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© Pilot Publishing Company Ltd. 2005 Chapter 3 Consumer Behaviour I --- The Indifference Curve Approach.

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Presentation on theme: "© Pilot Publishing Company Ltd. 2005 Chapter 3 Consumer Behaviour I --- The Indifference Curve Approach."— Presentation transcript:

1 © Pilot Publishing Company Ltd Chapter 3 Consumer Behaviour I --- The Indifference Curve Approach

2 © Pilot Publishing Company Ltd 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 Contents:

3 © Pilot Publishing Company Ltd Changes in Consumer Equilibrium in Response to Changes in ConstraintsChanges in Consumer Equilibrium in Response to Changes in Constraints Decomposition of Price Effect into Substitution Effect and Income EffectDecomposition of Price Effect into Substitution Effect and Income Effect Advanced Material 3.1: Postulate of utility maximizationAdvanced Material 3.1: Postulate of utility maximization Advanced Material 3.2: Corner solutions Contents:

4 © Pilot Publishing Company Ltd Postulates of Consumer Behaviour

5 © Pilot Publishing Company Ltd A theory has four components - definitions; postulates; test conditions; implications Chapter one: basic definitions This chapter: postulates + test conditions + implications

6 © Pilot Publishing Company Ltd A. An economic agent behaves rationally. Significance: Thus, economic investigation is possible and meaningful. 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. What are the basic postulates of consumer behaviour?

7 © Pilot Publishing Company Ltd Meaning: An economic agent always chooses the option that _________ the achievement of his goals among the options allowed by existing constraints. B. Postulate of constrained maximization / self-interest / selfishness Then how does an individual make his choice? 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.

8 © Pilot Publishing Company Ltd Competition Choice C. Each individual has many wants. D. To each individual, some goods are scarce. Scarcity Significance: Hence competition and choice are inevitable. They constitute the main content of economics. Significance: Hence choice and exchange may arise.

9 © Pilot Publishing Company Ltd 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. E. Scarce goods are substitutable Significance: Exchange is possible.

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

11 © Pilot Publishing Company Ltd Good, Bad and Neuter

12 © Pilot Publishing Company Ltd A good is something desired, i.e., _________ is preferred to _________. none (Options: more / less / none / some) some

13 © Pilot Publishing Company Ltd Goods Free goodsScarce goods (economic goods) Types of goods:

14 © Pilot Publishing Company Ltd (Options: more / less / some / no more ) Free good: Features its amount available is ______ than its amount desired at zero price, i.e., ________ is preferred. something desired no more more

15 © Pilot Publishing Company Ltd Scarce good (economic good): Features (Options: more / less / some / none ) something desired its amount available is _____ than its amount desired at zero price, i.e., ______ is preferred to _____. less moreless

16 © Pilot Publishing Company Ltd Depends on situations rather than kinds. Any examples? Distinction between free goods and scarce goods:

17 © Pilot Publishing Company Ltd Distinction between free goods and goods free-of-charge: A free good must be a good free-of-charge. Why? A good free-of-charge may not be a free good. 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 scarce good can also be free-of-charge if someone pays the cost for you. Any examples?

18 © Pilot Publishing Company Ltd Is sickness a bad ? more (Options: more / less / some / none ) A bad is something undesired, i.e., _________ is preferred to _________. less

19 © Pilot Publishing Company Ltd A neuter ( ) is something neither desired nor undesired, i.e., the quantity does not matter. Any examples?

20 © Pilot Publishing Company Ltd 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.

21 © Pilot Publishing Company Ltd Utility

22 © Pilot Publishing Company Ltd What is utility? Utility ( ) is a number arbitrarily assigned to entities to rank them according to ones preference. a criterion of maximization to rank options for making choice. the higher the utility, the more one prefers the entity.

23 © Pilot Publishing Company Ltd What is utility? Utility reflects preference social welfare happiness / satisfaction Why?

24 © Pilot Publishing Company Ltd 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

25 © Pilot Publishing Company Ltd Measurement of utility Which measurement of utility is used in the indifference curve approach? Ordinal measure of utility

26 © Pilot Publishing Company Ltd Indifference Curve

27 © Pilot Publishing Company Ltd U=10 An indifference curve (IC, ) is a line joining all the points (representing different baskets of goods) giving the same utility to an individual. Good X Good Y 0 What is an indifference curve?

