INDIFFERENCE CURVES AND UTILITY MAXIMIZATION • Indifference curve – A curve that shows combinations of goods which gives the same level of satisfaction to the consumers so that an individual is indifferent.
Dec 23, 2015
INDIFFERENCE CURVES AND UTILITY MAXIMIZATION
• Indifference curve – A curve that shows combinations of goods which gives the same level of satisfaction to the consumers so that an individual is indifferent.
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aP
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Oranges
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Oranges
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Point
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Constructing an indifference curve
Assumption
• More of a commodity is better than less• Preference of a consumer are transitive• Diminishing marginal rate of substitution
More of a commodity is better than less
Preference of a consumer are transitive
Marginal rate of substitution
• Marginal rate of substitution – The rate at which consumer is prepared to exchange goods X and Y is known as MRS ie the rate at which one good must be added when the other is taken away in order to keep the individual indifferent between the two combinations without changing total satisfaction .
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Deriving the marginal rate of substitution (MRS)a
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Un
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f goo
d Y
Units of good X
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6 7
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a
b
Un
its o
f goo
d Y
Units of good X
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6 7
Y = 4
X = 1
MRS = 4
Deriving the marginal rate of substitution (MRS)
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a
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Un
its o
f goo
d Y
Units of good X
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cd
Y = 4
X = 1
Y = 1
X = 1
MRS = 1
MRS = 4
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Deriving the marginal rate of substitution (MRS)
Indifference schedule
• Indifference schedule
CombinaCombinationtion
Good XGood X Good YGood Y MRSMRS
AA 11 1212
BB 22 88 44
CC 33 55 33
DD 44 33 22
EE 55 22 11
Marginal Rate of Substitution
• MRS declines as we move downward to the right along an indifference curve.
• Indifference curves with diminishing MRS are thus convex.
• Convexity illustrates that people like variety.
Law of diminishing marginal rate of substitution
• Law of diminishing marginal rate of substitution – As you get more and more of a good X , one is prepared to forego less and less of Y, that is MRS of X for Y diminishes as more and more of good X is substituted for good Y.
DMRS
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d Y
Units of good X
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I3
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An indifference map
Properties of Indifference Curve
– Indifference curves are downward sloping to the right
– Indifference curves are convex to the origin– Indifference curves cannot intersect each other – A higher Indifference curves represents a higher
satisfaction
BUDGET LINE
• Budget line graphically shows the budget constraint.
• The combination of commodities lying to the right of the budget line are unattainable because the income of the consumer is not sufficient to be able to buy those combinations.
• The combination of commodities lying to the left of the budget line are attainable because the income of the consumer is sufficient to be able to buy those combinations
What is a Budget Constraint?• A budget constraint shows the consumer’s
purchase opportunities as every combination of two goods that can be bought at given prices using a given amount of income.
• The budget constraint measures the combinations of purchases that a person can afford to make with a given amount of monetary income.
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its o
f goo
d Y
Units of good X
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b
Units ofgood X
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Units ofgood Y
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Point onbudget line
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Assumptions
PX = £2PY = £1
Budget = £30
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A budget line
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Un
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d Y
Units of good X
Assumptions
PX = £2PY = £1
Budget = £40
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Budget = £40
Budget = £30
Effect of an increase in income on the budget line
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Effect on the budget line of a fall in the price of good XU
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Units of good X
Assumptions
PX = £1PY = £1
Budget = £30
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The Best Feasible Bundle
• Tools needed to determine how consumers should allocate their income between 2 goods :– Budget Constraint– Indifference Curves
• Consumer’s strategy is to keep moving to higher and higher indifference curves until he reaches the highest one that is still affordable.
How to Find the Best Combination
• Utility is maximized when:–the indifference curve is just
tangent to the budget line.
Consumer Equilibrium
The Best Affordable Bundle
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I2
I3
I4
I5
Un
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f goo
d Y
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Units of good X
Budget line
Finding the optimum consumption
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I5
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d Y
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Units of good X
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indifference curve and budget line
Un
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f goo
d Y
O
Units of good X
B1
Effect on consumption of a change in incomeEffect on consumption of a change in income
I1
I2
Un
its o
f goo
d Y
O
Units of good X
B1 B2 I1
Effect on consumption of a change in incomeEffect on consumption of a change in income
I2
Un
its o
f goo
d Y
O
Units of good X
B1 B2 B3 B4 I1
I3
I4
Effect on consumption of a change in incomeEffect on consumption of a change in income
I2
Un
its o
f goo
d Y
O
Units of good X
B1 B2 B3 B4 I1
I3
I4
Income–consumption curve
Effect on consumption of a change in incomeEffect on consumption of a change in income