McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. INDIFFERENCE CURVE ANALYSIS INDIFFERENCE CURVE ANALYSIS Chapter 8 Appendix

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8A-2 Sophie’s Choice Given her budget constraint, Sophie wants to maximize the utility she gets from drinking sodas and eating chocolate bars. Chocolate bars cost $1 and sodas cost 50 cents, and she has $10 to spend. She can buy 10 chocolate bars or 20 sodas or some combination of the two.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8A-3 Graphing the Budget Constraint Sophie has $14 to spend. Price of soda is $1.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8A-4 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 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. Indifference curves are downward sloping and bowed inward.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8A-5 Graphing the Indifference Curve Law of diminishing marginal rate of substitution – as you get 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8A-6 Graphing the Indifference Curve

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8A-7 A Group of Indifference Curves Sophie will have a whole group of indifference curves, each representing a different level of satisfaction. If she prefers more to less, she is better off with the indifference curve that is farthest to the right.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8A-8 Why Indifference Curves Cannot Cross If indifference curves crossed, it would violate the “prefer- more-to-less” principle.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8A-9 Indifference Curves and Budget Constraints Sophie will maximize her utility by consuming on the highest indifference curve as possible, given her budget constraint. The best combination is the point where the slope of the budget line equals the slope of the indifference curve. so that

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8A-10 Indifference Curves and Budget Constraints

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8A-11 Deriving a Demand Curve from the Indifference Curve Demand is the quantity of a good that a person will buy at various prices. By varying the price of one of the goods while holding the price of the other constant, the alternative price/quantity combinations of the demand curve can be found.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8A-12 Deriving a Demand Curve from the Indifference Curve