1. Chapter 3 Consumer Behaviour I --- The Indifference Curve Approach
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2. Postulates of Consumer Behaviour Good, Bad and Neuter Utility
Contents:
Postulates of Consumer Behaviour
Good, Bad and Neuter
Utility
Indifference Curve
Properties of Indifference Curves of Two Goods
Other Shapes of Indifference Curves
Budget Line
Consumer Equilibrium
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3. Changes in Consumer Equilibrium in Response to Changes in Constraints
Contents:
Changes in Consumer Equilibrium in Response to Changes in Constraints
Decomposition of Price Effect into Substitution Effect and Income Effect
Advanced Material 3.1: Postulate of utility maximization
Advanced Material 3.2: Corner solutions
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4. Postulates of Consumer Behaviour
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5. A theory has four components - definitions; postulates;
test conditions;
implications
Chapter one: basic definitions
This chapter: postulates
+ test conditions
+ implications
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6. A. An economic agent behaves rationally.
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 (審慎的)
choice among alternative means. In other words,
consumer behaviour is not random or arbitrary(隨意的).
It has patterns and can be explained.
Significance: Thus, economic investigation is possible and meaningful.
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7. B. Postulate of constrained maximization / self-interest / selfishness
Then how does an individual make his choice?
B. Postulate of constrained maximization / self-interest / selfishness
Meaning: An economic agent always chooses the option that _________ the achievement of his goals among the options allowed by existing constraints.
maximizes
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.
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8. D. To each individual, some goods are scarce.
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
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9. 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.
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10. 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 ____________ as more units of the good are obtained, ceteris paribus.
declines
Significance: (Both interior and corner solutions are possible.)
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11. Good, Bad and Neuter
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12. (Options: more / less / none / some)
A good is something desired,
i.e., _________ is preferred to _________.
some
none
(Options: more / less / none / some)
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13. Scarce goods (economic goods)
Types of goods:
Goods
Free goods
Scarce goods (economic goods)
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14. i.e., ________ is preferred.
Free good: Features
something desired
its amount available is ______ than its amount desired at zero price,
i.e., ________ is preferred.
more
no more
(Options: more / less / some / no more )
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15. i.e., ______ is preferred to _____.
Scarce good (economic good): Features
something desired
its amount available is _____ than its amount desired at zero price,
i.e., ______ is preferred to _____.
less
more
less
(Options: more / less / some / none )
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16. Distinction between free goods and scarce goods:
Depends on situations rather than kinds.
Any examples?
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17. A good free-of-charge may not be a free good. Why?
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?
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18. A bad is something undesired,
i.e., _________ is preferred to _________.
less
more
(Options: more / less / some / none )
Is sickness a bad ?
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19. A neuter (中性物品) is something neither desired nor undesired,
i.e., the quantity does not matter.
Any examples?
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20. Which of the following are free goods? Explain.
Q3.2:
Which of the following are free goods? Explain.
air pocket money sea water parental care
Q3.3:
Draw a demand and supply diagram to illustrate a free good and a scarce good respectively.
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21. Utility
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22. Utility (效用) is a number
What is utility?
Utility (效用) is a number
arbitrarily assigned to entities to rank them according to one’s preference.
the higher the utility, the more one prefers the entity.
a criterion of maximization to rank options for making choice.
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23. Utility reflects preference
What is utility?
Utility reflects preference
 happiness / satisfaction
 social welfare
Why?
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24. Measurement of utility
Ordinal utility
only reflects an order
but the difference between the numbers assigned is meaningless
Cardinal utility
can also reflect an order
and the difference between the numbers assigned is meaningful
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25. Measurement of utility
Which measurement of utility is used in the indifference curve approach?
Ordinal measure of utility
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26. Indifference Curve
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27. What is an indifference curve?
An indifference curve (IC, 等優曲線) is a line joining all the points (representing different baskets of goods) giving the same utility to an individual.
Good X
Good Y
U=10
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28. What is an indifference map?
An indifference map (等優曲 線圖) is a set of ICs showing the _________ of an individual.
Good Y
Good X
preference
U=10
U=20
U=30
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29. Properties of Indifference Curves of Two Goods
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30. 1. ICs of two goods are negatively sloped
Keeping utility constant, along an IC, a basket with more units of good X must have _____ units of good Y.
