© Pilot Publishing Company Ltd. 2005 Chapter 3 Consumer Behaviour I --- The Indifference Curve Approach.

© Pilot Publishing Company Ltd. 2005

Chapter 3Consumer Behaviour I ---The Indifference Curve

Approach


• Postulates of Consumer Behaviour• Good, Bad and Neuter• Utility• Indifference Curve • Properties of Indifference Curves of Two Goods• Other Shapes of Indifference Curves• Budget Line • Consumer Equilibrium

Contents:


• Changes in Consumer Equilibrium in Response to Changes in Constraints• Decomposition of Price Effect into Substitution Effect and Income Effect• Advanced Material 3.1: Postulate of utility maximization• Advanced Material 3.2: Corner solutions

Contents:


Postulates of Consumer Behaviour


• A theory has four components - definitions; postulates; test conditions; implications

• Chapter one: basic definitions This chapter: postulates

+ test conditions + implications


A. An economic agent behaves rationally.

• Significance: Thus, economic investigation is possible and meaningful.

• Meaning: Behaviour of an economic agent has objectives and involves a prudent (審慎的 ) choice among alternative means. In other words, consumer behaviour is not random or arbitrary(隨意的 ). It has patterns and can be explained.

What are the basic postulates of consumer behaviour?


• Meaning: An economic agent always chooses the option that _________ the achievement of his goals among the options allowed by existing constraints.

B. Postulate of constrained maximization / self-interest / selfishness

Then how does an individual make his choice?

maximizes

• Significance: Without a postulate on economic choice, there is no economics. Without a confirmed postulate on economic choice, economics might not have survived.

Note: This is the most important & most useful postulate in economics.


Competition Choice

C. Each individual has many wants.

D. To each individual, some goods are scarce.

Scarcity

• Significance: Hence competition and choice are inevitable. They constitute the main content of economics.

• Significance: Hence choice and exchange may arise.


• Meaning: One is willing to forgo something to get more of the scarce good — substitution, provided that the value got is larger than the cost paid.

E. Scarce goods are substitutable

• Significance: Exchange is possible.


F. The law of diminishing MRS

• Marginal rate of substitution (MRS): is the maximum amount of good Y that an individual is willing to forgo for an additional unit of good X.

• The law states that MRS or MUV of a good ____________ as more units of the good are obtained, ceteris paribus.

• It is equal to marginal use value (MUV) of good X in terms of good Y.

declines

• Significance: (Both interior and corner solutions are possible.)


Good, Bad and Neuter


A good is something desired,

i.e., _________ is preferred to _________. none

(Options: more / less / none / some)

some


Goods

Free goods Scarce goods (economic goods)

Types of goods:


(Options: more / less / some / no more )

Free good: Features

its amount available is ______ than its amount desired at zero price,

i.e., ________ is preferred.

something desired

no more

more


Scarce good (economic good): Features

(Options: more / less / some / none )

something desired

its amount available is _____ than its amount desired at zero price,

i.e., ______ is preferred to _____.

less

more less


• Depends on situations rather than kinds.

• Any examples?

Distinction between free goods and scarce goods:


Distinction between free goods and goods free-of-charge:

A free good must be a good free-of-charge. Why?

A good free-of-charge may not be a free good. Why?

• its amount available is more than its amount desired.

• no one desires to have more of it

• no production nor exchange takes place zero-priced.

• a scarce good can also be free-of-charge if someone pays the cost for you. Any examples?


Is sickness a bad ?

more

(Options: more / less / some / none )

A bad is something undesired,

i.e., _________ is preferred to _________. less


A neuter (中性物品 ) is something neither desired nor undesired,

i.e., the quantity does not matter.

Any examples?


Q3.2:Which of the following are free goods? Explain.air pocket money sea water parental care

Q3.3:

Draw a demand and supply diagram to illustrate a free good and a scarce good respectively.


Utility


What is utility?

Utility (效用 ) is a number

• arbitrarily assigned to entities to rank them according to one’s preference.

a criterion of maximization to rank options for making choice.

the higher the utility, the more one prefers the entity.


What is utility?

Utility reflects preference

social welfare

happiness / satisfaction

Why?


Measurement of utility

Ordinal utility

• only reflects an order

• but the difference between the numbers assigned is meaningless

Cardinal utility

• can also reflect an order

• and the difference between the numbers assigned is meaningful


Measurement of utility

Which measurement of utility is used in the indifference curve approach?

Ordinal measure of utility


Indifference Curve


U=10

An indifference curve (IC, 等優曲線) is a line joining all the points (representing different baskets of goods) giving the same utility to an individual.

Good X

Good Y

0

What is an indifference curve?


An indifference map (等優曲線圖 ) is a set of ICs showing the _________ of an individual.

