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The Indifference
Curve Approach
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A. An economic agent behaves rationally.
Significance:Thus, economic investigation is
possible and meaningful.
Meaning:Behaviour of an economic agent
has objectives and involves a prudentchoice among alternative means. In other words,
consumer behaviour is not random or arbitrary.
It has patterns and can be explained.
What are the basic postulates of consumer behaviour?
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Then how does an individual make his choice?
B. Postulate of constrained maximization / self -
interest / self ishness
Meaning:An economic agent always chooses the
option that maximizesthe achievement of his goals
among the options allowed by existing constraints.Significance:Without a postulate on economic choice,
there is no economics. Without a confirmed postulate
on economic choice, economics might not have
survived.
Note: This isthe most important & most useful postulate in
economics.
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C. Each individual has many wants.
Significance:Hence choice and exchange may
arise.D. To each individual, some goods are scarce.
Significance:Hence competition and choice are
inevitable. They constitute the main content of
economics.
Competition Choice
Scarcity
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E. Scarce goods are substi tutable
Meaning:One is willingto forgosomethingto getmore of the scarce goodsubstitution,provided that the value got is larger than the
cost paid.
Significance:Exchangeis possible.
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F. The law of diminishing MRS
Marginal rate of substitution (MRS): is the
maximumamountof good Y that an individual is
wil l ing to forgoforan additional uni tof good X.
It is equal to marginal use value (MUV)of goodX in terms of good Y.
The law states that MRS or MUV of a good
declinesas moreunits of the good are obtained,
ceteris paribus.
Significance:(Both interior and corner solutions are
possible.)
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Good, Bad and Neuter
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A goodis something desired,
i.e., _________ is preferred to _________.nonesome
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Goods
Free goods Scarce goods
(economic goods)
Types of goods:
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Free good: Features
its amount availableis ______ than its
amount desiredat zero price,
i.e., ________ is preferred.
something desired
no more
more
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Scarce good(economic good):Features
something desired
its amount availableis _____ than its amountdesiredat zero price,
i.e., ______ is preferred to _____.
less
more less
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Depends on situationsrather than kinds.
Any examples?
Distinction between free goods and scarce goods:
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Distinction between free goods and goods free-of-charge:
A free goodmust bea good free-of-charge. Why?
A good free-of-chargemay not bea free good. Why?
its amount available is more than its amount desired.
no one desires to have more of it
no production nor exchange takes place zero-priced.
a scarce good can also be free-of-charge if someone
pays the cost for you. Any examples?
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Is sickness bad ?
more
A badis something undesired,
i.e., _________ is preferred to _________.less
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A neuteris something neither
desirednorundesired,
i.e., the quantitydoes not matter.
Any examples?
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Utility
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What is utility?
Utilityis a number
arbitrar i ly assignedto entities to rankthem
according to ones preference.
a criterion ofmaximizationto rank options for makingchoice.
the higherthe utility, the moreone prefersthe entity.
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What is uti l i ty?
Utilityreflects preference
social welfare happiness / satisfaction
Why?
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Measurement ofutility
Ordinal utility
only reflects an
order
but the difference
betweenthe numbersassigned ismeaningless
Cardinal utility
can also reflect
an order
and the differencebetween
the numbersassigned ismeaningful
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Measurement of uti l i ty
Which measurement of utility is used
in the indifference curve approach?
Ordinal measure of uti l i ty
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Indifference Curve
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What is an indifferencecurve?
U=10
An indifference curve(IC, is a line
joining all the points (representing
different baskets of goods) giving the
same utility to an individual.
Good X
Good Y
0
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What is an indifference
map?An indifference mapis a set
of ICs showing the
__preference_______of anindividual.
U=10U=20
U=30
Good Y
Good X0
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Properties of IndifferenceCurves of Two Goods
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1. ICs of two goods are negativelysloped
U=10
Good Y
Good X0
+X
-Y
Keeping utility constant, along an IC,a basket with more units of good X
must have _____ units of good Y.fewer
negative
(Options: more / fewer /
positive / negative)
Slope of an IC of two goods (=Y/ X)must be ________.
