Indifference curve

• Indifference curve – A curve that shows

combinations of goods which gives the
same level o satisfaction to the consumers
so that an individual is indifferent.
 Constructing an indifference curve
30 a
28
Pears Oranges Point
26
24 30 6 a
24 7 b
22 20 8 c
20 14 10 d
18 10 13 e
Pears

8 15 f
16 g
6 20
14
12
10
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Oranges
 Assumption

• More of a commodity is better than less

• Preference of a consumer are transitive
• Diminishing marginal rate of substitution
More of a commodity is better than less
Preference of a consumer are transitive
 Marginal rate of substitution

• Marginal rate of substitution – The rate at

which consumer is prepared to exchange
goods X and Y is known as MRS ie the rate
at which one good must be added when the
other is taken away in order to keep the
individual indifferent between the two
combinations without changing total
satisfaction .
 Deriving the marginal rate of substitution (MRS)
30 a

26 b
Units of good Y

20

10

0
0 67 10 20
Units of good X
 Deriving the marginal rate of substitution (MRS)
30 a
∆ Y=4 MRS = 4
26 b

∆ X=1
Units of good Y

20

10

0
0 67 10 20
Units of good X
 Deriving the marginal rate of substitution (MRS)
30 a
∆ Y=4 MRS = 4
26 b

∆ X=1
Units of good Y

20

MRS = 1
c
10 d
∆ Y=1
9
∆ X=1

0
0 67 10 13 14 20
Units of good X
 Indifference schedule

• Indifference schedule

Combinati Good X Good Y MRS

on
A 1 12
B 2 8 4
C 3 5 3
D 4 3 2
E 5 2 1
 Marginal Rate of Substitution

• MRS declines as we move downward to the

right along an indifference curve.

• Indifference curves with diminishing MRS

are thus convex.

• Convexity illustrates that people like

variety.
 Law of diminishing marginal rate of substitution

• Law of diminishing marginal rate of

substitution – As you get more and more of
a good X , one is prepared to forego less
and less of Y that is MRS of X for Y
diminishes as more and more of good X is
substituted for good Y.
 An indifference map
30
Units of good Y

20

10

I5
I4
I3
I2
0 I1
0 10 20
Units of good X
 Properties of Indifference Curve

– Indifference curves are downward sloping to

the right
– Indifference curves are convex to the origin
– Indifference curves cannot intersect each
other
– A higher Indifference curves represents a
higher satisfaction
 BUDGET LINE

• Budget line graphically shows the budget

constraint.
• The combination of commodities lying to the
right of the budget line are unattainable
because the income of the consumer is not
sufficient to be able to buy those
combinations.
• The combination of commodities lying to the
left of the budget line are attainable because
the income of the consumer is sufficient to be
able to buy those combinations
 What is a Budget Constraint?

• A budget constraint shows the

consumer’s purchase opportunities as
every combination of two goods that
can be bought at given prices using a
given amount of income.
• The budget constraint measures the
combinations of purchases that a
person can afford to make with a given
amount of monetary income.
 A budget line
30 a

Units of Units of Point on

good X good Y budget line

0 30 a
b
Units of good Y

20 5 20 b
10 10
15 0

10 Assumptions

PX = £2
PY = £1
Budget = £30

0
0 5 10 15 20
Units of good X
 Effect of an increase in income on the budget line
40

Assumptions

PX = £2
30 PY = £1
Budget = £40
Units of good Y

n
20

16
m

10 Budget
= £40
Budget
= £30
0
0 5 7 10 15 20
Units of good X
 Effect on the budget line of a fall in the price of good X
30 a
Assumptions

PX = £1
PY = £1
Budget = £30
Units of good Y

20

10

B1 B2

b c
0
0 5 10 15 20 25 30
Units of good X
 The Best Feasible Bundle

• Tools needed to determine how consumers

should allocate their income between 2
goods :
– Budget Constraint
– Indifference Curves

• Consumer’s strategy is to keep moving to

higher and higher indifference curves until
he reaches the highest one that is still
affordable.
How to Find the Best Combination

• Utility is maximized when:

– the indifference curve is just
tangent to the budget line.
The Best Affordable Bundle
 Finding the optimum consumption
Units of good Y

Budget line

I5
I4
I3
I2
I1
O
Units of good X
 indifference curve and budget line

r
s
Units of good Y

t
Y1

u I5
I4
v I3
I2
I1
O X1
Units of good X
 Effect on consumption of a change in income
Units of good Y

B1 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

I2
B1 B2 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

I4
I3
I2
B1 B2 B3 B4 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

Income–consumption curve

I4
I3
I2
B1 B2 B3 B4 I1
O
Units of good X
 The Engel curve

• The Engel curve

– Shows the relationship between the quantity of
the good consumed and income

• Normal and inferior goods

– Normal goods – upward sloping Engel curve
– Inferior goods – downward sloping Engel curve
Deriving an Engel curve from an income–consumption curve

