In economic parlance, In economic parlance, preferencepreference and and choicechoice are are two distinct but related terms. two distinct but related terms. – II may have desire to buy a particular car, but cannot may have desire to buy a particular car, but cannot

buy it unless I have economic resources to buy it.buy it unless I have economic resources to buy it. Extent of satisfaction that a person gets after Extent of satisfaction that a person gets after

consuming any product/service is called as consuming any product/service is called as utilitutility.y. – utility denotes utility denotes satisfaction.satisfaction.

Utility is a Utility is a subjective conceptsubjective concept that cannot be that cannot be measured, bt can just be compared. Given the measured, bt can just be compared. Given the limited resources, a consumer can compare the limited resources, a consumer can compare the utility of 2 goods or services from which he utility of 2 goods or services from which he makes a choice. Thus, helping a consumer to makes a choice. Thus, helping a consumer to make better choices. make better choices.

The The want satisfying powerwant satisfying power of commodity is of commodity is utility.utility.

Same commodity gives Same commodity gives differentdifferent utility to utility to differentdifferent consumers. consumers.

Even for the same consumer, utility varies Even for the same consumer, utility varies from from unit to unitunit to unit, from , from time to timetime to time and and from from place to placeplace to place..

– Cardinal utility approach:Cardinal utility approach: based on Marshallian school of thought. based on Marshallian school of thought. It says that It says that utility can be measuredutility can be measured. . It has come out with a unit called It has come out with a unit called utilutil to measure to measure

the utility. Util reveals how much of money a the utility. Util reveals how much of money a consumer is willing to pay for a given unit of consumer is willing to pay for a given unit of product.product.

– Ordinal utility approach:Ordinal utility approach: based on view that utility based on view that utility cannot be measured at cannot be measured at

allall; ; it can just beit can just be ranked ranked in order of preferences. in order of preferences. This approach is based on the assumption that a This approach is based on the assumption that a

customer is consistent in ranking and preference customer is consistent in ranking and preference is based on the choice of products available.is based on the choice of products available.

Alfred Marshall (1890) introduced the Alfred Marshall (1890) introduced the Cardinal Utility Theory also known as Cardinal Utility Theory also known as Marshallian Utility Theory.Marshallian Utility Theory.

It assumes that customers make a It assumes that customers make a rational rational choicechoice..– Customers choose goods and services that Customers choose goods and services that

give them maximum satisfaction considering give them maximum satisfaction considering their tastes and preferences and the their tastes and preferences and the resource constraints. resource constraints.

consumers always consumers always prefer more quantityprefer more quantity. . – Example:Example: If there are two options, option A If there are two options, option A

(3 biscuits and 10 chocolates and option B (3 (3 biscuits and 10 chocolates and option B (3 biscuits and 12 chocolates), then consumers biscuits and 12 chocolates), then consumers will always prefer option B, since the will always prefer option B, since the quantity is more.quantity is more.

– defined as the amount of utility a person derives defined as the amount of utility a person derives from the consumption of a particular product in a from the consumption of a particular product in a given period. given period.

– The sum- total of satisfaction which a consumer The sum- total of satisfaction which a consumer derives by consuming various units of a derives by consuming various units of a commodity.commodity.

Nature of Total UtilityNature of Total Utility::– More units of a good he consumes, greater will be More units of a good he consumes, greater will be

his TU or satisfaction from it up to a certain point.his TU or satisfaction from it up to a certain point.– As he keeps on increasing the consumption of the As he keeps on increasing the consumption of the

good, he eventually reaches the point of saturation good, he eventually reaches the point of saturation represented by the maximum total utility. represented by the maximum total utility.

– If further units of the commodity are consumed, If further units of the commodity are consumed, his total utility starts declininghis total utility starts declining

Defined as the change in total utility resulting from Defined as the change in total utility resulting from 1 unit change in the consumption of the good.1 unit change in the consumption of the good.

