INDIFFERENCE CURVES AND UTILITY MAXIMIZATION Indifference curve – A curve that shows combinations of goods which gives the same level of satisfaction to the consumers so that an individual is indifferent.

a Pears Oranges Pears Oranges Point abcdefgabcdefg Constructing an indifference curve

Assumption More of a commodity is better than less Preference of a consumer are transitive Diminishing marginal rate of substitution

More of a commodity is better than less

Preference of a consumer are transitive

Marginal rate of substitution Marginal rate of substitution – The rate at which consumer is prepared to exchange goods X and Y is known as MRS ie 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 without changing total satisfaction.

Deriving the marginal rate of substitution (MRS) a b Units of good Y Units of good X 26 67

a b Units of good Y Units of good X  Y = 4  X = 1 MRS = 4 Deriving the marginal rate of substitution (MRS)

a b Units of good Y Units of good X c d  Y = 4  X = 1  Y = 1  X = 1 MRS = 1 MRS = Deriving the marginal rate of substitution (MRS)

Indifference schedule Combina tion Good X Good Y MRS A112 B284 C353 D432 E521

Marginal Rate of Substitution MRS declines as we move downward to the right along an indifference curve. Indifference curves with diminishing MRS are thus convex. Convexity illustrates that people like variety.

Law of diminishing marginal rate of substitution Law of diminishing marginal rate of substitution – As you get more and more of a good X, one is prepared to forego less and less of Y, that is MRS of X for Y diminishes as more and more of good X is substituted for good Y.

DMRS

Units of good Y Units of good X I1I1 I2I2 I3I3 I4I4 I5I5 An indifference map

Properties of Indifference Curve – Indifference curves are downward sloping to the right – Indifference curves are convex to the origin – Indifference curves cannot intersect each other – A higher Indifference curves represents a higher satisfaction

BUDGET LINE Budget line graphically shows the budget constraint. The combination of commodities lying to the right of the budget line are unattainable because the income of the consumer is not sufficient to be able to buy those combinations. The combination of commodities lying to the left of the budget line are attainable because the income of the consumer is sufficient to be able to buy those combinations

What is a Budget Constraint? A budget constraint shows the consumer’s purchase opportunities as every combination of two goods that can be bought at given prices using a given amount of income. The budget constraint measures the combinations of purchases that a person can afford to make with a given amount of monetary income.

Units of good Y Units of good X a b Units of good X Units of good Y Point on budget line a b Assumptions P X = £2 P Y = £1 Budget = £30 A budget line

Units of good Y Units of good X Assumptions P X = £2 P Y = £1 Budget = £ m n Budget = £40 Budget = £30 Effect of an increase in income on the budget line

Effect on the budget line of a fall in the price of good X Units of good Y Units of good X Assumptions P X = £1 P Y = £1 Budget = £30 B1B1 B2B2 a b c

The Best Feasible Bundle Tools needed to determine how consumers should allocate their income between 2 goods : – Budget Constraint – Indifference Curves Consumer’s strategy is to keep moving to higher and higher indifference curves until he reaches the highest one that is still affordable.

How to Find the Best Combination Utility is maximized when: – the indifference curve is just tangent to the budget line.

Consumer Equilibrium

The Best Affordable Bundle

I1I1 I2I2 I3I3 I4I4 I5I5 Units of good Y O Units of good X Budget line Finding the optimum consumption

I1I1 I2I2 I3I3 I4I4 I5I5 Units of good Y O Units of good X r s t Y1Y1 X1X1 v u indifference curve and budget line

Units of good Y O Units of good X B1B1 Effect on consumption of a change in income I1I1

I2I2 Units of good Y O Units of good X B1B1 B2B2 I1I1 Effect on consumption of a change in income

I2I2 Units of good Y O Units of good X B1B1 B2B2 B3B3 B4B4 I1I1 I3I3 I4I4 Effect on consumption of a change in income

I2I2 Units of good Y O Units of good X B1B1 B2B2 B3B3 B4B4 I1I1 I3I3 I4I4 Income–consumption curve Effect on consumption of a change in income