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2. Indifference curves arecontinuous
If quantities of good X and good Y can be
increased or decreased by infinitesimal amounts,
the ICs are continuous. Why?
U=10
Good Y
Good X0
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3. Indifference curves can neverintersect
Along U2: point A = point C = U2
Along U1: point A = point B = U1
What is the uti l i ty ofpoint A, =U1orU2?
U of the intersection pointlogical contradiction
A
B
C
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4. Full
coverage
U1U2
U3
Good Y
Good X0
The higher the IC ,
the higher the utility
(U3 > U2 > U1). Why?
If a consumerknows hispreference on every
basket of commodities, the commodity plane
will be fully covered by ICs. Why?
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5. Indifference curves of twogoods are convex to the origin
U1
ood Y
Good X0
+1X
-Y
As the consumption of good X rises,
MRS (the slope)falls. Why?
convex
As the IC becomes
f latter & flatter, its shape is
_______ to the origin.
The numerical value of the slopeof an IC
(+1X -?Y) is equal to the MRS. Why?
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Other Shapes of
Indifference Curves
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1. X is a neuter and Y is agood
Y (A good)
X(A neuter)0
U2
U1
U3
U3>U2>U1Any increase or
decrease in the quantity
of X makes no difference
to the consumer.
Why?
ICs are___________.horizontal
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ICs are _________slopingwith a/an _________slope.
2. X is a bad and Y is a good
U3>U2>U1
U1U2
U3
0
Y (A good)
X (A bad)
Why?
upwardincreasing
+X
+Y
To keep U constant,
in a bad (+X) requires
in a good (+Y) as a compensation.
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3. X is a commodity with a satiation threshold
(beyond which X turns from a good to a bad)
0
Good Y
X
U1
U2
U3
U3>U2>U1
X becomes a badX is a good
ICs are__________.
Why?
U-shaped
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4. X and Y are perfect substi tutes
Good X (pack of 5 kg rice)
Good Y (pack of 8 kg rice)
0 U1 U2 U3
U3>U2>U1
ICs are _________ sloping
_______ lines.
Why?
downward
straight
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5. X and Y are perfect complements
Good Y (left shoes)
Good X (right shoes)0
ICs are__________.
45o U3>U2>U1
U1
U2
U3Why?
right-angled
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Budget Line
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It is also called the budget constraint.
What is a budget line?
Budget l ine (BL )orconsumption possibil i ty curveisa
boundary showing the largest possible combinations of
goods that a consumer can buyin a market,givenhis money income and market pr ices of the goods.
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Y
X0
Given I = Rs.100, PX
= Rs.20 & PY
= Rs.25 The maxi.amount of X one can buy = Rs.100/Rs.20 = 5
Rs.100/Rs.25= 4
Rs.20/Rs.25=.8
4
5
+1X
-0.8Y
Derivation of a BL:
To buy 1 more unit of X, one
forgoes = unit of Y.
The maxi. amount of Y one can buy
=
The BL is a downwardsloping straight line.
The slope of BL = costof
consuming an additional unit ogood X in terms of good Y.
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Features:
Y
X0
A
CB
Point A:Expenditure ____ Income
Point B:Expenditure ____ IncomePoint C:Expenditure ____ Income
(Options: > = < )
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Equation of budget line
X PX+ Y PY= I
Expenditure
on good X
Expenditure
on good Y
Money income
of the consumer
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Changes in budget constraints
1. Changes in income
When ones income
increases, the budgetline will shift ______
in a parallel manner,
and vice versa.
Y
0 X
outward
Why?
in income
in income
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2. Proportionate changes in
prices
Y
0X
When prices of both
goodsrise
by the sameproportion, the budget
line will shift _______
in a parallel manner,
and vice versa.
inward
Why?
