Copyright 2002, Pearson Education Canada1 Indifference Curves Appendix to Chapter 6

Copyright 2002, Pearson Education Canada2 Marginal Rate of Substitution zThe marginal rate of substitution is the ratio at which a household is willing to substitute good Y for good X. MRS = MU x / MU y

Copyright 2002, Pearson Education Canada3 Basic Assumptions Underlying Indifference Curves zAll goods yield positive marginal utility. More is always better. zThe marginal rate of substitution is diminishing. That is, as more of X and less of Y is consumed, MU x / Mu y declines. zThe consumer has the ability to choose between the combinations of goods and services available. zThe consumer is rational. If A is preferred to B and B preferred to C then A is also preferred to C.

Copyright 2002, Pearson Education Canada4 Indifference Curve zAn indifference curve is a graph of a set of points, each point representing a combination of goods X and Y, all of which yield the same total utility.

Copyright 2002, Pearson Education Canada5 An Indifference Curve (Figure 6A.1) zThe consumer is indifferent between points A, B, and C. zAll three points yield the same amount of utility. zThe consumer would be worse of at point A’ than at any of the other points.

Copyright 2002, Pearson Education Canada6 Preference Map (Figure 6A.2) zThe shapes of the indifference curves depend upon the preferences of the consumer, and the whole set of indifference curves is called a preference map. zEach consumer has a unique preference map. zUtility increases at higher indifference curves.

Copyright 2002, Pearson Education Canada7 Properties of Indifference Curves zThey are commonly convex to the origin. zThis means they illustrate a diminishing marginal rate of substitution. zThey cannot cross.

Copyright 2002, Pearson Education Canada8 Consumer Utility-Maximizing Equilibrium (Figure 6A.3) zConsumers will choose that combination of X and Y that maximizes total utility. Graphically, the consumer will move along the budget constraint until the highest possible indifference curve is reached. zAt that point, the budget constraint and the indifference curve are tangent. zThis occurs at X* and Y* at point B.

Copyright 2002, Pearson Education Canada9 Deriving a Demand Curve from Indifference Curves and Budget Constraint (Figure 6A.4) In the first diagram we lower the price of X, and thus shift the budget constraint to the right. Plotting the three prices against the quantities of X chosen to maximize utility results in a standard downward-sloping demand curve.

Copyright 2002, Pearson Education Canada10 Review Terms and Concepts zindifference curve zmarginal rate of substitution zpreference map