28 © Pilot Publishing Company Ltd An indifference map ( ) is a set of ICs showing the _________ of an individual. What is an indifference map? U=10 U=20 U=30 Good Y Good X 0 preference

29 © Pilot Publishing Company Ltd Properties of Indifference Curves of Two Goods

30 © Pilot Publishing Company Ltd U=10 Good Y Good X 0 +X -Y 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. fewer negative (Options: more / fewer / positive / negative) Slope of an IC of two goods (= Δ Y/ Δ X) must be ________.

31 © Pilot Publishing Company Ltd If quantities of good X and good Y can be increased or decreased by infinitesimal amounts, the ICs are continuous. Why? 2. Indifference curves are continuous U=10 Good Y Good X 0

32 © Pilot Publishing Company Ltd Along U 2: point A = point C = U 2 Along U 1 : point A = point B = U 1 What is the utility of point A, = U 1 or U 2 ? 3. Indifference curves can never intersect U of the intersection point logical contradiction A B C

33 © Pilot Publishing Company Ltd U1U1 U2U2 U3U3 Good Y Good X 0 The higher the IC, the higher the utility (U 3 > U 2 > U 1 ). Why? If a consumer knows his preference on every basket of commodities, the commodity plane will be fully covered by ICs. Why? 4. Full coverage

34 © Pilot Publishing Company Ltd Indifference curves of two goods are convex to the origin U1U1 Good Y Good X 0 +1X -Y As the consumption of good X rises, MRS (the slope) falls. Why? convex As the IC becomes flatter & flatter, its shape is _______ to the origin. The numerical value of the slope of an IC (+1X -?Y) is equal to the MRS. Why?

35 © Pilot Publishing Company Ltd Other Shapes of Indifference Curves

36 © Pilot Publishing Company Ltd Y (A good) X (A neuter) 0 U2U2 U1U1 U3U3 U 3 >U 2 >U 1 1. X is a neuter and Y is a good Any increase or decrease in the quantity of X makes no difference to the consumer. Why? ICs are ___________. horizontal

37 © Pilot Publishing Company Ltd 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?

38 © Pilot Publishing Company Ltd ICs are _________ sloping with a/an _________slope. 2. X is a bad and Y is a good U 3 >U 2 >U 1 U1U1 U2U2 U3U3 0 Y (A good) X (A bad) Why? upward increasing +X +Y To keep U constant, in a bad (+X) requires in a good (+Y) as a compensation.

39 © Pilot Publishing Company Ltd 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?

40 © Pilot Publishing Company Ltd X is a commodity with a satiation threshold (beyond which X turns from a good to a bad) 0 Good Y X U1U1 U2U2 U3U3 U 3 >U 2 >U 1 X becomes a bad X is a good ICs are __________. Why? U-shaped

41 © Pilot Publishing Company Ltd What will be the shape of the ICs if both X and Y are goods with a satiation threshold?

42 © Pilot Publishing Company Ltd X and Y are perfect substitutes Good X (pack of 5 kg rice) Good Y (pack of 8 kg rice) 0 U1U1 U2U2 U3U3 U 3 >U 2 >U 1 ICs are _________ sloping _______ lines. Why? downward straight

43 © Pilot Publishing Company Ltd X and Y are perfect complements Good Y (left shoes) Good X (right shoes) 0 ICs are __________. 45 o U 3 >U 2 >U 1 U1U1 U2U2 U3U3 Why? right-angled

44 © Pilot Publishing Company Ltd Q3.7: Study the indifference maps below and determine if X and Y are goods, bads or neuters. Y U1U1 U2U2 U3U3 X U1U1 U2U2 U3U3 X Y (a) U 1 < U 2 < U 3 (b) U 1 > U 2 > U 3

45 © Pilot Publishing Company Ltd Budget Line

46 © Pilot Publishing Company Ltd It is also called the budget constraint. 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.

47 © Pilot Publishing Company Ltd Y X0 Given I = $100, P X = $20 & P Y = $25 The maxi. amount of X one can buy = ___________ $100/$20 = 5 $100/$25 = 4 $20/$25 = X -0.8Y Derivation of a BL: To buy 1 more unit of X, one forgoes =____________ unit of Y. The maxi. amount of Y one can buy = ___________ The BL is a downward sloping straight line. The slope of BL = cost of consuming an additional unit of good X in terms of good Y.