MU MU x x = = ΔΔTU TU x x / / ΔΔ Q Qxx

MU MU x x -- Marginal utility-- Marginal utility

ΔΔTU TU xx – change in total utility – change in total utility

ΔΔ Q Qx x –change in quantity of good X respectively–change in quantity of good X respectively

MU of nth Unit = TU n - TU n-1MU of nth Unit = TU n - TU n-1

Another way of finding marginal utility is by Another way of finding marginal utility is by differentiating total utility function:differentiating total utility function:

MUMUx x = dTU = dTU x x / dQ / dQxx

Quantity Quantity of ice-of ice-cream cream

consumeconsumedd

Total Total utilityutility

MarginaMarginal utilityl utility

00 00 --11 66 6622 1010 4433 1313 3344 1414 1155 1414 0066 1212 -2-2

In the given table, the behavior or total In the given table, the behavior or total utility schedule of person consuming utility schedule of person consuming ice-cream can be observed.ice-cream can be observed.

It can be observed that total utility It can be observed that total utility increases initially, later it become increases initially, later it become constant after reaching a certain point. constant after reaching a certain point. Subsequently it starts declining. It can Subsequently it starts declining. It can be seen that when a person starts be seen that when a person starts consuming ice-cream, his total utility is consuming ice-cream, his total utility is increasing initially. When the person had increasing initially. When the person had consumed 5consumed 5thth unit of ice-cream, total unit of ice-cream, total utility stopped increasing. On utility stopped increasing. On consumption of the 6consumption of the 6thth unit, total utility unit, total utility started decreasing.started decreasing.

Marginal utility starts decreasing as the Marginal utility starts decreasing as the consumer starts consuming more units consumer starts consuming more units of a product. If you refer to the above of a product. If you refer to the above table, the marginal utility became zero, table, the marginal utility became zero, when the person has consumed 5when the person has consumed 5thth unit. unit. Subsequent consumption leads to Subsequent consumption leads to negative marginal utility.negative marginal utility.

As consumption increases, As consumption increases, TU rises but TU rises but MU falls.MU falls.

When When TU is maximum, MU falls to zeroTU is maximum, MU falls to zero.. When When TU starts falling, MU becomes TU starts falling, MU becomes

negativenegative.. MU declines as consumer starts consuming MU declines as consumer starts consuming

more units of a particular commodity. It can be more units of a particular commodity. It can be noted in the earlier example that, when the TU noted in the earlier example that, when the TU reaches its’ maximum, MU becomes zero. The reaches its’ maximum, MU becomes zero. The decline in the total utility takes place when decline in the total utility takes place when marginal utility becomes negative. marginal utility becomes negative. 

for any individual consumer the value that he for any individual consumer the value that he attaches to successive units of a particular attaches to successive units of a particular commodity will diminish steadily as his total commodity will diminish steadily as his total consumption of that commodity increases, the consumption of that commodity increases, the consumption of all other goods being held constant.”consumption of all other goods being held constant.” (R. G. Lipsey)(R. G. Lipsey)– As consumer consumes extra units of a given good As consumer consumes extra units of a given good

at a given time, his desire for every successive unit at a given time, his desire for every successive unit becomes becomes less intenseless intense, thus utility derived from , thus utility derived from successive unit diminishes.successive unit diminishes.

– the extra or MU declines as a person consumes the extra or MU declines as a person consumes more and more of any particular good. The TU more and more of any particular good. The TU grows at a slower rate, when a person consumes grows at a slower rate, when a person consumes more and more of a good. TU grows at a slower more and more of a good. TU grows at a slower rate as the MU starts diminishing with each rate as the MU starts diminishing with each additional unit consumed. The diminishing MUis a additional unit consumed. The diminishing MUis a result of the fact that person’s enjoyment of a good result of the fact that person’s enjoyment of a good decline as more and more of the good is decline as more and more of the good is consumed. consumed.

