06A Appendix Consumer Behavior This appendix introduces indifference curve analysis for those who desire a more rigorous explanation of consumer choice. We will use indifference curve analysis to develop an individual’s demand curve for a product. Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

The Budget Line: What is Attainable Combinations of two products a consumer can purchase with their money income Slope is the ratio of the price of B to the price of A Location varies with income changes Location varies with price of products A budget line is a schedule or a curve showing the various combinations of two products a consumer can purchase with a specific money income. The budget line can also be referred to as the consumer’s budget constraint. It is assumed that product B is on the horizontal axis. An increase in income shifts the budget line to the right. A decrease in income shifts the budget line to the left. Change in the price of one or both products also changes the location of the budget line. An increase (decrease) in the price of one product will shift the budget line down (out) reflecting the ability to buy fewer (more) units of that product. If the prices of both goods increase (decrease) the budget line shifts left (right) reflecting the loss (increase) in ability to purchase as much of both goods as before. 6A-2 LO6

The Budget Line 8 6 4 2 3 6 9 12 $12 12 (Unattainable) (Attainable) 2 10 12 Quantity of A Quantity of B Units of B (Price = $1) Units of A (Price = $1.50) Total Expenditure Income = $12 PA = $1.50 8 6 4 2 3 6 9 12 $12 12 (Unattainable) Income = $12 PB = $1 (Attainable) The consumer’s budget line shows all of the combinations of two products that someone can purchase given the prices of the products and the person’s money income. 6A-3 LO6

Indifference Curves: What is Preferred Combinations of two products that yield the same amount of total utility The consumer is indifferent as to which combination to purchase Characteristics Downsloping Convex to the origin Reflects the MRS The indifference curve is made up of subjective data rather than the objective data that makes up the budget line. Because each combination yields the same amount of utility to the consumer, the consumer is indifferent as to which combination to purchase. The indifference curve is downward sloping because more of one product means fewer units of the other for total utility to remain the same. The MRS (marginal rate of substitution of one good for the other) results in a convex curve because the slope of the curve reflects an increasing unwillingness to substitute B for A as more of B is obtained. 6A-4 LO6

Indifference Curves j k l m 12 6 4 3 2 4 6 8 j k l m I 2 4 6 8 10 12 Quantity of A Quantity of B j Combination Units of A Units of B j k l m 12 6 4 3 2 4 6 8 k l m I Curves are downward sloping because the consumer will be able to maintain the same level of total utility by substituting more of B for less of A. Curves are convex to the origin. The slope of the curve measures the marginal rate of substitution of one good for the other (B for A) in order for the consumer to have a constant level of satisfaction. Rationale for this shape is related to diminishing marginal utility. If the consumer has a lot of A and very little of B, B is more valuable at the margin, while A has a lower marginal utility. The consumer will then be willing to give up a substantial amount of product A to get more units of B. However, as the consumer obtains more and more of B and gives up more and more of A, this relationship changes. The consumer will not be willing to give up much of A to get more of B. In other words, the slope of the curve diminishes, and the curve is, by definition, convex to the origin. 6A-5 LO6

Each successive curve outward reflects a higher level of utility The Indifference Map Series of indifference curves where each curve reflects different amounts of utility Each successive curve outward reflects a higher level of utility An indifference map refers to successive indifference curves where each entails a different level of utility, meaning that indifference curves cannot cross. As one moves away from the origin on the map, the level of utility increases. 6A-6 LO6

The Indifference Map 6 8 10 12 4 2 Quantity of A I4 I3 I2 I1 2 4 6 8 Quantity of A An indifference map is a set of indifference curves. Curves farther from the origin indicate higher levels of total utility. Thus, any combination of products A and B represented by a point on I4 has greater total utility than any combination of A and B represented by a point on I3, I2, or I1. I4 I3 I2 I1 2 4 6 8 10 12 Quantity of B 6A-7 LO6

Equilibrium at Tangency The consumer’s equilibrium position Indifference curve is tangent to the budget line Utility is maximized MRS equals the ratio of the price of B to the price of A The consumer’s utility maximizing combination will occur on the highest attainable indifference curve. This is where the budget constraint is tangent to an indifference curve, which reflects the highest attainable level of utility. Higher levels of utility will be unattainable or off the budget line. 6A-8 LO6

Equilibrium at Tangency 2 4 6 8 10 12 Quantity of A Quantity of B MRS = PB PA Preferred – But Requires More Income W X An indifference map is a set of indifference curves. Here, on the indifference curve map, the equilibrium position of the consumer is at point X. Here the slope of the budget line and the slope of the indifference curve are equal. Point W yields a higher utility, but the budget is insufficient to purchase the combination at point W. Combinations on I1 and I2 can be purchased, but the utility is lower. I4 I3 I2 I1 6A-9 LO6

Derivation of the Demand Curve 6 8 10 12 4 2 Quantity of A X I3 I2 2 4 6 8 10 12 Quantity of B When the price of product B is increased from $1 to $1.50, the equilibrium position moves from X to X', decreasing the quantity demanded of product B from 6 to 3 units. The demand curve for product B is determined by plotting the $1–6-unit and the $1.50–3-unit price-quantity combinations for product B. In other words, at $1 price for B, 6 units of B are purchased. As price of B increases to $1.50, only 3 units of B are bought. Connect the points to create the demand curve for B. Price of B $1.50 1.00 .50 DB 2 4 6 8 10 12 Quantity of B 6A-10 LO6