A proportionate
in all money prices
A proportionate
in all money prices
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3. Disproportionate changes inprices
Y
0X
A rise in Px
A fall in Px
til t inward
til t outward
When PX, the budget line
will _________ and become
steeper. Why?
When PX, the budget
line will __________ and
become _______. Why?flatter
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What is a consumer
equilibrium?
Optimumorequilibrium is the best choiceof
an economic agent in achieving his objective.
Optimali ty conditionsorequi l ibr ium Conditions
are descriptions on the defining featuresof the
optimum or the equilibrium.
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I nter ior solution
When a consumerbuys both goodsX & Y,
i.e., the equilibrium is not one of the _________on the budget l ine, the equilibrium is called
an inter ior solution.
intercepts
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It is the tangency
point, the only point on
the budget line reaching
the highest IC attainable.U1
U3
Y
X0
U3>U2>U1
X*
Y*
From observation, the
best choice achievable is
_____________.
Equi l ibr ium: From observation
E*
U2
E* (X* , Y* )
Why?
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Equi l ibr ium conditions:
U1U2
U3
Y
X0
U3>U2>U1
E*
X*
Y*
1. The consumer
equilibrium mustlie____the BL.
2. The consumer
equilibrium is the____________at which
the slope of IC equals
the slope of BL.
on
tangency point
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Slope of indifference curve Slope of budget line
1. =Y/X, holding util ityconstant
=Y/X, holding expenditureor income constant
2. = Marginal rate of substitution
in consumption, MRSc
= Marginal rate of substitution
in exchange, MRSe
Meaning of the slopes
3. = The maximum amountof Y
one is wil l ing to payfor an
additional unit of X
= The actual amountof Y one
is requi red to payfor an
additional unit of X in exchange
4. = Cost / Value?of an
additional unit of X in terms
of Y (=MUV)
=Cost / Value?of consuming
an additional unit of X in terms
of Y (= Px/Py)
Value Cost
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How is the consumer equilibriumreached?
Buy X
At point A, MRSc>MRSe (_______of an
additional X >its ________), utility can be
raised if the consumer _________ units of X.
U2
U1
Y
X0
A
buys more
(Options: buys more /
sells some /
value / cost )
value
cost
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Sell XU2
U1
Y
X0
At point B,MRSc
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U2
U1
Y
X0
MRSc=MRSe (value = cost),
utility is maximized &
the equilibrium is attained.
E*
How is the consumer equi l ibrium reached?
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Changes in
Consumer Equilibriumin Response toChanges in Constraints
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A. Changes in
income
When income with PX and PY unchanged,
the BL will shift in a parallel manner.
The effect of income on the consumption of a
consumer can be shown by 2 curves:
1. I ncome consumption curve
2. Engel curve
outward
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1. Income consumptioncurve
I ncome consumption
curve(ICC) is a line
joining all the
equilibrium(X,Y) of aconsumer when ones
incomechanges, holding
PX and PY constant.
ICCY
0 X
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Engel curveis
a line showing the
consumptionof agoodat different
incomelevels,
holding PX and PY
constant.
X
0Income
Engel
curve
2. Engel curve
I1 I2 I3
X3
X2
X1
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Y
X
ICC
A. Super ior good:
I ts consumption ispositively relatedto income.X
Income
Engel
curve
X1 X2 X3
X3
X2
X1
I1 I2 I3
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ICC
Y
X
B. I nfer ior good:
I ts consumption isnegatively relatedto income.X
I
Engel curve
X3X2X1
X1
X2
X3
I1 I2 I3
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B. Changes in price
The effect of price on the consumption of a
consumer can be shown by 2 curves:
1. Price consumption curve
2. Demand curve
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PCC
Price consumption
curveis a linejoining
all the equi l ibr iumofa consumerwhen PX
changes, holding I & PY
constant.