U=10
Good Y
Good X
fewer
Slope of an IC of two goods (= Δ Y/ Δ X)
must be ________. +X -Y
negative
(Options: more / fewer / positive / negative)
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31. 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
Good X
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32. 3. Indifference curves can never intersect
Along U1: point A = point B = U1
Along U2: point A = point C = U2  B  C
What is the utility of point A, = U1 or U2?  A
U of the intersection point  logical contradiction
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33. 4. Full coverage
If a consumer knows his preference on every basket of commodities, the commodity plane will be fully covered by ICs. Why? U1 U2 U3
Good Y
Good X
The higher the IC , the higher the utility (U3 > U2 > U1). Why?
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34. 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? U1
Good Y
Good X
As the consumption of good X rises, MRS (the slope) falls. Why?
+1X -Y
As the IC becomes flatter & flatter, its shape is _______ to the origin.
convex
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35. Other Shapes of Indifference Curves
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36. 1. X is a neuter and Y is a good
Why?
Y (A good)
X (A neuter)
Any increase or decrease in the quantity of X makes no difference to the consumer.
U3>U2>U1 U2 U1 U3
ICs are ___________.
horizontal
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37. What will be the shape of the ICs if (a) X is a good and Y is a neuter
What will be the shape of the ICs if (a) X is a good and Y is a neuter? (b) both X and Y are neuters?
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38. ICs are _________ sloping with a/an _________slope.
2. X is a bad and Y is a good
U3>U2>U1
Why?
To keep U constant,
in a bad (+X) requires
in a good (+Y) as a compensation.
Y (A good)
X (A bad) U1 U2 U3
ICs are _________ sloping with a/an _________slope. +X +Y
upward
increasing
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39. What will be the shape of the ICs if (a) X is a good and Y is a bad
What will be the shape of the ICs if (a) X is a good and Y is a bad? (b) both X and Y are bads?
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40. 3. X is a commodity with a satiation threshold (beyond which X turns from a good to a bad)
U3>U2>U1
ICs are __________.
U-shaped
Good Y X U1 U2 U3
Why?
X is a good
X becomes a bad
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41. What will be the shape of the ICs if both X and Y are goods with a satiation threshold?
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42. 4. X and Y are perfect substitutes
ICs are _________ sloping _______ lines.
downward
Good Y (pack of 8 kg rice)
straight
Why? U1 U2 U3
U3>U2>U1
Good X (pack of 5 kg rice)
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43. 5. X and Y are perfect complements
Good Y (left shoes)
ICs are __________.
right-angled U1 U2 U3
45o
Why?
U3>U2>U1
Good X (right shoes)
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44. Q3.7: Study the indifference maps below and determine if X and Y are goods, bads or neuters.
(a) U1 < U2 < U3
(b) U1 > U2 > U3
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45. Budget Line
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46. 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.
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47. Derivation of a BL: Given I = $100, PX = $20 & PY = $25
The maxi. amount of X one can buy
= ___________
The BL is a downward sloping straight line. Y X
$100/$20 = 5 4
The maxi. amount of Y one can buy
= ___________
The slope of BL = cost of consuming an additional unit of good X in terms of good Y.
+1X
-0.8Y
$100/$25 = 4
To buy 1 more unit of X, one forgoes =____________ unit of Y.
$20/$25 = 0.8 5
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48. < = > Features: Point A: Expenditure ____ IncomeY X =
Point B: Expenditure ____ Income
>
Point C: Expenditure ____ Income  C 
(Options: > = < ) B  A
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49. Equation of budget line
Expenditure on good X
Expenditure on good Y
Money income of the consumer
X  PX + Y  PY = I
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50. Changes in budget constraints
1. Changes in income
When one’s income increases, the budget line will shift ______ in a parallel manner, and vice versa. Y X
outward
in income
Why?
in income
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51. 2. Proportionate changes in pricesY X
When prices of both goods rise by the same proportion, the budget line will shift _______ in a parallel manner, and vice versa.
A proportionate in all money prices
inward
A proportionate in all money prices
Why?