48 © Pilot Publishing Company Ltd Y X 0 A C B Point A: Expenditure ____ Income Point B: Expenditure ____ Income Point C: Expenditure ____ Income Features: < = > (Options: > = < )

49 © Pilot Publishing Company Ltd Equation of budget line X P X + Y P Y = I Expenditure on good X Expenditure on good Y Money income of the consumer

50 © Pilot Publishing Company Ltd Changes in budget constraints 1. Changes in income When ones income increases, the budget line will shift ______ in a parallel manner, and vice versa. Y 0X outward Why? in income

51 © Pilot Publishing Company Ltd Y 0 X 2. Proportionate changes in prices When prices of both goods rise by the same proportion, the budget line will shift _______ in a parallel manner, and vice versa. inward Why? A proportionate in all money prices

52 © Pilot Publishing Company Ltd Y 0 X 3. Disproportionate changes in prices A rise in P x A fall in P x tilt inward tilt outward When P X, the budget line will _________ and become steeper. Why? When P X, the budget line will __________ and become _______. Why? flatter

53 © Pilot Publishing Company Ltd Q3.8: Under the following situations, what would happen to the budget line? Explain with the aid of diagrams. (a) I and P Y are constants, but P x increases from P 0 to P 1. (b) I and P Y are constants, but P X increases as the consumer buys more and more units of the good, i.e., P X and X are positively related. (c) I and P Y are constants, but P X decreases as the consumer buys more and more units of the good, i.e., P X and X are negatively related.

54 © Pilot Publishing Company Ltd Consumer Equilibrium

55 © Pilot Publishing Company Ltd Optimum ( ) or equilibrium ( ) is the best choice of an economic agent in achieving his objective. What is a consumer equilibrium? Optimality conditions ( ) or equilibrium conditions ( ) are descriptions on the defining features of the optimum or the equilibrium.

56 © Pilot Publishing Company Ltd 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 ( ). intercepts

57 © Pilot Publishing Company Ltd It is the tangency point, the only point on the budget line reaching the highest IC attainable. U1U1 U3U3 Y X 0 U 3 >U 2 >U 1 X* Y* From observation, the best choice achievable is _____________. Equilibrium: From observation E* U2U2 E* (X*, Y*) Why?

58 © Pilot Publishing Company Ltd Equilibrium conditions: U1U1 U2U2 U3U3 Y X 0 U 3 >U 2 >U 1 E* X* Y* 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. on tangency point

59 © Pilot Publishing Company Ltd Slope of indifference curveSlope of budget line 1. = Δ Y/ Δ X, holding utility constant = Δ Y/ Δ X, holding expenditure or income constant 2.= Marginal rate of substitution in consumption, MRSc = Marginal rate of substitution in exchange, MRSe Meaning of the slopes3.= 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 exchange4.= 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) ValueCost

60 © Pilot Publishing Company Ltd Buy X MRS c MRS e How is the consumer equilibrium reached? At point A, MRS c > MRS e (_______ of an additional X > its ________), utility can be raised if the consumer _________ units of X. U2U2 U1U1 Y X 0 A buys more (Options: buys more / sells some / value / cost ) value cost

61 © Pilot Publishing Company Ltd Sell X MRS e MRS c U2U2 U1U1 Y X 0 At point B, MRS c < MRS e (value < cost), utility can be raised if the consumer _________ units of X. B sells some (Options: buys some / sells some ) How is the consumer equilibrium reached?

62 © Pilot Publishing Company Ltd U2U2 U1U1 Y X 0 MRS c = MRS e (value = cost), utility is maximized & the equilibrium is attained. E* How is the consumer equilibrium reached?

63 © Pilot Publishing Company Ltd Changes in Consumer Equilibrium in Response to Changes in Constraints

64 © Pilot Publishing Company Ltd A. Changes in income When income with P X and P Y unchanged, the BL will shift outward / inward? in a parallel manner. The effect of income on the consumption of a consumer can be shown by 2 curves: 1. Income consumption curve 2. Engel curve outward

65 © Pilot Publishing Company Ltd Income consumption curve (, ICC) is a line joining all the equilibrium (X,Y) of a consumer when ones income changes, holding P X and P Y constant. ICC 1. Income consumption curve Y 0 X

66 © Pilot Publishing Company Ltd Engel curve ( ) is a line showing the consumption of a good at different income levels, holding P X and P Y constant. X 0 Income Engel curve 2. Engel curve I 1 I 2 I 3 X3X2X1X3X2X1

67 © Pilot Publishing Company Ltd Y X ICC A. Superior good: Its consumption is positively related to income. X Income Engel curve X 1 X 2 X 3 X3X2X1X3X2X1 I 1 I 2 I 3

