Economics Winter 14 February 28 th, 2014 Lecture 17 Ch. 9 Ordinal Utility: Indifference Curve Analysis

MRS MRS stands for Marginal Rate of Substitution

Combining Indifference Curves and Budget Line: Equilibrium at Tangency The goal for a consumer is to get as high on an indifference curve as possible, given her income constraint.

Which one of the following statements about Figure is true?

Which one of the following statements about Figure is true?

Consumer’s Equilibrium: a recap The utility-maximizing rule: a consumer with a fixed income and facing given market prices of goods will achieve maximum satisfaction (utility) when the marginal utility of the last dollar spent on each good is exactly the same as the marginal utility of the last dollar spent on any other good.

In Equilibrium, at point X, MRS = -P B /P A

If we move along I 3,Memo:  U A /  A =MU A  U B /  B =MU B Thus,  U A =  A*MU A  U B =  B*MU B  U A +  U B = 0 -  A/  B =MRS=MU B /MU A

In Equilibrium, at point X, MRS = -P B /P A Y X

Study Question A consumer decides not to buy a VCR when her income is $20,000. However, when her income rises to $30,000, she decides to buy one. In a single diagram, draw the budget lines and indifference curves to illustrate this situation (assume the VCR costs $300 in both time periods). Be sure to label your diagram completely.

Derivation of the Demand Curve, Income: $12 What happens if the price of B increases to $1.50? Quantity of A Quantity of B X I4I4 I1I1 I2I2 I3I3

Derivation of the Demand Curve New budget line reflects the price change Quantity of A Quantity of B I2I2 I3I3 I1I1 I4I4 X P B =$1.50

Quantity of A Quantity of B Derivation of the Demand Curve New budget line reflects the price change I2I2 I3I3 I1I1 I4I4 X P B =$1.00 P B =$1.50

Quantity of A Quantity of B Derivation of the Demand Curve New equilibrium point is X ' X'X'X'X' I2I2 I3I3 I1I1 I4I4 X P B =$1.00 P B =$1.50

Quantity of A Quantity of B Derivation of the Demand Curve A consumer’s demand curve can be viewed as a summary of the optimal decisions that arise from his or her budget constraint and indifference curves. X'X'X'X' I2I2 I3I3 I1I1 I4I4 X

Quantity of A Quantity of B X'X'X'X' I2I2 I3I3 I1I1 I4I4 X PBPB QBQB $1.006 $ Price of B Quantity of B $0.50 $1.00 $1.50 DBDBDBDB

The Effect of Price Change

A fall in the price of a good has two effects: 1. Consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive. 2. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power.

INCOME AND SUBSTITUTION EFFECTS Substitution effect Change in consumption of a good associated with a change in its price, with the level of utility held constant. Income effect Change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant.

The Substitution Effect of Price Change –The substitution effect is the effect of a change in price on the quantity bought when the consumer remains on the same indifferent curve. –When the relative price falls, the consumer always substitutes more of that good for other goods. –The substitution effect is the first reason why the demand curve slopes downward.

The total effect of a change in price is given theoretically by the sum of the substitution effect and the income effect