Economics Winter 14 February 26 th, 2014 Lecture 16 Ch. 9 Ordinal Utility: Indifference Curve Analysis

Indifference Curves An indifference curve represents all the combinations of the two goods amongst which an individual is indifferent. indifference curve An indifference curve shows consumption bundles that give the consumer the same level of satisfaction. Marginal utility theory assumes utility is numerically measurable Indifference curve approach requires only that a consumer specify if a particular combination of products yields more or less utility than another

Quantity of A Quantity of B j k l m I combinationUnits of AUnits of B j122 k64 l46 m38 Indifference Curves Memo: An indifference curve represents all the combinations of the two goods amongst which an individual is indifferent. indifference curve An indifference curve shows consumption bundles that give the consumer the same level of satisfaction.

NB! More of a good is better than less of it good: commodity for which more is preferred to less at least at some levels of consumption bad: something for which less is preferred to more, such as pollution Consumers are not satiated (satiated means excess satisfaction)

Study question Draw a set of indifference curves for the following pair of goods: Ice cream and pie if these are goods that you like, but if you consume enough of either, you get sick of them. If you are sick of a good, consuming more of it lowers your utility.

Study question Does this individual receive satisfaction from consuming good B? Good A? Good A Good B

Dimes 0 Nickels (a) Perfect Substitutes I1I1 I2I2 I3I Copyright©2004 South-Western

Study question Molly loves hamburgers and soft drinks, but insists on consuming exactly one soft drink for every two hamburgers that she eats. Draw an indifference curve that is consistent with her preferences.

Study question Jocasta loves to dance and hates housecleaning. She prefers dancing to any other activity and never gets tired of dancing, but the more time she spends cleaning house, the less happy she is. Draw an indifference curve that is consistent with her preferences.

Study question In the field of financial management it has been observed that there is a trade-off between the rate of return that one earns on investments and the amount of risk that one must bear to earn that return. A.Draw a set of indifference curves between risk and return for a person that is risk averse (a person that does not like risk). B.Draw a set of indifference curves for a person that is risk neutral (a person that does not care about risk one way or the other). C.Draw a set of indifference curves for a person that likes risk.

Properties of well-behaved Indifferent Curves Higher indifference curves are preferred to lower ones. Indifference curves do not cross. Indifference curves are “thin” Indifference curves are bowed inward (convex to the origin). Indifference curves are downward sloping.

The Impossibility of Intersecting Indifference Curves Quantity of Pizza Quantity of Pepsi 0 C A B Copyright©2004 South-Western

Indifference Curves are “THIN”! B, Burritos per semester a b Thick Z, Pizzas per semester I

Indifference curves are convex to the origin

Well-behaved indifference curves are downward sloping Overall, the slope of the indifference curve is called the marginal rate of substitution (MRS) MRS is the amount of the good on the vertical axis that the consumer is willing to give up to obtain one extra unit of the good measured on the horizontal axis.

Diminishing MRS: Rationale People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little. These differences in a consumer’s marginal substitution rates cause his or her indifference curve to bow inward.

Convex vs. Concave