68 © Pilot Publishing Company Ltd ICC Y X B. Inferior good: Its consumption is negatively related to income. X I Engel curve X3X2X1X3X2X1 X1X2X3X1X2X3 I 1 I 2 I 3

69 © Pilot Publishing Company Ltd 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

70 © Pilot Publishing Company Ltd PCC Price consumption curve ( ) is a line joining all the equilibrium of a consumer when P X changes, holding I & P Y constant. 1. Price consumption curve Y 0 X

71 © Pilot Publishing Company Ltd Demand Curve Px 0 X Px 1 Px 2 Px 3 Demand curve is a line showing the ________________ of a good of a consumer at different prices. 2. Demand curve quantity demanded X 1 X 2 X 3

72 © Pilot Publishing Company Ltd Px 1 Px 3 Px 2 Y 0 Px 0 X X PCC Demand Curve X 1 X 2 X 3 X4X4 If price (Px) & quantity demanded (X) of the good are negatively related.

73 © Pilot Publishing Company Ltd Px 1 Px 2 PCC Y 0 X Px 0 X Demand Curve Giffen paradox If price (Px) & quantity demanded (X) of a good are _________ related, the good is called a Giffen good. positively X 1 X 2

74 © Pilot Publishing Company Ltd Decomposition of the Price Effect into the Substitution Effect & the Income Effect

75 © Pilot Publishing Company Ltd 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. substitutionincome

76 © Pilot Publishing Company Ltd Px One will buy more good X to substitute good Y S.E. L3L3 X3X3 E3E3 Y 0 X E1E1 L1L1 X1X1 So substitution effect must be negative. 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. New equilibrium L2L2

77 © Pilot Publishing Company Ltd I.E. L2L2 X2X2 Y 0 X S.E. E3E3 E1E1 L1L1 L3L3 X3X3 X1X1 Using the saved income The saved income will raise the consumption of good X if good X is a superior good. E2E2 Income effect ( ) 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. 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.

78 © Pilot Publishing Company Ltd Price effect of different kinds of goods S.E. Positive I.E. Y 0 X E1E1 L1L1 L2L2 L3L3 E3E3 E2E2 2. If good X is a superior good, what will be the income effect? 3. And what will be the price effect? 1. The substitution effect must be negative.

79 © Pilot Publishing Company Ltd S.E. L3L3 L2L2 Negative I.E. Y 0 X L1L1 E1E1 2. If X is an inferior good with its -ve I.E. < S.E., what will be the price effect? E3E3 E2E2

80 © Pilot Publishing Company Ltd S.E. L1L1 L3L3 L2L2 E3E3 Y 0 X E1E1 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? E2E2

81 © Pilot Publishing Company Ltd 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 (c) If good X is an inferior good with its substitution effect smaller than its income effect (b) If good X is an inferior good with its substitution effect greater than its income effect

82 © Pilot Publishing Company Ltd 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.

83 © Pilot Publishing Company Ltd 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 ( ). There is a ___________________ in consumption. specialization

84 © Pilot Publishing Company Ltd Advanced Material 3.2: Corner solutions Possible reasons for a corner solution are: 3. MRS is not decreasing. 1. The good is too expensive. 2. The entity is a bad.

85 © Pilot Publishing Company Ltd E* Y (A good) X (A good but too expensive) MRS c (= value) MRS e (= cost) U1U1 U3U3 U2U2 U 3 >U 2 >U 1 1. The good is too expensive > 1X

86 © Pilot Publishing Company Ltd Y (A good) X (A bad) U1U1 U3U3 U2U2 E* 0 U 3 >U 2 >U 1 2. The entity is a bad

87 © Pilot Publishing Company Ltd Y (A good) X (A good) U1U1 U3U3 U2U2 E* 0 Increasing MRS U 3 >U 2 >U 1 3. MRS is not decreasing Constant MRS Y (A good) X (A good) U1U1 U3U3 U2U2 E* 0 U 3 >U 2 >U 1

88 © Pilot Publishing Company Ltd 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.

89 © Pilot Publishing Company Ltd 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:

90 © Pilot Publishing Company Ltd 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:

91 © Pilot Publishing Company Ltd Substitution effect is positive for superior good and negative for inferior good. 11. Giffen good has no relation with inferior good. Correcting Misconceptions:

92 © Pilot Publishing Company Ltd 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?

93 © Pilot Publishing Company Ltd 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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