1) Various units of goods are 1) Various units of goods are homogeneous.homogeneous.2) No time gap between consumption of 2) No time gap between consumption of different unitsdifferent units3) Tastes, preferences and fashions 3) Tastes, preferences and fashions remain unchangedremain unchanged4) Consumer is rational ( i.e has complete 4) Consumer is rational ( i.e has complete knowledge and maximizes utility)knowledge and maximizes utility)

If the above conditions holds good, law If the above conditions holds good, law holds good universally.holds good universally.

Equilibrium for one product: Equilibrium for one product: ((consumption of all other product remains constant)consumption of all other product remains constant)

The utility maximizing consumer will adjust The utility maximizing consumer will adjust her purchases until the MU of last unit her purchases until the MU of last unit purchased equal to the price of a unit of that purchased equal to the price of a unit of that product.product.

MU = PMU = POr, MU/P = 1Or, MU/P = 1

Equilibrium forEquilibrium for many productsmany products::To maximize utility, consumers allocate To maximize utility, consumers allocate expenditure among products so that equal expenditure among products so that equal utility is derived from the last unit of money utility is derived from the last unit of money spent on each.spent on each.

MUx/Px = MUy/Py = -------------- =MUn/ PnMUx/Px = MUy/Py = -------------- =MUn/ Pn

Law of equimarginal utility states Law of equimarginal utility states that the that the consumer will spend his money on consumer will spend his money on different products in such a way that the different products in such a way that the marginal utility of each product is marginal utility of each product is proportional to its price.proportional to its price.– Thus, level of satisfaction would be the same while Thus, level of satisfaction would be the same while

consuming the two products. A consumer with consuming the two products. A consumer with limited income has to choose between ice-cream limited income has to choose between ice-cream and a leather belt. If the leather belt costs six times and a leather belt. If the leather belt costs six times more than ice-cream, consumer would buy the more than ice-cream, consumer would buy the leather belt only when its marginal utility is at least leather belt only when its marginal utility is at least six times more than the marginal utility of ice-six times more than the marginal utility of ice-cream.cream.

In general, utility maximizing In general, utility maximizing consumer spread out their consumer spread out their expenditure until the following expenditure until the following condition holds:condition holds:

(MU x / Px ) = (MU y/ Py)(MU x / Px ) = (MU y/ Py)

Another View:Another View:

(MU x / MU y) = (Px / Py)(MU x / MU y) = (Px / Py)

Review QuestionsReview Questions

Marginal utilities of good A and B Marginal utilities of good A and B are 600 and 900, and the price of are 600 and 900, and the price of good B is Rs.120. if the consumer is good B is Rs.120. if the consumer is in equilibrium what is the price of in equilibrium what is the price of good A?good A?

Review QuestionReview Question A consumer has A consumer has

income of Rs. 24 to income of Rs. 24 to spend on 3 spend on 3 commodities X,Y and commodities X,Y and Z. The prices of X,Y Z. The prices of X,Y and Z are Rs.2, Rs.3 and Z are Rs.2, Rs.3 and Rs.5 respectively. and Rs.5 respectively. What is the optimal What is the optimal mix of X,Y and Z that mix of X,Y and Z that the consumer should the consumer should purchase? The MU purchase? The MU schedules are given schedules are given as follows: as follows:

UnitUnitss

MUxMUx MUyMUy MUzMUz

11 3030 2424 1515

22 2020 1515 1010

33 1616 99 88

44 88 66 55

55 66 33 11

66 44 11 00

Review QuestionsReview QuestionsArun has Arun has monthly budget monthly budget of Rs. 340 to be of Rs. 340 to be spent on fruit spent on fruit juices. The juices. The market price of market price of Apple, Mango Apple, Mango and Orange and Orange juices are juices are Rs.20, Rs. 40 Rs.20, Rs. 40 and Rs. 50 per and Rs. 50 per bottle, bottle, respectively. respectively. The total utility The total utility schedule for schedule for Arun is given:Arun is given:

