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1 Introductory Microeconomics Indifference Curves.

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1 1 Introductory Microeconomics Indifference Curves

2 2 Example: To encourage education, a government is considering three different options: A lump-sum cash to kids of school age. A matching subsidy to each dollar the kids spend on schooling. Provide education for free. Which is better?

3 3 Three Steps Involved In The Study Of Consumer Behavior. 1) We will study consumer preferences. To describe how and why people prefer one good to another. 2)Then we will turn to budget constraints. People have limited incomes. 3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices. What combination of goods will consumers buy to maximize their satisfaction?

4 4 Market basket defined A market basket is a collection of one or more commodities. One market basket may be preferred over another market basket containing a different combination of goods.

5 5 Three Basic Assumptions of Consumer Preferences Preferences are complete. Give me any two baskets of goods (A and B), I will be able to tell you on of the followings: I prefer A to B I prefer B to A I am indifferent between A and B Preferences are transitive. If I prefer A to B and B to C, I must also prefer A to C. Non-satiation: Consumers always prefer more of any good to less. Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person.

6 6 Preferences over market basket A2030 B1050 D4020 E3040 G1020 H1040 Market Basket Units of Food Units of Clothing E is preferred to Similarly, A, E, B, H, D are all preferred to G … Much easier to see in a graph. Observations based on more good is preferred to less G A H

7 7 Preferences over market basket Easier to see in a graph The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A. Food (units per week) Clothing (units per week) 50 G A EH B D

8 8 Preferences over market basket Easier to see in a graph U1U1 For example: Combination B,A, & D yield the same satisfaction E is preferred to U 1 U 1 is preferred to H & G Food (units per week) Clothing (units per week) 50 G D A E H B

9 9 Preferences over market basket U1U1 Food (units per week) Clothing (units per week) 50 G D A E H B Any market basket lying above and to the right of an indifference curve is preferred to any market basket that lies on the indifference curve. Indifference curves slope downward to the right. If it sloped upward it would violate the assumption that more of any commodity is preferred to less.

10 10 Indifference map An indifference map is a set of indifference curves that describes a person s preferences for all combinations of two commodities. Each indifference curve in the map shows the market baskets among which the person is indifferent. U2U2 U3U3 Food (units per week) Clothing (units per week) U1U1 A B D Market basket A is preferred to B. Market basket B is preferred to D. Market basket A is preferred to B. Market basket B is preferred to D.

11 11 Indifference Curves Cannot Cross U1U1 U2U2 Food (units per week) Clothing (units per week) A D B If crossed the consumer should be indifferent between A, B and D. However, B contains more of both goods than D. Thus, given transitivity assumption, the assumption of more is preferred to less is violated.

12 12 The amount of clothing given up for unit of food decreases with amount of food A B D E G Observation: The amount of clothing given up for a unit of food decreases from 6 to 1 Food (units per week) Clothing (units per week) Question: Does this relation hold for giving up food to get clothing?

13 13 Marginal Rate of Substitution Food (units per week) Clothing (units per week) A B D E G MRS = 6 MRS = 2 The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good MRS is measured by the slope of the indifference curve MRS = - C / F

14 14 Assumption: Diminishing Marginal Rate of Substitution Food (units per week) Clothing (units per week) A B D E G MRS = 6 MRS = 2 Along an indifference curve there is a diminishing marginal rate of substitution. Example: the MRS for AB was 6, while that for DE was 2 Indifference curves are convex because as more of one good is consumed, a consumer would prefer to give up fewer units of a second good to get additional units of the first one. That is, consumers prefer a balanced market basket.

15 15 Perfect Substitutes Orange Juice (glasses) Apple Juice (glasses) Perfect Substitutes Perfect Substitutes Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant.

16 16 Perfect Complements Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. Right Shoes Left Shoes Perfect Complements Perfect Complements

17 17 BADS Things for which less is preferred to more Examples Air pollution Asbestos How does the indifference curve over 1.Two bads 2.One good and one bad look like?

18 18 Utility and utility functions Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket. Utility Functions Assume: The utility function for food (F) and clothing (C) U(F,C) = F + 2C Market Baskets: F units C units U(F,C) = F + 2C A (3) = 14 B (4) = 14 C (4) = 12 The consumer is indifferent between A & B The consumer prefers A & B to C

19 19 Utility Functions & Indifference Curves Food (units per week) Clothing (units per week ) U 1 = 25 U 2 = 50 (Preferred to U 1 ) U 3 = 100 (Preferred to U 2 ) A B C Assume: U = FC Market Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5)

20 20 Ordinal Versus Cardinal Utility Ordinal Utility Function: places market baskets in the order of most preferred to least preferred, but it does not indicate how much one market basket is preferred to another. Cardinal Utility Function: utility function describing the extent to which one market basket is preferred to another. Ordinal Versus Cardinal Rankings an ordinal ranking is sufficient to explain how most individual decisions are made.

21 21 Budget Constraints Budget constraints limit an individual s ability to consume in light of the prices they must pay for various goods and services. The budget line indicates all combinations of two commodities for which total money spent equals total income.

