Indifference Curves: (pp. 65 - 79) An Exampleyamamoto/files/Apr_27.pdf · ©2005 Pearson Education,...
Transcript of Indifference Curves: (pp. 65 - 79) An Exampleyamamoto/files/Apr_27.pdf · ©2005 Pearson Education,...
Chapter 3 1©2005 Pearson Education, Inc.
Indifference Curves:An Example (pp. 65 - 79)
4010H
2010G
4030E
2040D
5010B
3020A
Units of ClothingUnits of FoodMarket Basket
Chapter 3 2©2005 Pearson Education, Inc.
Indifference Curves:An Example (pp. 65 - 79)
�Graph the points with one good on the x-axis and one good on the y-axis
�Plotting the points, we can make someimmediate observations aboutpreferences�The more, the better
Chapter 3 3©2005 Pearson Education, Inc.
The consumer prefersA to all combinations
in the yellow box, whileall those in the pink
box are preferred to A.
Indifference Curves:An Example (pp. 65 - 79)
Food
10
20
30
40
10 20 30 40
Clothing 50
G
A
EH
B
D
Chapter 3 4©2005 Pearson Education, Inc.
Indifference Curves:An Example (pp. 65 - 79)
�Points such as B & D have more of onegood but less of another compared to A�Need more information about consumer
ranking
�Consumer may decide they areindifferent between B, A and D�We can then connect those points with an
indifference curve
Chapter 3 5©2005 Pearson Education, Inc.
•Indifferentbetween points B,A, & D•E is preferred toany points on theindifference curveU1•Points on U1 arepreferred to H & G
Indifference Curves:An Example (pp. 65 - 79)
Food
10
20
30
40
10 20 30 40
Clothing50
U1GD
A
EH
B
Chapter 3 6©2005 Pearson Education, Inc.
Indifference Curves (pp. 65 - 79)
�Any market basket lying northeast of anindifference curve is preferred to anymarket basket that lies on theindifference curve
�Points on the curve are preferred topoints southwest of the curve
Chapter 3 7©2005 Pearson Education, Inc.
Indifference Curves (pp. 65 - 79)
� Indifference curves slope downward tothe right�If they sloped upward, they would violate the
assumption that more is preferred to less
Chapter 3 8©2005 Pearson Education, Inc.
Indifference Curves (pp. 65 - 79)
� To describe preferences for allcombinations of goods/services, we havea set of indifference curves – anindifference map�Each indifference curve in the map shows
the market baskets among which the personis indifferent
Chapter 3 9©2005 Pearson Education, Inc.
U2
U3
Indifference Map (pp. 65 - 79)
Food
Clothing
U1
ABD
Market basket Ais preferred to B.Market basket B ispreferred to D.
Chapter 3 10©2005 Pearson Education, Inc.
Indifference Maps (pp. 65 - 79)
� Indifference maps give more informationabout shapes of indifference curves�Indifference curves cannot cross
� Violates assumption that more is better
�Why? What if we assume they can cross?
Chapter 3 11©2005 Pearson Education, Inc.
Indifference Maps (pp. 65 - 79)
Food
Clothing
•B is preferred to D•A is indifferent to B & D•B must be indifferent toD but that can’t be if B ispreferred to D. Acontradiction•Other example: On a map, twocontours never crosseach other.
U1
U1
U2
U2
A
B
D
Chapter 3 12©2005 Pearson Education, Inc.
Indifference Curves (pp. 65 - 79)
� The shapes of indifference curvesdescribe how a consumer is willing tosubstitute one good for another�A to B, give up 6 clothing to get 1 food
�D to E, give up 2 clothing to get 1 food
� The more clothing and less food a personhas, the more clothing they will give up toget more food
Chapter 3 13©2005 Pearson Education, Inc.
A
B
D
EG
-1
-6
1
1
-4
-21
1
Observation: The amountof clothing given up for 1 unit of food decreasesfrom 6 to 1
Indifference Curves (pp. 65 - 79)
Food
Clothing
2 3 4 51
2
4
6
8
10
12
14
16
Chapter 3 14©2005 Pearson Education, Inc.
Indifference Curves (pp. 65 - 79)
�We measure how a person trades onegood for another using the marginal rateof substitution (MRS)�It quantifies the amount of one good a
consumer will give up to obtain more ofanother good, or the individual terms of trade
�From a geometric viewpoint, it is measuredby the slope of the indifference curve
Chapter 3 15©2005 Pearson Education, Inc.
