The Indifference Curve Approach

What are the basic postulates of consumer behaviour?

A. An economic agent behaves rationally.

Meaning: Behaviour of an economic agent

has objectives and involves a prudent choice among alternative means. In other words, consumer behaviour is not random or arbitrary. It has patterns and can be explained.
Significance: Thus, economic investigation is

possible and meaningful.

Then how does an individual make his choice? B. Postulate of constrained maximization / selfinterest / selfishness
Meaning: An economic agent always chooses the

option that maximizes the 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 is the most important & most useful postulate in economics.

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.

Scarcity

Competition

Choice

E. Scarce goods are substitutable

Meaning: One is willing to forgo something

to get more of the scarce good substitution, provided that the value got is larger than the cost paid.

Significance: Exchange is possible.

F. The law of diminishing MRS Marginal rate of substitution (MRS): is the maximum amount of good Y that an individual is willing to forgo for an additional unit of good X.

It is equal to marginal use value (MUV) of good X in terms of good Y. The law states that MRS or MUV of a good declines as more units of the good are obtained, ceteris paribus. Significance: (Both interior and corner solutions are
possible.)

Good, Bad and Neuter

A good is something desired,

some is preferred to _________. none i.e., _________

Types of goods:

Goods

Free goods

Scarce goods (economic goods)

Free good: Features

something desired its amount available is ______ more than its amount desired at zero price,
i.e., ________ no more is preferred.

Scarce good (economic good): Features

something desired
less than its amount its amount available is _____ desired at zero price, more is preferred to _____. less i.e., ______

Distinction between free goods and scarce goods: Depends on situations rather than kinds.

Any examples?

Distinction between free goods and goods free-of-charge: A free good must be a good free-of-charge. 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 good free-of-charge may not be a free good. Why?

a scarce good can also be free-of-charge if someone pays the cost for you. Any examples?

A bad is something undesired, less more i.e., _________ is preferred to _________.

Is sickness bad ?

A neuter is something neither desired nor undesired,

i.e., the quantity does not matter. Any examples?

Utility

What is utility?

Utility is a number

arbitrarily assigned to entities to rank them according to ones preference.

the higher the utility, the more one prefers the entity. a criterion of maximization to rank options for making
choice.

What is utility?

Utility reflects preference

happiness / satisfaction social welfare Why?

Measurement of utility

Ordinal utility

Cardinal utility

only reflects an order but the difference between the numbers assigned is meaningless

can also reflect an order and the difference between the numbers assigned is meaningful

Measurement of utility Which measurement of utility is used in the indifference curve approach?

Ordinal measure of utility

Indifference Curve

What is an indifference curve? An indifference curve (IC, is a line joining all the points (representing different baskets of goods) giving the same utility to an individual.

Good Y

U=10 0 Good X

What is an indifference map? An indifference map is a set Good Y of ICs showing the __preference_______ of an individual.
U=30 U=20 U=10 Good X

Properties of Indifference Curves of Two Goods

1. ICs of two goods are negatively sloped Keeping utility constant, along an IC, a basket with more units of good X Good Y fewer units of good Y. must have _____
Slope of an IC of two goods (= Y/ X)

+X
-Y

negative must be ________.

U=10 (Options: more / fewer / positive / negative)

Good X

2. Indifference curves are continuous If quantities of good X and good Y can be increased or decreased by infinitesimal amounts, the ICs are continuous. Why?
Good Y

U=10 0 Good X

3. Indifference curves can never intersect

Along U1: point A = point B = U1

B
A

Along U2: point A = point C = U2

What is the utility of point A, = U1 or U2? U of the intersection point logical contradiction

4. Full coverage
If a consumer knows his preference on every basket of commodities, the commodity plane will be fully covered by ICs. Why?
The higher the IC , the higher the utility (U3 > U2 > U1). Why?
U1 U2 U3

Good Y

Good X

5. Indifference curves of two goods are convex to the origin

The numerical value of the slope of an IC (+1X -?Y) is equal to the MRS. Why?
+1X

Good Y

As the consumption of good X rises, MRS (the slope) falls. Why?

-Y U1

Good X

As the IC becomes flatter & flatter, its shape is convex _______ to the origin.

Other Shapes of Indifference Curves

1. X is a neuter and Y is a good

Why?
Y (A good) U3>U2>U1 U3 U2 Any increase or decrease in the quantity of X makes no difference to the consumer.

U1

horizontal ICs are ___________.

0
X (A neuter)

2. X is a bad and Y is a good

U3>U2>U1
Y (A good) U3 U2 U1

Why?
To keep U constant, in a bad (+X) requires in a good (+Y) as a compensation.