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52. 3. Disproportionate changes in prices
When PX , the budget line will _________ and become steeper. Why? Y X
tilt inward
When PX  , the budget
line will __________ and
become _______. Why?
flatter
A rise in Px
tilt outward
A fall in Px
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53. Q3.8: Under the following situations, what would happen to the budget line? Explain with the aid of diagrams. (a) I and PY are constants, but Px increases from P0 to P1. (b) I and PY are constants, but PX increases as the consumer buys more and more units of the good, i.e., PX and X are positively related. (c) I and PY are constants, but PX decreases as the consumer buys more and more units of the good, i.e., PX and X are negatively related.
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54. Consumer Equilibrium
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55. What is a consumer equilibrium?
Optimum (最優點) or equilibrium (均衡) is the best choice of an economic agent in achieving his objective.
Optimality conditions (最優性條件) or equilibrium
conditions (均衡條件) are descriptions on the
defining features of the optimum or the equilibrium.
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56. Interior solution When a consumer buys both goods X & Y,
i.e., the equilibrium is not one of the _________
on the budget line, the equilibrium is called
an interior solution (內解點).
intercepts
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57. Equilibrium: From observation
From observation, the best choice achievable is _____________. U1 U3 Y X
U3>U2>U1
E* (X*, Y*)
It is the tangency point, the only point on the budget line reaching the highest IC attainable.  E* Y* X* U2
Why?
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58. Equilibrium conditions:
1. The consumer equilibrium must lie ____ the BL.
2. The consumer equilibrium is the ____________ at which the slope of IC equals the slope of BL.
Equilibrium conditions: on U1 U2 U3 Y X
U3>U2>U1  E* X* Y*
tangency point
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59. Slope of indifference curve
Meaning of the slopes
Slope of indifference curve
Slope of budget line 1.
=ΔY/ΔX, holding utility constant
=ΔY/ΔX, holding expenditure or income constant 2.
= Marginal rate of substitution in consumption, MRSc
= Marginal rate of substitution in exchange, MRSe 3.
= The maximum amount of Y one is willing to pay for an additional unit of X
= The actual amount of Y one is required to pay for 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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60. How is the consumer equilibrium reached?
At point A, MRSc > MRSe (_______ of an additional X > its ________), utility can be raised if the consumer _________ units of X.
value U2 U1 Y X
cost
buys more A 
Buy X
(Options: buys more / sells some / value / cost )
MRSe
MRSc 
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61. How is the consumer equilibrium reached?
At point B, MRSc < MRSe (value < cost), utility can be raised if the consumer _________ units of X. U2 U1 Y X
sells some
(Options: buys some / sells some ) 
Sell X
MRSe B 
MRSc
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62. How is the consumer equilibrium reached?
MRSc = MRSe (value = cost), utility is maximized & the equilibrium is attained. Y  E* U2 U1 X
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63. Changes in Consumer Equilibrium in Response to Changes in Constraints
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64. When income  with PX and PY unchanged, outward
A. Changes in income
When income  with PX and PY unchanged,
the BL will shift outward / inward? 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
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65. 1. Income consumption curve
Income consumption curve (所得消費曲線, ICC) is a line joining all the equilibrium (X,Y) of a consumer when one’s income changes, holding PX and PY constant. Y
ICC    X
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66. 2. Engel curve Engel curve X Engel curve (恩格爾曲線) is a line showing the
Income
Engel curve
(恩格爾曲線) is
a line showing the
consumption of a
good at different
income levels,
holding PX and PY
constant. X3 X2 X1
I I I3
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67. Its consumption is positively related to income.
A. Superior good:
Its consumption is positively related to income. X Y
ICC
Engel curve X3 X2 X1
X1 X2 X3
I I I3
Income X
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68. Its consumption is negatively related to income.
B. Inferior good:
Its consumption is negatively related to income. Y X
ICC
Engel curve X1 X2 X3
I I I3 I
X3X2X1 X
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69. 1. Price consumption curve 2. Demand curve
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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70. 1. Price consumption curveY
Price consumption curve (價格消費曲線) is a line joining all the equilibrium of a consumer when PX changes, holding I & PY constant.  
PCC   X
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71. 2. Demand curve
Demand curve is a line showing the ________________ of a good of a consumer at different prices. Px X
quantity demanded
Px1
Demand Curve
Px2
Px3 X1 X2 X3
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72. Y
If price (Px) & quantity demanded (X) of the good are negatively related.