Marginal Rate of Substitution (pp. 65
- 79)
Food2 3 4 51
Clothing
2
4
6
8
10
12
14
16 A
B
D
EG
-6
1
1
11
-4
-2-1
MRS = 6
MRS = 2
FCMRS Δ
Δ−=
Chapter 3 16©2005 Pearson Education, Inc.
Marginal Rate of Substitution (pp. 65
- 79)
From A to B, give up 6 clothing to get 1 food.That is,
ΔF=2-1=1, ΔC=10-16 =-6; MRS=- ΔC / ΔF=6
From D to E, , give up 2 clothing to get 1 food;ΔF=4-3=1, ΔC=4-6 =-2; MRS =- ΔC / ΔF= 2
Chapter 3 17©2005 Pearson Education, Inc.
Marginal Rate of Substitution (pp. 65
- 79)
� Indifference curves are convex�As more of one good is consumed, a consumer would
prefer to give up fewer units of a second good to getadditional units of the first one. As food becomes lessscarce, he/she would give up less of clothing for anadditional food.
� Consumers generally prefer a balanced marketbasket (preference for varieties; the Doctrine ofthe Mean in a Chinese classic)
Chapter 3 18©2005 Pearson Education, Inc.
Marginal Rate of Substitution (pp. 65
- 79)
� The MRS decreases as we move downthe indifference curve�Along an indifference curve there is a
diminishing marginal rate of substitution.
�The MRS went from 6 to 4 to 1
Chapter 3 19©2005 Pearson Education, Inc.
Marginal Rate of Substitution (pp. 65
- 79)
� Indifference curves with different shapesimply a different willingness to substitute
[That is, an indifference map is a conceptto represent one’s preference for marketbaskets.]
� Two polar cases are of interest�Perfect substitutes
�Perfect complements
Chapter 3 20©2005 Pearson Education, Inc.
Marginal Rate of Substitution (pp. 65
- 79)
�Perfect Substitutes�Two goods are perfect substitutes when the
marginal rate of substitution of one good forthe other is constant
�Example: a person might consider applejuice and orange juice perfect substitutes� They would always trade 1 glass of OJ for 1
glass of Apple Juice
� Find your own examples.
Chapter 3 21©2005 Pearson Education, Inc.
Consumer Preferences (pp. 65 - 79)
Orange Juice(glasses)
Apple Juice
(glasses)
2 3 41
1
2
3
4
0
PerfectSubstitutes
Chapter 3 22©2005 Pearson Education, Inc.
Consumer Preferences (pp. 65 - 79)
�Perfect Complements�Two goods are perfect complements when
the indifference curves for the goods areshaped as right angles
�Example: If you have 1 left shoe and 1 rightshoe, you are indifferent between havingmore left shoes only� Must have one right for one left. That’s why we
always get a pair of shoes, not one by one.
� Find your own examples.
Chapter 3 23©2005 Pearson Education, Inc.
Consumer Preferences (pp. 65 - 79)
Right Shoes
LeftShoes
2 3 41
1
2
3
4
0
PerfectComplements
Chapter 3 24©2005 Pearson Education, Inc.
Consumer Preferences:An Application (pp. 65 - 79)
� In designing new cars, automobileexecutives must determine how muchtime and money to invest in restylingversus increased performance�Higher demand for car with better styling and
performance
�Both cost more to improve
Chapter 3 25©2005 Pearson Education, Inc.
Consumer Preferences:An Application (pp. 65 - 79)
�An analysis of consumer preferenceswould help to determine where to spendmore on change: performance or styling
�Some consumers will prefer better stylingand some will prefer better performance
� In recent years we have seen more andmore SUVs on our roads. Certainly moreowners/drivers prefer SUVs to otherstyles.
Chapter 3 26©2005 Pearson Education, Inc.
Consumer Preferences (pp. 65 - 79)
� The theory of consumer behavior doesnot required assigning a numerical valueto the level of satisfaction. Can you tellthe level of satisfaction from your monthlybasket?
�Although ranking of market baskets isgood, sometimes numerical value isuseful
Chapter 3 27©2005 Pearson Education, Inc.
Consumer Preferences (pp. 65 - 79)
�Utility�A numerical score (concept) representing the
satisfaction that a consumer gets from agiven market basket. The concept of utility wasborn before that of consumer preference.