What is an indifference map?

U=10U=20

U=30

Good Y

Good X0

preference


Properties of Indifference Curves of Two Goods


U=10

Good Y

Good X0

+X

-Y

1. ICs of two goods are negatively sloped Keeping utility constant, along an

IC, a basket with more units of good X must have _____ units of good Y.fewer

negative

(Options: more / fewer / positive / negative)

• Slope of an IC of two goods (= Δ Y/ Δ X)

must be ________.


If quantities of good X and good Y can be increased or decreased by infinitesimal amounts, the ICs are continuous. Why?

2. Indifference curves are continuous

U=10

Good Y

Good X0


Along U2: point A = point C = U2

Along U1: point A = point B = U1

• What is the utility of point A, = U1 or U2?

3. Indifference curves can never intersect

U of the intersection point logical contradiction

A

B

C


U1

U2

U3

Good Y

Good X0

The higher the IC , the higher the utility (U3 > U2 > U1). Why?

The higher the IC , the higher the utility (U3 > U2 > U1). Why?

• If a consumer knows his preference on every basket of commodities, the commodity plane will be fully covered by ICs. Why?

4. Full coverage


5. Indifference curves of two goods are convex to the origin

U1

Good Y

Good X0

+1X

-Y

As the consumption of good X rises, MRS (the slope) falls. Why?

convex

As the IC becomes flatter & flatter, its shape is _______ to the origin.

The numerical value of the slope of an IC (+1X -?Y) is equal to the MRS. Why?


Other Shapes of Indifference Curves


Y (A good)

X (A neuter)

0

U2

U1

U3

U3>U2>U1

1. X is a neuter and Y is a good

Any increase or decrease in the quantity of X makes no difference to the consumer.

Why?

ICs are ___________.horizontal


What will be the shape of the ICs if (a) X is a good and Y is a neuter?(b) both X and Y are neuters?


ICs are _________ sloping with a/an _________slope.

2. X is a bad and Y is a good

U3>U2>U1

U1

U2

U3

0

Y (A good)

X (A bad)

Why?

upwardincreasing

+X

+Y

To keep U constant, in a bad (+X) requires in a good (+Y) as a compensation.


What will be the shape of the ICs if (a) X is a good and Y is a bad?(b) both X and Y are bads?


3. X is a commodity with a satiation threshold (beyond which X turns from a good to a bad)

0

Good Y

X

U1

U2

U3

U3>U2>U1

X becomes a bad X is a good

ICs are __________.

Why?

U-shaped


What will be the shape of the ICs if both X and Y are goods with a satiation threshold?


4. X and Y are perfect substitutes

Good X (pack of 5 kg rice)

Good Y (pack of 8 kg rice)

0 U1 U2 U3

U3>U2>U1

ICs are _________ sloping _______ lines.

Why?

downwardstraight


5. X and Y are perfect complements

Good Y (left shoes)

Good X (right shoes)0

ICs are __________.

45o U3>U2>U1

U1

U2

U3Why?

right-angled


Q3.7: Study the indifference maps below and determine if X and Y are goods, bads or neuters.

Y

U1

U2

U3

X

U1 U2 U3

X

Y

(a) U1 < U2 < U3 (b) U1 > U2 > U3


Budget Line


It is also called the budget constraint.

What is a budget line?

Budget line (BL) or consumption possibility curve is a boundary showing the largest possible combinations of goods that a consumer can buy in a market, given his money income and market prices of the goods.


Y

X0

Given I = $100, PX = $20 & PY = $25

The maxi. amount of X one can buy

= ___________$100/$20 = 5

$100/$25 = 4

$20/$25 = 0.8

4

5

+1X

-0.8Y

Derivation of a BL:

To buy 1 more unit of X, one forgoes =____________ unit of Y.

The maxi. amount of Y one can buy

= ___________

The BL is a downward sloping straight line.

The slope of BL = cost of consuming an additional unit of good X in terms of good Y.


Y

X0

A

C

B

Point A: Expenditure ____ Income

Point B: Expenditure ____ Income

Point C: Expenditure ____ Income

Features: Features:

<=>

(Options: > = < )


Equation of budget line

X PX + Y PY = I

Expenditure on good X

Expenditure on good Y

Money income of the consumer


Changes in budget constraints

1. Changes in income When one’s income

increases, the budget line will shift ______ in a parallel manner, and vice versa.

Y

0 X

outward

Why?

in income

in income


Y

0X

2. Proportionate changes in prices

When prices of both goods rise by the same proportion, the budget line will shift _______ in a parallel manner, and vice versa.

inward

Why?

A proportionate in all money prices

A proportionate in all money prices


Y

0X

3. Disproportionate changes in prices

A rise in Px

A fall in Px

tilt inward

tilt outward

When PX , the budget line will _________ and become steeper. Why?

