©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 1 Chapter 16 Appendix

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 2 Appendix: Indifference Curves In economic terms, when people are indifferent to the choices before them, they obtain the same amount of utility from each of those choices.In economic terms, when people are indifferent to the choices before them, they obtain the same amount of utility from each of those choices. An indifference curve shows the combinations of two goods that provide an individual with equal amounts of utility.An indifference curve shows the combinations of two goods that provide an individual with equal amounts of utility. An indifference curve slopes downward.An indifference curve slopes downward. In economic terms, when people are indifferent to the choices before them, they obtain the same amount of utility from each of those choices.In economic terms, when people are indifferent to the choices before them, they obtain the same amount of utility from each of those choices. An indifference curve shows the combinations of two goods that provide an individual with equal amounts of utility.An indifference curve shows the combinations of two goods that provide an individual with equal amounts of utility. An indifference curve slopes downward.An indifference curve slopes downward.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 3 Indifference Curves Ray’s indifference curve between shrimp and chicken wings reveals combinations of the two products that would leave him equally satisfied.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 4 The Marginal Rate of Substitution  The marginal rate of substitution is the quantity of one good that must be given up as the consumption of the other good increases by one unit and total utility remains constant.  The marginal rate of substitution can be expressed as:  The marginal rate of substitution is the quantity of one good that must be given up as the consumption of the other good increases by one unit and total utility remains constant.  The marginal rate of substitution can be expressed as: Marginal rate of substitution = Change in the consumption of one good Change in the consumption of one good Change in the consumption of another good

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 5 The Marginal Rate of Substitution Diminishes The marginal rate of substitution is an approximation for the absolute value of the slope of an indifference curve.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 6 Indifference Maps  An indifference map shows a set of indifference curves.  An indifference curve shows combinations of two goods that are equally preferred by the consumer.  They slope downward and are convex to the origin, not straight lines.  They can be characterized by the marginal rate of substitution, an approximation to the absolute value of its slope. That slope varies along an indifference curve.  A consumer’ s indifference map will have many indifference curves, each indicating a different level of utility. Higher utility is shown by indifference curves farther from the origin.  An indifference map shows a set of indifference curves.  An indifference curve shows combinations of two goods that are equally preferred by the consumer.  They slope downward and are convex to the origin, not straight lines.  They can be characterized by the marginal rate of substitution, an approximation to the absolute value of its slope. That slope varies along an indifference curve.  A consumer’ s indifference map will have many indifference curves, each indicating a different level of utility. Higher utility is shown by indifference curves farther from the origin.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 7 Indifference Maps More is better Good 1 Good 2 Indifference curves

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 8 Budget Constraints Consumer choice is limited by the amount of money that people can spend and the prices of the goods they buy. The budget constraint is a curve that shows a consumer’s consumption possibilities for two goods. Points outside the budget constraint require more income than is currently available and thus cannot be purchased now. The slope of the budget constraint in absolute value terms equals the ratio of the prices of the two goods. Consumer choice is limited by the amount of money that people can spend and the prices of the goods they buy. The budget constraint is a curve that shows a consumer’s consumption possibilities for two goods. Points outside the budget constraint require more income than is currently available and thus cannot be purchased now. The slope of the budget constraint in absolute value terms equals the ratio of the prices of the two goods.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 9 Budget Constraints The budget constraint will be a downward-sloping straight line, with the slope equal to -(price of one good/price of another good). The slope of Ray’s budget constraint is -(price of shrimp/price of wings) = -1/.25 = -4.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 10 Budget Constraints The budget constraint will shift in a parallel manner if income changes or will pivot if one of the prices changes. In the examples shown, a decrease in income shifts the budget constraint inward. Alternatively, if the shrimp price doubles, the budget constraint pivots inward until it intersects the shrimp axis at half the number of shrimp that could previously have been purchased.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 11 The End! Next Chapter 17 “The Firm and Production"