+Y
+X

upward sloping ICs are _________ with a/an increasing _________slope.

X (A bad)

3. X is a commodity with a satiation threshold

(beyond which X turns from a good to a bad) Good Y U3>U2>U1

ICs are __________. U-shaped

U3

Why?

U2
U1

0 X is a good X becomes a bad

4. X and Y are perfect substitutes

Good Y (pack of 8 kg rice)

downward sloping ICs are _________ straight lines. _______

Why?

U3>U2>U1

U1

U2

U3 Good X (pack of 5 kg rice)

5. X and Y are perfect complements

Good Y (left shoes)
right-angled . ICs are __________

U3 U2 U1 0

Why?

45o

U3>U2>U1 Good X (right shoes)

Budget Line

What is a budget line?

Budget line (BL) or consumption possibility curve is a boundary showing the largest possible combinations of goods that a consumer can buy in a market, given his money income and market prices of the goods. It is also called the budget constraint.

Given I = Rs.100, PX = Rs.20 & PY = Rs.25 The maxi. The BL is a downward amount of X one can buy = Rs.100/Rs.20 = 5 sloping straight line. Y The maxi. amount of Y one can buy Rs.100/Rs.25 4 = =4 +1X To buy 1 more unit of X, one The of BL = cost of of Y. forgoes = slope unit Rs.20/Rs.25=.8 -0.8Y consuming an additional unit of good X in terms of good Y. 0 5 X

Derivation of a BL:

Features: Point A: Expenditure ____ < Income

Y

Point B: Expenditure ____ = Income Point C: Expenditure ____ > Income

C
X

(Options: >

< )

A
0

Equation of budget line X PX + Y PY = I

Expenditure on good X Expenditure on good Y Money income of the consumer

Changes in budget constraints

1. Changes in income
Y

in income in income
0

When ones income increases, the budget outward line will shift ______ in a parallel manner, and vice versa. Why?

2. Proportionate changes in prices

Y

A proportionate in all money prices A proportionate in all money prices

0 X

When prices of both goods rise by the same proportion, the budget inward line will shift _______ in a parallel manner, and vice versa. Why?

3. Disproportionate changes in prices

Y

When PX , the budget line tilt inward and become will _________ steeper. Why?
A rise in Px

When PX , the budget outward and line willtilt __________ flatter Why? become _______.
X

A fall in Px
0

Consumer Equilibrium

What is a consumer equilibrium?

Optimum or equilibrium is the best choice of an economic agent in achieving his objective.
Optimality conditions or equilibrium Conditions are descriptions on the defining features of the optimum or the equilibrium.

Interior solution
When a consumer buys both goods X & Y, i.e., the equilibrium is not one of the _________ intercepts on the budget line, the equilibrium is called an interior solution .

Equilibrium: From observation

Y
From observation, the best choice achievable is E* (X*, Y*) . _____________ It is the tangency point, the only point on the budget line reaching the highest IC attainable. X Why?

U3>U2>U1
Y*

E* U3 U2

U1
X*

Equilibrium conditions:
Y

1. The consumer equilibrium must lie ____ on the BL. 2. The consumer equilibrium is the ____________ tangency point at which the slope of IC equals the slope of BL.

U3>U2>U1
E*

Y*

U3 U2 0 U1
X*

Meaning of the slopes Slope of indifference curve Slope of budget line

1.
2. 3.

=Y/X, holding utility constant

=Y/X, holding expenditure or income constant

= Marginal rate of substitution = Marginal rate of substitution in consumption, MRSc in exchange, MRSe = The maximum amount of Y = The actual amount of Y one one is willing to pay for an is required to pay for an additional unit of X additional unit of X in exchange

4.

Value = Cost / Value? of an additional unit of X in terms of Y (=MUV)

= CostCost / Value? of consuming an additional unit of X in terms of Y (= Px/Py)

How is the consumer equilibrium reached?

Y

value of an At point A, MRSc > MRSe (_______ cost additional X > its ________), utility can be buys more units of X. raised if the consumer _________

A Buy X

U2

(Options: buys more / sells some / value / cost )

U1 0

How is the consumer equilibrium reached?

Y
At point B, MRSc < MRSe (value < cost), utility can be raised if the consumer _________ sells some units of X. (Options: buys some / sells some ) U2 Sell X

U1

How is the consumer equilibrium reached?

Y MRSc = MRSe (value = cost), utility is maximized & the equilibrium is attained.