When PX , the budget line will __________ and become _______. Why?flatter


Q3.8: Under the following situations, what would happen to the budget line? Explain with the aid of diagrams. (a) I and PY are constants, but Px increases from P0 to

P1. (b) I and PY are constants, but PX increases as the consumer buys more and more units of the good, i.e., PX and X are positively related. (c) I and PY are constants, but PX decreases as the consumer buys more and more units of the good, i.e., PX and X are negatively related.


Consumer EquilibriumConsumer Equilibrium


Optimum (最優點 ) or equilibrium (均衡 ) is the best choice of an economic agent in achieving his objective.

What is a consumer equilibrium?

Optimality conditions (最優性條件 ) or equilibrium conditions (均衡條件 ) are descriptions on thedefining features of the optimum or the equilibrium.


Interior solution

When a consumer buys both goods X & Y, i.e., the equilibrium is not one of the _________ on the budget line, the equilibrium is called an interior solution (內解點 ).

intercepts


It is the tangency point, the only point on the budget line reaching the highest IC attainable.

U1

U3

Y

X0

U3>U2>U1

X*

Y*

From observation, the best choice achievable is _____________.

Equilibrium: From observation

E*

U2

E* (X*, Y*)

Why?


Equilibrium conditions:

U1

U2

U3

Y

X0

U3>U2>U1

E*

X*

Y*

1. The consumer equilibrium must lie ____ the BL.

2. The consumer equilibrium is the ____________ at which the slope of IC equals the slope of BL.

on

tangency point


Slope of indifference curve Slope of budget line

1.1. =ΔY/ΔX, holding utility constant

=ΔY/ΔX, holding expenditure or income constant

2. 2. = Marginal rate of substitution in consumption, MRSc

= Marginal rate of substitution in exchange, MRSe

Meaning of the slopes

3.3. = The maximum amount of Y one is willing to pay for an additional unit of X

= The actual amount of Y one is required to pay for an additional unit of X in exchange

4. 4. = Cost / Value? of an additional unit of X in terms of Y (=MUV)

= Cost / Value? of consuming an additional unit of X in terms of Y (= Px/Py)

Value Cost


Buy X

MR

Sc

MR

Se

How is the consumer equilibrium reached?

At point A, MRSc > MRSe (_______ of an additional X > its ________), utility can be raised if the consumer _________ units of X.

U2

U1

Y

X0

A

buys more

(Options: buys more / sells some / value / cost )

valuecost


Sell X

MR

Se

MRSc

U2

U1

Y

X0

At point B, MRSc < MRSe (value < cost), utility can be raised if the consumer _________ units of X.

B

sells some

(Options: buys some / sells some )



U2

U1

Y

X0

MRSc = MRSe (value = cost), utility is maximized & the equilibrium is attained.

E*



Changes in Consumer Equilibrium

in Response to Changes in Constraints


A. Changes in income

When income with PX and PY unchanged,the BL will shift outward / inward? in a parallel manner.

• The effect of income on the consumption of a consumer can be shown by 2 curves:

1. Income consumption curve2. Engel curve

outward


Income consumption curve (所得消費曲線 , ICC) is a line joining all the equilibrium (X,Y) of a consumer when one’s income changes, holding PX and PY constant.

ICC

1. Income consumption curve

Y

0 X


Engel curve (恩格爾曲線 ) is a line showing the consumption of a good at different income levels, holding PX and PY constant.

X

0Income

Engel curve

2. Engel curve

I1 I2 I3

X3

X2

X1


Y

X

ICC

A. Superior good: Its consumption is positively related to income.

X

Income

Engel curve

X1 X2 X3

X3

X2

X1

I1 I2 I3


ICC

Y

X

B. Inferior good: Its consumption is negatively related to income.

X

I

Engel curve

X3X2X1

X1

X2

X3

I1 I2 I3


B. Changes in price

The effect of price on the consumption of a consumer can be shown by 2 curves:

1. Price consumption curve2. Demand curve


PCC

Price consumption curve ( 價格消費曲線 ) is a line joining all the equilibrium of a consumer when PX changes, holding I & PY constant.

1. Price consumption curve

Y

0 X


Demand Curve

Px

0 X

Px1

Px2

Px3

Demand curve is a line showing the ________________ of a good of a consumer at different prices.

2. Demand curve

quantity demanded

X1 X2 X3


Px1

Px3

Px2

Y

0Px

0 X

X

PCCPCC

Demand Curve

X1 X2 X3 X4

If price (Px) & quantity demanded (X) of the good are negatively related.