�If buying 3 copies of Microeconomics makesyou happier than buying one shirt, then wesay that the books give you more utility thanthe shirt
Chapter 3 28©2005 Pearson Education, Inc.
Utility (pp. 65 - 79)
�Utility function�Formula that assigns a level of utility to
individual market baskets
�If the utility function is
U(F,C) = F + 2CA market basket with 8 units of food and 3 units of
clothing gives a utility of
14 = 8 + 2(3)
Chapter 3 29©2005 Pearson Education, Inc.
Utility - Example (pp. 65 - 79)
4 + 2(4) = 1244C
6 + 2(4) = 1446B
8 + 2(3) = 1438A
UtilityClothingFoodMarketBasket
Consumer is indifferent between A & B andprefers both to C.
Chapter 3 30©2005 Pearson Education, Inc.
Utility - Example (pp. 65 - 79)
�Baskets for each level of utility can beplotted to get an indifference curve�To find the indifference curve for a utility of
14, we can change the combinations of foodand clothing that give us a utility of 14
Chapter 3 31©2005 Pearson Education, Inc.
Utility - Another Example (pp. 65 - 79)
Food10 155
5
10
15
0
Clothing
U1 = 25
U2 = 50
U3 = 100A
B
C
Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5)
Chapter 3 32©2005 Pearson Education, Inc.
Utility (pp. 65 - 79)
� Although we numerically rank baskets andindifference curves, numbers are ONLY forranking
� A utility of 4 is not necessarily twice as good asa utility of 2. A umber assigned to a utility levelDOES NOT have any meaning.
� There are two types of rankings�Ordinal ranking; Ordinal Utility Function Think of a number on your ticket when you are in a
waiting line.�Cardinal ranking; Cardinal Utility Function Think of the total number of students in this class.
Chapter 3 33©2005 Pearson Education, Inc.
Budget Constraints (pp. 79 - 83)
�Preferences do not explain all ofconsumer behavior
�Budget constraints limit an individual’sability to consume in light of the pricesthey must pay for various goods andservices
Chapter 3 34©2005 Pearson Education, Inc.
Budget Constraints (pp. 79 - 83)
� The Budget Line (Constraint)�Indicates all combinations of two
commodities for which total money spentequals total income
�We assume only 2 goods are consumed, sowe do not consider savings
Chapter 3 35©2005 Pearson Education, Inc.
The Budget Line (pp. 79 - 83)
� Let F equal the amount of foodpurchased, and C is the amount ofclothing
�Price of food = PF and price ofclothing = PC
� Then PFF is the amount of money spenton food, and PCC is the amount of moneyspent on clothing
Chapter 3 36©2005 Pearson Education, Inc.
ICPFPCF =+
The Budget Line (pp. 79 - 83)
� The budget line then can be written:
All income is allocated to food (F) and/or clothing(C)
Chapter 3 37©2005 Pearson Education, Inc.
The Budget Line (pp. 79 - 83)
�Different choices of food and clothing canbe calculated that use all income�These choices can be graphed as the budget
line
�Example:�Assume income of $80/week, PF = $1 and PC
= $2
Chapter 3 38©2005 Pearson Education, Inc.
Budget Constraints (pp. 79 - 83)
$80080G
$801060E
$802040D
$803020B
$80400A
IncomeI = PFF + PCC
Clothing
PC = $2
Food
PF = $1
MarketBasket
Chapter 3 39©2005 Pearson Education, Inc.
C
F
P
P
F
C Slope -
2
1- ==
Δ
Δ=
The Budget Line (pp. 79 - 83)
10
20
A
B
D
E
G
(I/PC) = 40
Food40 60 80 = (I/PF)20
10
20
30
0
Clothing
Chapter 3 40©2005 Pearson Education, Inc.
The Budget Line (pp. 79 - 83)
�As consumption moves along a budgetline from the intercept, the consumerspends less on one item and more on theother
� The slope of the line measures therelative cost of food and clothing
� The slope is the negative of the ratio ofthe prices of the two goods
Chapter 3 41©2005 Pearson Education, Inc.
The Budget Line (pp. 79 - 83)
� The slope indicates the rate at which thetwo goods can be substituted withoutchanging the amount of money spent
It represents exchange ratio or terms oftrade in market places.
�We can rearrange the budget lineequation to make this more clear
Chapter 3 42©2005 Pearson Education, Inc.
The Budget Line (pp. 79 - 83)
YXP
P
P
I
YPXPI
YPXPI
Y
X
Y
YX
YX
=−
=−
+=