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UTILITIES INDIFFERENCE CURVES Chapter 3. Budget line 2 Points on the budget line indicate all the bundles of goods that the consumer can afford. Good.

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Presentation on theme: "UTILITIES INDIFFERENCE CURVES Chapter 3. Budget line 2 Points on the budget line indicate all the bundles of goods that the consumer can afford. Good."— Presentation transcript:

1 UTILITIES INDIFFERENCE CURVES Chapter 3

2 Budget line 2 Points on the budget line indicate all the bundles of goods that the consumer can afford. Good Good

3 Indifference Curve 3 Indifference curve: locus of bundles that provide the consumer with the same level of satisfaction

4 Indifference curves 4 Good 1 ( x 1 ) 0 10 Good 2 ( x 2 ) w b a Points on the same indifference curve represent bundles yielding the same amount of utility.

5 Indifference Curves 5 Indifference map  Set of indifference curves for a consumer  Every bundle On an indifference curve  Indifference curves  Farther from origin ->Higher utility

6 The Shape of Indifference Curves 6 Indifference curves  Cannot slope upward  Nonsatiation assumption  Cannot cross each other  Transitivity and nonsatiation assumptions  Farther from the origin – higher utility  Nonsatiation assumption  Cannot cross each other  Are bowed in toward the origin  Convexity assumption  Farther from the origin - higher utility

7 Indifference curves cannot slope upward 7 Good 1 ( x 1 ) 0 Good 2 ( x 2 ) y x a If an indifference curve ran from a to x, then bundle x would be no better than bundle a despite containing more of both goods. This upward slope of the indifference curve would be a violation of the nonsatiation assumption. B CD E

8 Indifference curves cannot cross each other 8 Good 1 ( x 1 ) 0 Good 2 ( x 2 ) I1I1 I2I2 c b a If indifference curves I 1 and I 2 crossed at a, then by transitivity of preferences bundle b would be no better than bundle c despite containing more of both goods. This crossing of indifference curves would be a violation of the nonsatiation assumption

9 Farther from the origin -> higher utility 9 Good 1 ( x 1 ) 0 Good 2 ( x 2 ) w a Bundle w must be preferred to bundle a because it contains more of both goods

10 Bowed-in 10 Good 1 ( x 1 ) 0 Good 2 ( x 2 ) (a) Bowed-out indifference curves violate convexity of preferences. Bundle c is a weighted average of bundles a and b, but yields lower utility level because it is on an indifference curve that is closer to the origin. (b) Bowed-in indifference curves satisfy the convexity of preferences. Bundle c, a weighted average of bundles a and b, yields a higher utility level a b c (a) Good 1 ( x 1 ) 0 Good 2 ( x 2 ) a b c (b)

11 The Marginal Rate of Substitution 11 Marginal rate of substitution (MRS)  Particular point on indifference map  One consumer  Ratio of exchanging goods  Same utility MRS = - ∆x 2 / ∆x 1

12 The Marginal Rate of Substitution 12 Diminishing marginal rate of substitution  From convexity  Move along the indifference curve  Same utility level  MRS decreases

13 I1I1 Convex preferences and the MRS 13 As the consumer is given bundles containing more and more of good 2, she values an individual unit of good 2 less and less a d c Good 1 ( x 1 ) Good 2 ( x 2 ) b -∆x 1 +∆x 2 -∆x 1

14 Indifference Curves and Tastes 14 Flat indifference curves  Goods that yield no utility Straight-line indifference curves  Goods that are perfect substitutes  MRS - constant along an indifference curve  In a two-good world Indifference curve - straight line

15 15 Good 1 ( x 1 ) 0 Good 2 ( x 2 ) (a) Flat indifference curves. The good measured on the horizontal axis is yielding no utility for the consumer. (b) Straight-line indifference curves: perfect substitutes. The same amount of good 2 is always needed to compensate the consumer for the loss of one unit of good 1. (a) (b) a Good 1 ( x 1 ) Good 2 ( x 2 ) ∆x 2 -∆x 1 +∆x 2 -∆x 1

16 Indifference Curves and Tastes 16 Right-angle indifference curves  Goods that are perfect complements  Must be consumed in a fixed ratio to produce utility  In a two-good world Right angle indifference curves Bowed-out indifference curves  Nonconvex preferences

17 I1I1 17 Good 1 ( x 1 ) 0 Good 2 ( x 2 ) (c) Right-angle indifference curves: perfect complements. Adding any amount of only one good to bundle a yields no additional utility. (d) Bowed-out indifference curves: nonconvex preferences and the MRS. As the consumer is given bundles containing more and more of good 2, he values an individual unit of good 2 more and more. (c) (d) Good 2 ( x 2 ) ∆x 1 Good 1 ( x 1 ) 0 56 b c a -∆x 1 b a +∆x 2

18 Perfect substitutes 18 Coke 0 Pepsi Mary’s marginal rate of substitution is constant at any bundle of Pepsi and Coke.

19 Optimal Consumption Bundle 19 Optimal consumption bundle  Maximize consumer’s utility  Within the economically feasible set  Best bundle  According to consumer’s preferences Characteristics of optimal bundles  Indifference curve tangent to budget line Slope of indifference curve = MRS = -∆x 2 /∆x 1 Slope of budget line = price ratio = p 1 /p 2  MRS = p 1 /p 2

20 The optimal consumption bundle 20 At the optimal point e, the indifference curve is tangent to the boundary BB’ of the economically feasible consumption set. Good 1 ( x 1 ) 0 Good 2 ( x 2 ) x e z B B’ F m n k


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