Px1

Px2

PCC

Y

0X

Px

0 X

Demand Curve

Giffen paradox

If price (Px) & quantity demanded (X) of a good are _________ related, the good is called a Giffen good.

positively

X1 X2


Decomposition of the Price Effect into

the Substitution Effect & the Income Effect


Price effect

Price effect is the overall change in the quantity demanded of a good caused by a change in its price, holding money income constant.

Price effect can be decomposed into ___________ effect and __________ effect. substitution income


Px One will buy more good X to substitute good Y

S.E.S.E.

L3

X3

E3

Y

0 X

E1

L1

X1

So substitution effect must be negative.

Substitution effect ( 替代效應 ) is the change in the quantity demanded of a good caused by a change in its price, holding utility or real income constant.

New equilibrium

L2


I.E.

L2

X2

Y

0X

S.E.

E3

E1

L1L3

X3X1

Using the saved income

The saved income will raise the consumption of good X if good X is a superior good.

E2

Income effect ( 所得效應 ) is the change in the quantity demanded of a good as a result of a change in real income caused by a change in its price.

When Px, income is saved. Income is further saved by the S.E. as the consumption of an expensive good is substituted by the consumption of a cheaper good.


Price effect of different kinds of goods

S.E.

Positive I.E.

Y

0 X

E1

L1 L2L3

E3

E2

2. If good X is a superior good, what will be the income effect?

3. And what will be the price effect?

1. The substitution effect must be negative.


S.E.

L3 L2

Negative I.E.Y

0 XL1

E1

2. If X is an inferior good

with its -ve I.E. < S.E.,

what will be the price effect?

E3

E2


S.E.

L1 L3L2

E3

Y

0 X

E1

Negative I.E. 3. If X is an inferior good with its -ve I.E. > S.E., (called Giffen good), what will be the price effect?

E2


Q3.12:Decompose the price effect into the substitution effect and the income effect, when the price of good X rises.(a) If good X is a superior good

(c) If good X is an inferior good with its substitution effect smaller than its income effect

(b) If good X is an inferior good with its substitution effect greater than its income effect


Advanced Material 3.1: Postulate of utility maximization If the utility and the cost of each option

can be measured or asserted beforehand• the postulate can generate refutable predictions and it is useful if it is not refuted.

cannot be measured or asserted beforehand

• the postulate cannot generate refutable predictions, then it becomes tautological and useless in explanation and prediction.


Advanced Material 3.2: Corner solutions

When a consumer buys one good only, i.e., the equilibrium is one of the intercepts on the budget line, the equilibrium is called a corner solution (角隅解 ).

There is a ___________________ in consumption.specialization


Advanced Material 3.2: Corner solutions

Possible reasons for a corner solution are:

3. MRS is not decreasing.

1. The good is too expensive.

2. The entity is a bad.


E*

Y (A good)

X (A good but too expensive)

MRSc (= value)

MRSe (= cost)

U1

U3

U2

U3>U2>U1

1. The good is too expensive

>

1X


Y (A good)

X (A bad)

U1

U3

U2

E*

0

U3>U2>U1

2. The entity is a bad


Y (A good)

X (A good)

U1

U3

U2

E*

0Increasing MRS

U3>U2>U1

3. MRS is not decreasing

Constant MRS

Y (A good)

X (A good)

U1

U3

U2

E*

0

U3>U2>U1


Correcting Misconceptions:

1. A free good is a good provided by the government free of charge.

2. A free good is a good without utility and is not preferred.

3. Utility is a measure of individual satisfaction or a measure of social welfare.


4. Utility of a good must be a positive number and that of a bad must be negative.

5. Postulate of utility maximization is tautological.

6. A straight-line indifference curve denies the postulate of substitution.



7. A concave indifference map cannot have consumer equilibrium or can have an interior solution.

8. A good with its price and quantity demanded negatively related is a normal good.

9. Holding money income constant is the same as holding real income constant.



10. Substitution effect is positive for superior good and negative for inferior good.

11. Giffen good has no relation with inferior good.



Survival Kit in Exam:Question 3.1(a) What is utility? Must the utility of a bad be a negative number?

(b) Michael says, “Anderson fails in HKCEE and he commits suicide. Why? He is maximizing utility. Mary also fails in HKCEE but she does not commit suicide. Why? She is maximizing utility. So, the postulate of utility maximization is tautological.” Do you agree?


Survival Kit in Exam:Question 3.2Being a member of a club, a consumer can purchase cosmetics at a reduced price. However, he has to pay a membership fee, and after which he has just enough income to purchase the original basket of goods. Does he prefer to be a member? Use an indifference map to illustrate.

© Pilot Publishing Company Ltd. 2005 Chapter 3 Consumer Behaviour I --- The Indifference Curve Approach.

Documents

pilot publishing company

neuter slide

moreless slide

terms of good

good y

scarce good substitution

economic choice

additional unit of good