Indifference Curves A simple numerical example of indifference curves. Marginal utility is the change in utility when goods or services change. MU = ∆TU / ∆Q Consumer base their purchasing decision on the marginal utility they receive per dollar spent. MU / PRICE
Budget Constraints Basic Characteristics Show affordable combinations of X and Y. Slope of –P X /P Y reflects relative prices. Effects of Changing Income and Prices Budget increase (decrease) causes parallel outward (inward) shift. Relative price change alters budget slope. Income and Substitution Effects Income effect changes overall consumption. Substitution effect alters relative consumption.
Optimal Consumption Marginal Rate of Substitution (MRS) MRS XY = -MU X /MU Y and equals indifference curve slope. MRS XY shows tradeoff between X and Y consumption, holding utility constant. MRS XY diminishes as substitution of X for Y increases. Utility maximization requires P X /P Y = MU X /MU Y, or MU X /P X = MU Y /P Y.
The Relationship between income and goods and services consumed. Consumption Path When income increases, do you buy more of both goods? What does this mean? As I demand for good X . X is an inferior good.
Demand Sensitivity Analysis: Elasticity Elasticity measures sensitivity. Point elasticity shows sensitivity of Y to small changes in X. ε X = ∂Y/Y ÷ ∂X/X. Arc elasticity shows sensitivity of Y to big changes in X. E X = (Y 2 – Y 1 )/(Y 2 +Y 1 ) ÷ (X 2 -X 1 )/(X 2 +X 1 ).
Price Elasticity and Optimal Pricing Policy Optimal Price Formula MR and ε P are directly related. MR = P/[1+(1/ ε P )]. Optimal P* = MC/[1+(1/ ε P )]. Determinants of Price Elasticity Essential goods have low│ε P │. Nonessential goods have high│ε P │.