22 22 The Budget Line Let F equal the amount of food purchased, and C is the amount of clothing. Price of food = P f and price of clothing = P c Then P f F is the amount of money spent on food, and P c C is the amount of money spent on clothing. P f F + P c C = I

23 23 Budget Constraints A040$80 B2030$80 D4020$80 E6010$80 G800$80 Market BasketFood (F) Clothing (C)Total Spending P f = ($1)P c = ($2)P f F + P c C = I

24 24 Budget Constraints Budget Line F + 2C = $80 (I/P C ) = 40 Food (units per week) = (I/P F ) A B D E G Clothing (units per week ) Pc = $2 P f = $1 I = $80 As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other.

25 25 Budget Constraints Budget Line F + 2C = $80 (I/P C ) = 40 Food (units per week) = (I/P F ) A B D E G Clothing (units per week ) Pc = $2 P f = $1 I = $80 The vertical intercept (I/PC), illustrates the maximum amount of C that can be purchased with income I. The horizontal intercept (I/PF), illustrates the maximum amount of F that can be purchased with income I.

26 26 Budget Constraints Budget Line F + 2C = $ (I/P C ) = 40 Food (units per week) = (I/P F ) A B D E G Clothing (units per week ) Pc = $2 P f = $1 I = $80 The slope of the line measures the relative cost of food and clothing. The slope is the negative of the ratio of the prices of the two goods. The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent.

27 27 Effects of Changes in Income Food (units per week) Clothing (units per week) A increase in income shifts the budget line outward A increase in income shifts the budget line outward (I = $160) L2L2 L2L2 (I = $80) L1L1 L3L3 (I =$40) A decrease in income shifts the budget line inward A decrease in income shifts the budget line inward

28 28 Effects of Changes in Prices Food (units per week) Clothing (units per week) (P F = 1) L1L1 An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward. L3L3 (P F = 2) (P F = 1/2) L2L2 A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward.

29 29 Effects of Changes in Prices Food (units per week) Clothing (units per week) If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change. Same as an increase in income If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change. Same as an increase in income P c = $1, P f =$0.5 L2L2 L2L2 L1L1 L3L3 P c = $4, P f =$2 If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change. Same as a decrease in income. If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change. Same as a decrease in income. Pc = $2 P f = $1 I = $80

30 30 Consumer Choice Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them. The maximizing market basket must satisfy two conditions: 1) It must be located on the budget line. 2) Must give the consumer the most preferred combination of goods and services.

31 31 Consumer Choice Budget Line U3U3 D Market basket D cannot be attained given the current budget constraint. Pc = $2 P f = $1 I = $80 Food (units per week) Clothing (units per week)

32 32 Consumer Choice Food (units per week) Clothing (units per week) U1U1 B Budget Line Pc = $2 P f = $1 I = $80 Point B does not maximize satisfaction because there exist a point A which is attainable and yields a higher satisfaction. -10C +10F Note that the MRS -(-10/10) = 1 is greater than the price ratio (1/2). A

33 33 Consumer Choice Recall, the slope of an indifference curve is: Further, the slope of the budget line is: Therefore, it can be said that satisfaction is maximized where:

34 34 Example: Matching vs. Non-matching grant from the federal government Local official has a preference on police spending (by taxing its citizens) and private consumption (by its citizens). The budget line represents the total amount of resources available for the public spending and private spending. A non-matching grant from the federal government is simply a check from the federal government. A matching grant from the federal government is offered as a subsidy of the local spending.

35 35 Before Grant Budget line: PQ A: Preference maximizing market basket Expenditure OR: Private OS: Police Choosing between a non-matching and matching grant to fund police expenditures V T U3U3 U1U1 After Grant Budget line: TV B: Preference maximizing market basket Expenditure OU: Private OZ: Police B U Z R Non-matching Grant P Police Expenditures ($) Private Expenditures ($) OSQ A

36 36 Before Grant Budget line: PQ A: Preference maximizing market basket Choosing between a non-matching and matching grant to fund police expenditures P R U2U2 T U1U1 Matching Grant Police ($) Private Expenditures ($) OQS R After Grant C: Preference maximizing market basket Expenditures OW: Private OX: Police C X W A

37 37 Choosing between a non-matching and matching grant to fund police expenditures T U3U3 U1U1 Nonmatching Grant Point B OU: Private expenditure OZ: Police expenditure Matching Grant Point C OW: Private expenditure OX: Police expenditure W X Matching vs. Non-Matching Grant P Police ($) Private Expenditures ($) OQ A U2U2 C R B U Z Note that the amount of grant at point B and C are the same.

38 38 Example: A College Trust Fund Suppose Jane Doe s parents set up a trust fund for her college education. Originally, the money must be used for education. If part of the money could be used for the purchase of other goods, her preferred consumption bundle changes.

39 39 A College Trust Fund The trust fund shifts the budget line P Q Education ($) Other Consumption ($) U2U2 A College Trust Fund A U1U1 A: Consumption before the trust fund C U3U3 C: If the trust could be spent on other goods B B: Requirement that the trust fund must be spent on education

40 40 End


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