Bread Qb3
c
Income-consumption
Qb2 curve
b
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd 1 Qcd 2 Qcd 3 CDs
Income (£)

Y3
c
Y2 b
Y1 a

Qcd 1 Qcd 2 Qcd 3

Deriving an Engel curve from an income–consumption curve

Bread Qb3
c
Income-consumption
Qb2 curve
b
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd 1 Qcd 2 Qcd 3 CDs
Income (£)

Engel curve
Y3
c
Y2 b
Y1 a

Qcd 1 Qcd 2 Qcd 3

 Engel Curves
Income
($ per
month) 30

Engel curve slopes

upward for a
20 normal good.

10

Food (units
0 4 8 12 16 per month)
 Engel Curves
Income
($ per
month) 30

Inferior
Engel curve is
backward bending
20 for inferior goods.

Normal

10

Food (units
0 4 8 12 16 per month)
 Effect of a rise in income on the demand for an inferior good
Units of good Y
(normal good)

B1 I1

O
Units of good X
(inferior good)
 Effect of a rise in income on the demand for an inferior good

b
Units of good Y
(normal good)

I2

B1 I1 B2
O
Units of good X
(inferior good)
 Effect of a rise in income on the demand for an inferior good

Income–consumption curve

b
Units of good Y
(normal good)

I2

B1 I1 B2
O
Units of good X
(inferior good)
 Effect of a fall in the price of good X
30
Assumptions

PX = £2
PY = £1
Budget = £30
Units of good Y

20

10

B1 I1
0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30 a
Assumptions

PX = £1
PY = £1
Budget = £30
Units of good Y

20
k

10 I2

B1 I1 B2
0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30 a

Price–consumption curve
Units of good Y

20
k

10 I2

B1 I1 B2
0
0 5 10 15 20 25 30
Units of good X
Deriving a demand curve from a price–consumption curve

Further falls in

Expenditure on
all other goods
the price of X
a b
c d

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X
Deriving a demand curve from a price–consumption curve

Expenditure on
all other goods
a b Price-consumption
c d
curve

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X
Deriving a demand curve from a price–consumption curve

Expenditure on
all other goods
a b Price-consumption
c d
curve

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X

P1 a
Price of good X

P2 b

Q1 Q2 Units of good X
Deriving a demand curve from a price–consumption curve

Expenditure on
all other goods
a b Price-consumption
c d
curve

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X

P1 a
Price of good X

P2 b
P3 c
P4 d

Q1 Q2 Q 3 Q 4 Units of good X
Deriving a demand curve from a price–consumption curve

Expenditure on
all other goods
a b Price-consumption
c d
curve

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X

P1 a
Price of good X

P2 b
P3 c
P4 d
Demand

Q1 Q2 Q 3 Q 4 Units of good X
 Income and Substitution Effects of a Price
Change
• Income effect – A change in the quantity
purchased of a good by a consumer as
result of a change in his income, prices
remaining constant.
• Substitution effect – Substitution effect
means the change in the quantity
purchased of a good by a consumer as
result of a change in relative prices alone ,
real income remaining constant.
 Income and Substitution Effects

• A fall in the price of a good has two effects:

Substitution & Income
– Substitution Effect
 Consumers will tend to buy more of the good that
has become relatively cheaper, and less of the good
that is now relatively more expensive.
 Income and Substitution Effects

• A fall in the price of a good has two effects:

Substitution & Income
– Income Effect
 Consumers experience an increase in real
purchasing power when the price of one good falls.
 Response to an income increase: both goods normal

C
100

U1

20 35
F
 Income effects

C Normal; F inferior

C
100 Both F and C Normal

B
F Normal; C inferior

U1

20 35
F
Decomposing the price change
Prices Drop
 Income and Substitution Effects
Illustrated: The Normal-Good Case
[Figure 4.3]
• Price effect =substitution effect + Income
effect

• The movement from W –W’ =Price effect

• The movement from W –J = substitution
effect
• The movement from J–W’ =Income effect
 Income and Substitution
Effects: Normal Good
Clothing
When the price of food falls,
(units per consumption increases by F1F2
month) R as the consumer moves from A
to B.
The substitution effect,F1E,
(from point A to D), changes the
C1 A relative prices but keeps real income
(satisfaction) constant.

The income effect, EF2,

( from D to B) keeps relative
D B prices constant but
C2 increases purchasing power.

Substitution U2
Effect U1
Food (units
O F1 Total Effect E S F2 T per month)
Income Effect