Bottles Bottles ConsumConsumeded

Total UtilityTotal Utility

Apple Apple JuiceJuice

MangMango o JuiceJuice

OrangOrange Juicee Juice

11 7070 8080 160160

22 130130 160160 290290

33 170170 210210 410410

44 205205 250250 510510

55 230230 285285 590590

66 250250 315315 650650

77 260260 335335 680680

  Pioneered by Marshall. Pioneered by Marshall. The excess of the price which a The excess of the price which a

consumer would be willing to pay consumer would be willing to pay rather than go without a thing over rather than go without a thing over which he actually does pay, is the which he actually does pay, is the economic measure of his surplus economic measure of his surplus satisfaction.satisfaction.– can be defined as the difference can be defined as the difference

between what consumers would like to between what consumers would like to pay for a product and what they actually pay for a product and what they actually pay.pay.

1 2 3 4 6 8

1.00

2.00

3.00

9

Glasses of milk consumed per week

Pric

e o f

milk

[£

pe r

gla

ss]

Consumer’s Surplus for an Individual (Explanation see in the next slide)

0.30

75 10

Market price

Consumer’s surplus is the sum of the extra Consumer’s surplus is the sum of the extra valuations placed on each unit above the market valuations placed on each unit above the market price paid for each. price paid for each.

For the 1For the 1stst unit consumption of glass of milk, the unit consumption of glass of milk, the price the consumer is willing to pay is £3 but the price the consumer is willing to pay is £3 but the actual price which he pays is £0.30. actual price which he pays is £0.30.

Ms. Green pays the red area for the 8 glasses of Ms. Green pays the red area for the 8 glasses of milk she consumes per week when the market milk she consumes per week when the market price is £0.30 a glass. price is £0.30 a glass.

The total value she places on these 8 glasses of The total value she places on these 8 glasses of milk is the entire shaded area (red and green). milk is the entire shaded area (red and green).

Hence her consumer’s surplus is the green area.Hence her consumer’s surplus is the green area.

Consumer’s Surplus for an Individual

Limitations of Cardinal Utility ApproachLimitations of Cardinal Utility Approach OUT deals with consumer’s behavior under OUT deals with consumer’s behavior under

the assumption that utility from different the assumption that utility from different units of a good or between different goods units of a good or between different goods need only beneed only be rankable rankable and not measurable.and not measurable.

If a consumer gets more utility from bundle If a consumer gets more utility from bundle A than from bundle B, it means that the A than from bundle B, it means that the consumer will rank bundle A above bundle consumer will rank bundle A above bundle B.B.

He need not know by He need not know by how much quantityhow much quantity A A is preferred to B.is preferred to B.

This approach was originally due to Vilfredo This approach was originally due to Vilfredo Pareto and was further elaborated by John Pareto and was further elaborated by John Hicks and R.G.D. Allen.Hicks and R.G.D. Allen.

Rationality:Rationality: – A consumer aims to maximize his utility A consumer aims to maximize his utility

(subject to income and prices)(subject to income and prices) Utility is Ordinal :Utility is Ordinal :

– TheThe consumer can rank his preferences consumer can rank his preferences (order the various ‘baskets of goods’) (order the various ‘baskets of goods’) according to the satisfaction of each according to the satisfaction of each basket. He need not know precisely the basket. He need not know precisely the amount of satisfaction. amount of satisfaction.

Consistency:Consistency: – this condition requires that if a consumer this condition requires that if a consumer

prefers bundle A to bundle B, he does not, prefers bundle A to bundle B, he does not, at the same time prefers bundle B to at the same time prefers bundle B to bundle A.bundle A.

Transitivity: Transitivity: – If the consumer prefers bundle A to B and B If the consumer prefers bundle A to B and B

to C, he prefers bundle A to bundle C.to C, he prefers bundle A to bundle C. Non- satiety: Non- satiety:

– A bigger bundle is preferred to a smaller A bigger bundle is preferred to a smaller bundle.bundle.

A curve showing A curve showing different different combinationscombinations of two goods of two goods yielding the yielding the same level of same level of utility (satisfaction)utility (satisfaction) to the to the consumer is known as an consumer is known as an Indifference Curve/ Equal – Indifference Curve/ Equal – Utility Curve.Utility Curve.

