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Outcomes• Define, explain and illustrate how the budget constraint
(and the slope) can change.
• Discuss the characteristics of consumer preferences• Define, illustrate and discuss the different charateristics
of indifference curves.• Calculate, illustrate and explain the slope and change in
the budget line.• Use a graph to illustrate the consumer’s equilibrium.• Explain and illustrate the difference between the income
and substitutuion effect by using indifference curves.• Derive the demand curve by using the indifference
approach.• Apply the rational choice model.
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Properties of Preference
Orderings
• Completeness : the consumer is able to rank
all possible combinations of goods andservices.
• More-Is-Better : other things equal, more of a
good is preferred to less.
• Transitivity : for any three bundles A, B, and
C, if one prefers A to B and prefers B to C,
then one always prefers A to C.
• Covexity : mixtures of goods are preferable to
extremes.
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Figure 3.1: Generating Equally
Preferred Bundles
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Indifference Curves• Indifference curve : a set of bundles
among which the consumer is indifferent.
• Indifference map : a representativesample of the set of a consumer’sindifference curves, used as a graphical
summary of her preference ordering.
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Properties of Indifference
Curves• Indifference curves …
1. Are Ubiquitous.Any bundle has an indifference curve passing through it.
2. Are Downward-sloping.This comes from the “more-is-better” assumption.
3. Cannot cross.
4. Become less steep as we move downward and to theright along them.
This property is implied by the convexity property of
preferences.
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Trade-offs Between Goods• Marginal rate of substitution (MRS): the
rate at which the consumer is willing toexchange the good measured along thevertical axis for the good measured alongthe horizontal axis.
– Equal to the absolute value of the slope of the
indifference curve.
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Figure 3.2: An Indifference Curve
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Fig. 3.7: People have different tastes
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Figure 3.10: Part of an Indifference
Map
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Figure 3.13: Why Two Indifference
Curves Do Not Cross
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Figure 3.14: The Marginal Rate
of Substitution
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Figure 3.15: Diminishing Marginal
Rate of Substitution
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Budget constraint
• Definition:
– All the combinations
(bundles) of 2 goods aperson can purchase givena certain money incomeand prices for the twogoods.
– Any point on budgetconstrain (and below)represents possiblecombinations.
• Slope = relative prices of
two goods, X and Y
(Px/Py).
• Changes in budgetconstraint:
– Relative prices changes :budget constraint revolves(rotates) away or towardsorigin
• Number of bundlesavailable increases ordecreases
– Individuals incomechanges: budget constraintmoves parallel towards oraway from origin.
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Figure 3.8: The Budget Line,
or Budget Constraint
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Budget shifts due to price or income
changes
• If the price of ONLY one good changes…
– The slope of the budget constraint changes.
• If the price of both goods change by the sameproportion…
– The budget constraint shifts parallel to the originalone.
• If income changes ….
– The budget constraint shifts parallel to the original
one.
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Figure 3.10: The Effect of a Rise
in the Price of Shelter
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Figure 3.11: The Effect of Cutting
Income by Half
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The Best Feasible Bundle• Consumer’s Goal : to choose the best
affordable bundle. – The same as reaching the highest indifference
curve she can, given her budget constraint.
– For convex indifference curves.
• the best bundle will always lie at the point oftangency between the budget line and theindifference curve.
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Figure 3.17: The Best Affordable Bundle
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Calculation of optimal bundle• Example: pg 92 -95
• Optimal bumdle where U =XY, Px = 4, Py= 2 and M = 40
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Figure 3.25: The Optimal Bundle when
U = XY, P x = 4, P y = 2, and M = 40
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