PCC X Px
Demand Curve
Px1
Px2
Px3 X X1 X2 X3
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73. Y
Giffen paradox
If price (Px) & quantity demanded (X) of a good are _________ related, the good is called a Giffen good.
PCC
positively X Px
Px1
Demand Curve
Px2 X X2 X1
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74. Decomposition of the Price Effect into the Substitution Effect & the Income Effect
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75. in the quantity demanded of a good caused by a change in its price,
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 ___________ effect and __________ effect.
substitution
income
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76. Y E1 New equilibrium E3 L2 L3 L1 X S.E. X1 X3
Substitution effect (替代效應) is the change in the quantity demanded of a good caused by a change in its price, holding utility or real income constant. Y X  E1 L1 X1
Px One will buy more good X to substitute good Y
So substitution effect must be negative. L3
New equilibrium E3  X3 L2
S.E.
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77. Y X S.E. E3 E1 X3 X1 E2 X2 I.E. L1 L3 L2 Using the saved income
Income effect (所得效應) is the change in the quantity demanded of a good as a result of a change in real income caused by a change in its price. Y X
S.E.  E3 E1 L1 L3 X3 X1 L2
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.
Using the saved income E2 
The saved income will raise the consumption of good X if good X is a superior good.  X2
I.E.
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78. Price effect of different kinds of goods YX  E1 L1
1. The substitution effect must be negative.
Positive I.E.
2. If good X is a superior good, what will be the income effect? L3  E2  E3
3. And what will be the price effect? L2
S.E.
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79. what will be the price effect? Negative I.E.Y X L1  E1
2. If X is an inferior good
with its -ve I.E. < S.E.,
what will be the price effect?
Negative I.E. L2  E2 L3 E3 
S.E.
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80. Y X E1 
Negative I.E.
3. If X is an inferior good with its -ve I.E. > S.E., (called Giffen good), what will be the price effect? L2  E2 L3 E3  L1
S.E.
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81. (b) If good X is an inferior good with its substitution
Q3.12: Decompose the price effect into the substitution effect and the income effect, when the price of good X rises. (a) If good X is a superior good
(b) If good X is an inferior good with its substitution
effect greater than its income effect
(c) If good X is an inferior good with its substitution
effect smaller than its income effect
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82. Advanced Material 3.1: 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.
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83. Advanced Material 3.2: Corner solutions
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 (角隅解).
specialization
There is a ___________________ in consumption.
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84. Advanced Material 3.2: Corner solutions
Possible reasons for a corner solution are:
1. The good is too expensive.
2. The entity is a bad.
3. MRS is not decreasing.
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85. 1. The good is too expensive
Y (A good)
MRSe (= cost)
>
MRSc (= value) U3 E* U2
U3>U2>U1 U1
X (A good but too expensive) 1X
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86. 2. The entity is a bad Y (A good) U3 U2 E* U1 U3>U2>U1 X (A bad)
U3>U2>U1
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87. 3. MRS is not decreasing Constant MRS Y (A good) X (A good) U1 U3 U2
U3>U2>U1
Y (A good)
X (A good) U1 U3 U2 E*
Increasing MRS
U3>U2>U1
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88. 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.
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89. 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.
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90. 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.
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91. Correcting Misconceptions:
10. Substitution effect is positive for superior good and negative for inferior good.
11. Giffen good has no relation with inferior good.
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92. Survival Kit in Exam: Question 3. 1 (a) What is utility
Survival Kit in Exam: Question 3.1 (a) What is utility? Must the utility of a bad be a negative number?
(b) Michael says, “Anderson fails in HKCEE and he commits suicide. Why? He is maximizing utility. Mary also fails in HKCEE but she does not commit suicide. Why? She is maximizing utility. So, the postulate of utility maximization is tautological.” Do you agree?
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93. Survival Kit in Exam: Question 3
Survival Kit in Exam: Question 3.2 Being a member of a club, a consumer can purchase cosmetics at a reduced price. However, he has to pay a membership fee, and after which he has just enough income to purchase the original basket of goods. Does he prefer to be a member? Use an indifference map to illustrate.
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