Since all points on the curve Since all points on the curve yield equal satisfaction, the yield equal satisfaction, the consumer likes equally all the consumer likes equally all the combinations, and is thus combinations, and is thus indifferent between these indifferent between these combinations.combinations.

A A set of indifference curvesset of indifference curves is is called an indifference map. called an indifference map.

The further the curve from the The further the curve from the origin, the higher the level of origin, the higher the level of satisfaction it represents.satisfaction it represents.

Indifference curve is downward Indifference curve is downward slopingsloping: : – By defn, different points on an indifference By defn, different points on an indifference

curve represents the same level of utility. curve represents the same level of utility. – If we decrease the consumption of one good, If we decrease the consumption of one good,

obviously we need to increase the obviously we need to increase the consumption of the other good to attain the consumption of the other good to attain the same level of satisfaction as before the same level of satisfaction as before the change. change.

– This gives rise to a downward sloping This gives rise to a downward sloping indifference curve.indifference curve.

Indifference curve is convex to the origin:Indifference curve is convex to the origin: – Convexity of IC curve implies that the two goods can Convexity of IC curve implies that the two goods can

substitute on another, but not perfectly. As substitute on another, but not perfectly. As consumer gets additional units of good X at the cost consumer gets additional units of good X at the cost of good Y, marginal utility of good X(MUof good Y, marginal utility of good X(MUxx) decrease. ) decrease.

– On the other hand, due to reduced availability of On the other hand, due to reduced availability of good Y the marginal utility of Y(MUgood Y the marginal utility of Y(MUyy) increases. So, ) increases. So, consumer would be ready to sacrifice lesser and consumer would be ready to sacrifice lesser and lesser amount of Y for each additional unit of X.This lesser amount of Y for each additional unit of X.This gives rise to diminishing MRS.gives rise to diminishing MRS.

– In case the phenomenon of diminishing MRS holds In case the phenomenon of diminishing MRS holds good, the indifference curve would be convex to the good, the indifference curve would be convex to the originorigin

Indifference curve is convex to the Indifference curve is convex to the origin (contd.): origin (contd.): – Convexity assumption implies imperfect Convexity assumption implies imperfect

substitution among the two goods. However, substitution among the two goods. However, there are cases where the shape and slope of there are cases where the shape and slope of indifference curve will not be convex to the indifference curve will not be convex to the origin.origin. a) a) Perfect substitutesPerfect substitutes: Two goods are perfect : Two goods are perfect

substitutes if each is substituted for the other substitutes if each is substituted for the other at a constant rate, e.g. ball pen and fountain at a constant rate, e.g. ball pen and fountain pen. In other words, marginal rate of pen. In other words, marginal rate of substitution of these goods is constant. substitution of these goods is constant.

This results in a straight line downward- This results in a straight line downward- sloping IC or IC becomes a straight line with sloping IC or IC becomes a straight line with negative slope.negative slope.

– What about perfect complements?What about perfect complements?

B

A

D

EG

-1

-6

1

1

-4

-21

1

Observation: The amountof clothing given up for a unit of food decreasesfrom 6 to 1

Indifference Curves - Indifference Curves - PropertiesProperties

Food(units per week)

Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16

Question: Does thisrelation hold for givingup food to get clothing?

ICs do not intersect each other:ICs do not intersect each other:– If they did, the point of their intersection If they did, the point of their intersection

would imply two different levels of would imply two different levels of satisfaction, which is impossible.satisfaction, which is impossible.

The further away from the origin The further away from the origin an IC lies, the higher the level of an IC lies, the higher the level of satisfaction it denotes;satisfaction it denotes; – bundles of goods on a higher indifference bundles of goods on a higher indifference

curve are preferred by the rational curve are preferred by the rational consumer.consumer.

U1U2

Indifference Curves - Indifference Curves - PropertiesProperties

Food(units per week)

Clothing(units per week)

A

D

B

The consumer shouldbe indifferent betweenA, B and D. However,B contains more ofboth goods than D.