1. Price consumption curveY
0 X
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Px1
Px3
Px2
Y
0Px
0 X
X
PCC
Demand
Curve
X1 X2 X3 X4
If price (Px) &
quantity demanded
(X) of the good are
negatively related.
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Px1
Px2
PCC
Y
0X
Px
0 X
DemandCurve
Giffen paradox
If price (Px) &
quantity demanded
(X) of a good are
_________ related,the good is calleda
Giffen good.
positively
X1X2
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Decomposition of
the Price Effect into
the Substitution Effect &
the Income Effect
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Price effect
Price effectis the overallchange
in the quantity demandedof a good
caused by achange in its price,holdingmoney income constant.
Price effect can be decomposed into___________ effectand__________ effect.substitution income
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PxOne will buy moregood X to substi tutegood Y
S.E.
L3X3
E3
Y
0 X
E1
L1X1
So substitution effect must be negative.
Substi tution effectis the change in the quantity
demanded of a good caused by a change in its price,
holding util i ty or real income constant.
New equi l ibr ium
L2
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I.E.
L2
X2
Y
0X
S.E.
E3
E1
L1 L3
X3X1
Using thesavedincome
The saved income will raise
the consumption of good X
if good X is a superior good.
E2
I ncome effectis the change in the quantitydemanded of a good as a result of a change in real
incomecaused by a change in its price.When Px, income is saved. Income
is further saved by the S.E. as the
consumption of an expensive good is
substituted by the consumption of
a cheaper good.
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Price effect of different kinds of goods
S.E.
Positive I.E.
Y
X
E1
L1 L2L3
E3
E2
2. I f good X isa super ior
good,what wil l be theincome effect?
3. And what wil l be the
price effect?
1. Thesubsti tution effect
must be negative.
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S.E.
L3 L2
Negative I.E.Y
0 XL1
E1
2. I f X isan infer ior good
with its-ve I .E.< S.E.,
what wi l l be the price effect?
E3
E2
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S.E.
L1 L3 L2
E3
Y
0 X
E1
Negative I.E. 3. I f X isan infer ior goodwith its-ve I .E.>S.E.,
(cal led Giffen good),what wi ll be the price effect?
E2
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Postulate of utility maximization
Ifthe utility and the cost of each option
can be measured or asserted beforehand
the postulate can generate refutable predictionsand
it isusefulif it is not refuted.
cannot be measured or asserted beforehand
the postulate cannot generate refutable predictions,
then it becomestautological and uselessin explanation
and prediction.
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When a consumerbuys one good only, i.e., the
equilibrium is one of the interceptson the budget line,
the equilibrium is called a corner solution.
There is a___________________ in consumption.specialization
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Possible reasons for a corner solution are:
3. MRS is not decreasing.
1. The good is too expensive.2. The entity is a bad.
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E*
Y (A good)
X (A good but
too expensive)
MRSc (= value)
MRSe (= cost)
U1
U3
U2
U3>U2>U1
1. The good is too expensive
>
1X
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Y (A good)
X (A bad)
U1
U3U2
E*
0
U3>U2>U1
2. The enti ty is a bad
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Y (A good)
X (A good)
U1
U3
U2
E*
0
I ncreasing MRS
U3>U2>U1
3. MRS is not decreasing
Constant MRS
Y (A good)
X (A good)
U1
U3
U2
E*
0
U3>U2>U1
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4. Uti l i ty of a good must be a positive number
and that of a bad must be negative.
5. Postulate of uti l i ty maximization is tautological.
6. A straight-l ine indifference curve denies
the postulate of substi tution.
Correcting M isconceptions:
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7. A concave indifference map cannot have
consumer equi l ibrium or can have an inter ior
solution.
8. A good with its price and quanti ty demanded
negatively related is a normal good.
9. Holding money income constant is the same asholding real income constant.
Correcting M isconceptions:
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10. Substitution effect is positive for super ior good
and negative for infer ior good.
11. Giffen good has no relation with infer ior good.
Correcting M isconceptions: