Economics 111.3 Winter 14

February 24th, 2014Lecture 15

Ch. 8 and Ch. 9

The Budget Line : a recap

We use the following symbols:

PA = price of good A, PB = price of good B, QA = quantity of good A, QB = quantity of good B, y (or M or I) = income.

The budget line can be written as:

PA QA + PB QB = y

or, $4.00 QA + $8 QB = $40

We can choose any combination of goods that satisfies this equation.

Good “A”

Good “B”

The slope of Budget Line: a recap

Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

0

2 4 6 8 10 12

The Budget Line

Price changes cause

a change in the quantity

demanded of the items

Price changes cause

a change in the quantity

demanded of the items

Price of A risesPrice of A rises

Qu

an

tity

of

A

Quantity of B

12

10

8

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2

0

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An increase in income

makes the purchase of

more of either or both

items possible

An increase in income

makes the purchase of

more of either or both

items possible

Income increasesIncome increases

Study question

Consumer’s Choice: Ordinal Utility:

Indifference Curve Analysis

Indifference Curves

An indifference curve represents all the combinations of the two goods amongst which an individual is indifferent.An indifference curve shows consumption bundles that give the consumer the same level of satisfaction.Marginal utility theory assumes utility is numerically measurableIndifference curve approach requires only that a consumer specify if a particular combination of products yields more or less utility than another

NB!

• more of a good is better than less of it• good: commodity for

which more is preferred to less at least at some levels of consumption

• bad: something for which less is preferred to more, such as pollution

• consumers are not satiated

Qu

an

tity

of

A

Quantity of B

12

10

8

6

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2

0

2 4 6 8 10 12

j

k

lm

I

combination Units of A Units of B

j 12 2

k 6 4

l 4 6

m 3 8

Indifference Curves

Study question• Does this individual receive satisfaction from

consuming good B? Good A?

Good A

Good B

Dimes0

Nickels

(a) Perfect Substitutes

I1 I2 I3

3

6

2

4

1

2

Copyright©2004 South-Western

Study question

• Molly loves hamburgers and soft drinks, but insists on consuming exactly one soft drink for every two hamburgers that she eats.

• Draw an indifference curve that is consistent with her preferences.

Study question

Draw a set of indifference curves for the following pair of goods:

• Ice cream and pie if these are goods that you like, but if you consume enough of either, you get sick of them. If you are sick of a good, consuming more of it lowers your utility.

Study question

• Jocasta loves to dance and hates housecleaning. She prefers dancing to any other activity and never gets tired of dancing, but the more time she spends cleaning house, the less happy she is.

• Draw an indifference curve that is consistent with her preferences.

Study questionIn the field of financial management it has been observed that there is a trade-off between the rate of return that one earns on investments and the amount of risk that one must bear to earn that return.

A. Draw a set of indifference curves between risk and return for a person that is risk averse (a person that does not like risk).

B. Draw a set of indifference curves for a person that is risk neutral (a person that does not care about risk one way or the other).

C. Draw a set of indifference curves for a person that likes risk.

Properties of well-behaved Indifferent Curves

• Higher indifference curves are preferred to lower ones.

• Indifference curves do not cross.

• Indifference curves are “thin”

• Indifference curves are bowed inward (convex to the origin).

• Indifference curves are downward sloping.

The Impossibility of Intersecting Indifference Curves

Quantityof Pizza

Quantityof Pepsi

0

C

A

B

Copyright©2004 South-Western

Indifference Curves are “THIN”!

B, Burritosper semester

a

b

Thick

Z, Pizzas per semester

I

Indifference curves are convex to the origin

Well-behaved indifference curves are downward sloping

• Overall, the slope of the indifference curve is called the marginal rate of substitution (MRS)

• MRS is the amount of the good on the vertical axis that the consumer is willing to give up to obtain one extra unit of the good measured on the horizontal axis.

Convex vs. Concave

Diminishing MRS: Rationale• People are more willing

to trade away goods that they have in abundance and less willing to trade away goods of which they have little.

• These differences in a consumer’s marginal substitution rates cause his or her indifference curve to bow inward.

Combining Indifference Curves and Budget Line

• The goal for a consumer is to get as high on an indifference curve as possible, given her income constraint.

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of

A

Quantity of B

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10

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2 4 6 8 10 12

Equilibrium at Tangency

Point X represents the optimal attainable

combination of products A & B

Point X represents the optimal attainable

combination of products A & B

X I4

I1

I2I3