Indifference CurvesCannot Cross

U2

U3

Indifference Curves - Indifference Curves - PropertiesProperties

Food(units per week)

Clothing(units per week)

U1

AB

D

Market basket Ais preferred to B.Market basket B ispreferred to D.

MarginalMarginal Rate of Rate of SubstitutionSubstitution

The The marginal rate of substitution (marginal rate of substitution (MRSMRS)) quantifies the amount of one good a consumer quantifies the amount of one good a consumer will give up to obtain more of another good.will give up to obtain more of another good.– It is measured by the It is measured by the slope of the indifference slope of the indifference

curvecurve..

– Along an indifference curve there is a Along an indifference curve there is a diminishing diminishing marginal rate of substitution.marginal rate of substitution.

Note:Note: the MRS for AB was 6, while that for DE was 2. the MRS for AB was 6, while that for DE was 2.

Marginal Rate of Marginal Rate of SubstitutionSubstitution

Food(units per week)

Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16 A

B

D

EG

-6

1

1

11

-4

-2-1

MRS = 6

MRS = 2

FCMRS

The marginal rate of substitution of X for Y The marginal rate of substitution of X for Y (MRS(MRSx,yx,y) is defined as the number of units of ) is defined as the number of units of good Y that must be given up in exchange for good Y that must be given up in exchange for an extra unit of good X so that the consumer an extra unit of good X so that the consumer maintains the same level of satisfaction. maintains the same level of satisfaction. – The rate at which one good is substituted for The rate at which one good is substituted for

another good, while remaining on the same another good, while remaining on the same indifference curve. Thus,indifference curve. Thus,

(slope of indifference curve) = -dY / dX = (slope of indifference curve) = -dY / dX = MRS MRS MRS MRS x,yx,y = = MUy / MUx = (-) MUy / MUx = (-) ΔΔY / Y / ΔΔX X

A good is demanded by the A good is demanded by the consumer if he has consumer if he has – (i) A preference for that good, and (i) A preference for that good, and – (ii) purchasing power to buy the good.(ii) purchasing power to buy the good.

His preference pattern is represented His preference pattern is represented by a set of ICs, by a set of ICs,

His purchasing power depends upon His purchasing power depends upon his money income and market prices his money income and market prices of the goods.of the goods.

Assume that the consumer has allocated some Assume that the consumer has allocated some money to be spent on goods X and Y, whose prices money to be spent on goods X and Y, whose prices are Pare Pxx and P and Pyy , then his purchasing power can be , then his purchasing power can be represented in terms of a budget equation:represented in terms of a budget equation:

Y= PY= Px x QQxx + P + Py y QQyy

Where Y = Income or expenditure on goods X and YWhere Y = Income or expenditure on goods X and Y

QQxx and and QQy y = Quantity of good X and Y respectively = Quantity of good X and Y respectively

PPx x and P and Pyy = Prices of good X and Y respectively. = Prices of good X and Y respectively.The budget equation gives us a budget line.The budget equation gives us a budget line.

The Budget LineThe Budget Line

AA 00 4040 $80$80

BB 2020 3030 $80$80

DD 4040 2020 $80$80

EE 6060 1010 $80$80

GG 8080 00 $80$80

Market Basket Food (F) Clothing (C) Total SpendingPf = ($1) Pc = ($2) PfF + PcC = I

Budget Line F + 2C = $80

CF/PPFC - 2

1- / Slope

10

20

(I/PC) = 40

The Budget LineThe Budget Line

Food(units per week)40 60 80 = (I/PF)20

10

20

30

0

A

B

D

E

G

Clothing(units

per week)

Pc = $2 Pf = $1 I = $80

Affordable

Not affordable

12

Shifts in the Budget LineShifts in the Budget Line

Changes in the prices of the goods or income Changes in the prices of the goods or income shift the budget lineshift the budget line

A change in income causes a A change in income causes a parallelparallel shift the shift the budget linebudget line

A change in the price of A change in the price of oneone good good swivelsswivels the the budget line (budget line (i.e. the slope changesi.e. the slope changes))

Effects of Changes in Income Effects of Changes in Income and Pricesand Prices

Effects of Income ChangesEffects of Income Changes

– An increase in income causes the budget An increase in income causes the budget line to shift outward, parallel to the original line to shift outward, parallel to the original line (holding prices constant).line (holding prices constant).

