Introduction to Economics Lecture# 5 Consumer behavior Ordinal Approach/ Indifference Curve...

Introduction to Economics

Lecture# 5

Consumer behavior

Ordinal Approach/ Indifference Curve Analysis

Indifference Curves

• Indifference analysis is an alternative way of explaining consumer choice that does not require an explicit discussion of utility.

• Indifferent: the consumer has no preference among the choices.

• Indifference curve: a curve showing all the combinations or bundle of two goods which yield the same level satisfaction to the consumer so that he is indifferent among these combination.

• We can say that these bundles of consumption make the consumer equally happy.

Shape of Indifference Curve

• The indifference curves are not likely to be vertical, horizontal, or upward sloping.

• A common shape for an indifference curve is downward sloping.– For the consumer to be indifferent to the bundle of

goods chosen, as less of one good is consumed, more of another must be consumed to remain equally happy.

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Shape of Indifference

Curve


Slope of Indifference Curve

• The slope or steepness of indifference curves is determined by consumer preferences.– It reflects the amount of one good that a consumer

must give up to get an additional unit of the other good while remaining equally satisfied. It is known as Marginal Rate of Substitution (MRS)

– This relationship changes according to diminishing marginal utility—the more a consumer has of a good, the less the consumer values an additional value of that good. This is shown by an indifference curve that bows in toward the origin. This notion is known as Diminishing Marginal Rate of Substitution DMRS


Indifference Map

• An indifference map is a complete set of indifference curves.

• It indicates the consumer’s preferences among all combinations of goods and services.

• The farther from the origin the indifference curve is, the more the combinations of goods along that curve are preferred. It means higher indifference curves will be preferred to lower ones


Indifference Map

Assumptions of Indifference Curve Theory

• Rationality: it is assumed that consumer is rational _means has full knowledge about market conditions and aware of his costs and benefits.

• Utility is Ordinal: this theory assumes that consumer can rank all his preferences according to the level of satisfaction without precisely quantifying the utility.

• Consistency: It is assumed that consumer is consistent in his choice, if in one period he prefers bundle A over B he will never choose B over A in another period if both bundles are available to him

• Transitivity: consumer choices should be transitive. If bundle A is preferred to B , and b is preferred to , Then bundle A must be preferred to C. Symbolically it means

If A > B ,and B >C , then A >C

Properties of Indifference Curve

• Higher indifference curves are preferred to lower ones. As higher indifference curve represent larger quantities of goods than the lower ones

• Indifference curves are downward sloping. If a consumer wants to increase the quantity of one thing he has to reduce the units of other products

• Indifference curves are bowed inward. The diminishing marginal rate of substitution causes the indifference curve to bow inward or convex to the origin

Indifference curves do not cross

• Indifference curves cannot cross.• If the curves crossed, it would

mean that the same bundle of goods would offer two different levels of satisfaction at the same time. (C & B)

• If we allow that the consumer is indifferent to all points on both curves, then the consumer must not prefer more to less.

• There is no way to sort this out. The consumer could not do this and remain a rational consumer


Budget Constraint

• The indifference map only reveals the ordering of consumer preferences among bundles of goods. It tells us what the consumer is willing to buy.

• It does not tell us what the consumer is able to buy. It does not tell us anything about the consumer’s buying power.

• The budget line shows all the combinations of goods that can be purchased with a given level of income.

Numerical Examplesuppose Px=2, Py=1, I=10

Combinations Commodity X Commodity Y Income constraintXPx+ YPy= I

A 0 10 0(2)+10(1)=10

B 1 8 1(2)+8(1)=10

C 2 6 2(2)+6(1)=10

D 3 4 3(2)+4(1)=10

E 4 2 4(2)+2(1)=10

F 5 0 5(2)+0(1)=10


Consumer Equilibrium

• The indifference map in combination with the budget line allows us to determine the one combination of goods and services that the consumer most wants and is able to purchase. This is the consumer equilibrium.

• It means consumer will be in equilibrium when higest indifference curve will touch the lowest budget line or the slopes of both curves is same. Symbolically this point of tangency of both curves can be expressed as

MRS or Dy/Dx= Px/Py


Consumer Equilibrium

The consumer maxi-mizes satisfaction by purchasing the combination of goods that is on the indifference curve farthest from the origin but attainable given the consumer’s budget.


Deriving the Individual Demand Curve

By changing the price of one of the goods and leaving everything else the same, we can derive the demand curve.

In (a), the price of a gallon of gasoline doubles, rotating the budget line from Y1 to Y2. The consumer equilibrium moves from point C to E, and the quantity demanded of gasoline falls from 3 to 2.

Introduction to Economics Lecture# 5 Consumer behavior Ordinal Approach/ Indifference Curve...

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