1, 1:1 respectively This is the Law of Diminishing MRS.
An indifference map is a complete set of indifference curves. It indicates the consumer’s preferences among all combinations of goods and services. The farther from the origin the indifference curve is, the more the combinations of goods along that curve are preferred.
Indifference curves are negatively sloped Given a combination of commodity X and commodity Y,with every increase in X, the amount in Y should fall in orderthat the level of satisfaction from every combination shouldremain the same. Indifference curves are convex to the origin Convexity illustrates the law of diminishing marginal rate ofsubstitution. Indifference curves can never intersect each other Indifference curves can never intersect each other becauseeach indifference curve represents a specific level ofsatisfaction. If two indifference curves intersect each other,then at the point of intersection, the consumer is experiencingtwo different levels of utility.
A consumer seeks a market basket that generates the maximum level of happiness. However, one’s money income and prices of goods imposes a limit on the level of satisfaction that one may attain. Thus, the income at the disposal of the consumer in conjunction with prices of the commodities will determine the budgetary constraint or the price line.
Consumer equilibrium is attained when, given his budget constraint, the consumer reaches the highest possible point on the indifference curve. The maximum satisfaction is yielded when the consumer reaches equilibrium at the point of tangency between an indifference curve and the price line. At point E, the price line is tangent to the indifference curve. At the equilibrium point, slope of indifference curve = slope of price line slope of indifference curve = MRS slope of price line = PX / PY Thus, at point E, MRS = PX / PY Thus, satisfaction is maximized when the marginal rate of substitution of X for Y is just equal to the price of X to the price of Y.