– A decrease in income causes the budget line A decrease in income causes the budget line to shift inward, parallel to the original line to shift inward, parallel to the original line (holding prices constant).(holding prices constant).

The Effect of Income The Effect of Income ChangesChanges

Food(units per week)

Clothing(units

per week)

80 120 16040

20

40

60

80

0

A increase inincome shifts

the budget lineoutward

(I = $160)L2

(I = $80)

L1

L3

(I =$40)

A decrease inincome shifts

the budget lineinward

Effects of Changes in Income Effects of Changes in Income and Pricesand Prices

Effects of Price ChangesEffects of Price Changes

– If the price of one good increases, the If the price of one good increases, the budget line shifts inward, pivoting from the budget line shifts inward, pivoting from the other good’s intercept.other good’s intercept.

– If the price of one good decreases, the If the price of one good decreases, the budget line shifts outward, pivoting from budget line shifts outward, pivoting from the other good’s intercept.the other good’s intercept.

The Effect of Price ChangesThe Effect of Price Changes

Food(units per week)

Clothing(units

per week)

80 120 16040

40

(PF = 1)

L1

An increase in theprice of food to$2.00 changes

the slope of thebudget line and

rotates it inward.

L3

(PF = 2)(PF = 1/2)

L2

A decrease in theprice of food to$.50 changes

the slope of thebudget line and

rotates it outward.

Effects of Changes in PricesEffects of Changes in Prices If the two goods increase in price, but the If the two goods increase in price, but the ratioratio of the of the

two prices is unchanged, the slope will not change.two prices is unchanged, the slope will not change.

– The budget line will shift inward to a point parallel The budget line will shift inward to a point parallel to the original budget line.to the original budget line.

If the two goods decrease in price, but theIf the two goods decrease in price, but the ratioratio of of the two prices is unchanged, the slope will not the two prices is unchanged, the slope will not change.change.

– The budget line will shift outward to a point The budget line will shift outward to a point parallel to the original budget line.parallel to the original budget line.

U2

Consumer Choice Consumer Choice (Equilibrium)(Equilibrium)

Pc = $2 Pf = $1 I = $80

Budget Line

A

At market basket A the budget line and theindifference curve aretangent and no higherlevel of satisfaction

can be attained.

At A:MRS =Pf/Pc = .5

Food (units per week)

Clothing(units per

week)

40 8020

20

30

40

0

16

Equilibrium ConditionsEquilibrium Conditions The slope of the indifference curve equals the The slope of the indifference curve equals the

slope of the budget lineslope of the budget line

MRS = the relative price ratioPx/Py= MUx / MUyPx/Py= MUx / MUy

Review QuestionsReview Questions

A consumer has a monthly budget A consumer has a monthly budget of rs.4000 he spends all his income of rs.4000 he spends all his income on two goods A and B. the prices of on two goods A and B. the prices of goods A and B are Rs.2 and rs.4 goods A and B are Rs.2 and rs.4 respectively. His marginal utility respectively. His marginal utility functions are given by MUA = 3/A functions are given by MUA = 3/A and MUB = 9/B. what is the and MUB = 9/B. what is the optimum amount that should be optimum amount that should be spent on good A?spent on good A?

Review QuestionsReview Questions

Utility function of a consumer is U = Utility function of a consumer is U = X1.5Y. Prices of good X and Y are X1.5Y. Prices of good X and Y are Rs.3 and Rs.4 respectively. His Rs.3 and Rs.4 respectively. His weekly budget is Rs.100. what is weekly budget is Rs.100. what is the optimum allocation of the optimum allocation of expenditure on good X and good Y expenditure on good X and good Y for the consumer?for the consumer?