E*

U2

U1

Changes in Consumer Equilibrium in Response to Changes in Constraints

A. Changes in income
When income with PX and PY unchanged, the BL will shift in a parallel manner.

outward
The effect of income on the consumption of a consumer can be shown by 2 curves: 1. Income consumption curve 2. Engel curve

1. Income consumption curve

Income consumption curve (ICC) is a line joining all the equilibrium (X,Y) of a consumer when ones income changes, holding PX and PY constant. Y

ICC

2. Engel curve
Engel curve is a line showing the consumption of a good at different income levels, holding PX and PY constant. X
X3
X2 X1

Engel curve

I1

I2

I3

Income

A. Superior good: Its consumption is positively related to income.

Y
X ICC
X3

Engel curve

X2
X1

X1 X2 X3

I1

I2

I3 Income

B. Inferior good: Its consumption is negatively related to income.

ICC X

Engel curve
X1

X2
X3

X3X2X1

I1

I2

I3 I

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

1. Price consumption curve

Y

PCC

Price consumption curve is a line joining all the equilibrium of a consumer when PX changes, holding I & PY constant. X

2. Demand curve
Px Px1 Px2 Px3 0 Demand Curve

Demand curve is a line showing quantity demanded of a good the ________________ of a consumer at different prices.

X1

X2 X3

Y
If price (Px) & quantity demanded (X) of the good are negatively related. 0 Px Px1 Px2 Px3 0 PCC

X Demand Curve

X1 X2

X3

X4

Giffen paradox
If price (Px) & quantity demanded (X) of a good are _________ positively related, the good is called a Giffen good.

PCC 0 Px Px1 Px2 0 X2 X1

Demand Curve
X

Decomposition of the Price Effect into the Substitution Effect & the Income Effect

Price effect

Price effect is the overall change in the quantity demanded of a good caused by a change in its price, holding money income constant.
Price effect can be decomposed into substitution effect and __________ income effect. ___________

Substitution effect is the change in the quantity

demanded of a good caused by a change in its price, holding utility or real income constant. Px One will buy more good X to substitute good Y So substitution effect must be negative.

E1

E3

New equilibrium L2

L1
X1 X3

L3

S.E.

Income effect is the change in the quantity

Y
Using the saved income

demanded of a good as a result of a change income caused by a change in its price.

in real

E1

E3

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 E2 a cheaper good. The saved income will raise the consumption of good X if good X is a superior good.

L1

L3

L2

X1 X3 S.E. I.E.

X2

Price effect of different kinds of goods Y Positive I.E. E1

1. The substitution effect must be negative. 2. If good X is a superior good, what will be the income effect? 3. And what will be the price effect?
L2

E3
L1

E2

0 S.E.

L3

Negative I.E. E2

2. If X is an inferior good

with its -ve I.E. < S.E.,

E1

what will be the price effect?

E3
L3 L2

L1

S.E.

Y Negative I.E.

E2

3. If X is an inferior good with its -ve I.E. > S.E., (called Giffen good),
what will be the price effect?

E1

E3
L3

L1

L2

S.E.

Postulate of utility maximization If the utility and the cost of each option

can be measured or asserted beforehand the postulate can generate refutable predictions and it is useful if it is not refuted.
cannot be measured or asserted beforehand the postulate cannot generate refutable predictions, then it becomes tautological and useless in explanation and prediction.

When a consumer buys one good only, i.e., the equilibrium is one of the intercepts on the budget line, the equilibrium is called a corner solution .

specialization in consumption. There is a ___________________

Possible reasons for a corner solution are:

1. The good is too expensive.

2. The entity is a bad.

3. MRS is not decreasing.

1. The good is too expensive

Y (A good) E*

MRSe (= cost) > MRSc (= value) U

3

U2 U3>U2>U1 U1 1X X (A good but too expensive)

2. The entity is a bad

Y (A good)
U3 U2 E* U1 U3>U2>U1

X (A bad)

3. MRS is not decreasing

Y (A good) Y (A good)

U3>U2>U1
E*

U3>U2>U1 E* U3 U2 U1

U3 U2
U1

X (A good) Constant MRS

X (A good) Increasing MRS

Correcting Misconceptions:
1. A free good is a good provided by the government free of charge.

2. A free good is a good without utility and is not preferred. 3. Utility is a measure of individual satisfaction or a measure of social welfare.

Correcting Misconceptions:
4. Utility of a good must be a positive number and that of a bad must be negative. 5. Postulate of utility maximization is tautological. 6. A straight-line indifference curve denies the postulate of substitution.

Correcting Misconceptions:
7. A concave indifference map cannot have consumer equilibrium or can have an interior solution.

8. A good with its price and quantity demanded negatively related is a normal good. 9. Holding money income constant is the same as holding real income constant.

Correcting Misconceptions:
10. Substitution effect is positive for superior good and negative for inferior good.

11. Giffen good has no relation with inferior good.