Indifference Curve Analysis Chapter 8 Appendix

Sophie’s Choice Sophie eats chocolate bars and drinks soda. She wants to maximize her utility given a budget constraint.

Graphing the Budget Constraint Chocolate bars cost $1 and sodas cost 50 cents each. Sophie has $10 to spend. She can buy 10 chocolate bars or 20 sodas or some combination of each.

Graphing the Budget Constraint

Graphing the Budget Constraint The slope of the budget constraint is the ratio of the prices of the two goods. The slope changes when the prices change.

Graphing the Indifference Curve Indifference curve – a curve that shows combinations of goods among which an individual is indifferent. The slope of the indifference curve is the ratio of marginal utilities of the two goods.

Graphing the Indifference Curve The absolute value of the slope of an indifference curve is called the marginal rate of substitution.

Graphing the Indifference Curve Marginal rate of substitution – the rate at which one good must be added when the other is taken away in order to keep the individual indifferent between the two combinations.

Graphing the Indifference Curve Indifference curves are downward sloping and bowed inward.

Graphing the Indifference Curve Law of diminishing marginal rate of substitution – as you get more and more of a good, if some of that good is taken away, then the marginal addition of another good you need to keep you on your indifference curve gets less and less.

Graphing the Indifference Curve

A Group of Indifference Curves Sophie will have a whole group of indifference curves, each representing a different level of happiness.

A Group of Indifference Curves If she prefers more to less, she is better off with the indifference curve that is farthest to the right.

A Group of Indifference Curves

Why Indifference Curves Cannot Cross If indifference curves crossed, it would violate the “prefer-more-to-less” principle.

Why Indifference Curves Cannot Cross

Indifference Curves and Budget Constraints Sophie will maximize her utility by consuming on the highest indifference curve as possible, given her budget constraint.

Indifference Curves and Budget Constraints The best combination is the point where the indifference curve and the budget line are tangent.

Indifference Curves and Budget Constraints The best combination is the point where the slope of the budget line equals the slope of the indifference curve.

Indifference Curves and Budget Constraints

Deriving a Demand Curve from the Indifference Curve Demand is the quantity of a good that a person will buy at various prices.

Deriving a Demand Curve from the Indifference Curve The point of tangency of the indifference curve and the budget line gives the quantity that a person would buy at a given price.

Deriving a Demand Curve from the Indifference Curve By varying the price of one of the goods while holding the price of other constant, the points of tangency will change. This gives alternative price/quantity combinations.

Deriving a Demand Curve from the Indifference Curve

Indifference Curve Analysis End of Chapter 8 Appendix