McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Indifference Curve Analysis Chapter 8 Appendix

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Sophie’s Choice n Sophie eats chocolate bars and drinks soda. n She wants to maximize her utility given a budget constraint.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing the Budget Constraint n Chocolate bars cost $1 and sodas cost 50 cents each. n Sophie has $10 to spend. n She can buy 10 chocolate bars or 20 sodas or some combination of each.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing the Budget Constraint

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing the Budget Constraint n The slope of the budget constraint is the ratio of the prices of the two goods. n The slope changes when the prices change.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing the Indifference Curve n Indifference curve – a curve that shows combinations of goods among which an individual is indifferent. n The slope of the indifference curve is the ratio of marginal utilities of the two goods.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing the Indifference Curve n The absolute value of the slope of an indifference curve is called the marginal rate of substitution.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing the Indifference Curve n 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.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing the Indifference Curve n Indifference curves are downward sloping and bowed inward.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing the Indifference Curve n Law of diminishing marginal rate of substitution – as you get more and 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 © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Graphing the Indifference Curve

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Group of Indifference Curves n Sophie will have a whole group of indifference curves, each representing a different level of happiness.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Group of Indifference Curves n If she prefers more to less, she is better off with the indifference curve that is farthest to the right.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. A Group of Indifference Curves

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Indifference Curves Cannot Cross n If indifference curves crossed, it would violate the “prefer-more-to-less” principle.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Indifference Curves Cannot Cross

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Indifference Curves and Budget Constraints n Sophie will maximize her utility by consuming on the highest indifference curve as possible, given her budget constraint.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Indifference Curves and Budget Constraints n The best combination is the point where the indifference curve and the budget line are tangent.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Indifference Curves and Budget Constraints n The best combination is the point where the slope of the budget line equals the slope of the indifference curve.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Indifference Curves and Budget Constraints

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Deriving a Demand Curve from the Indifference Curve n Demand is the quantity of a good that a person will buy at various prices.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Deriving a Demand Curve from the Indifference Curve n The point of tangency of the indifference curve and the budget line gives the quantity that a person would buy at a given price.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Deriving a Demand Curve from the Indifference Curve n By varying the price of one of the goods while holding the price of other constant, the points of tangency will change. n This gives alternative price/quantity combinations.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Deriving a Demand Curve from the Indifference Curve

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Indifference Curve Analysis End of Chapter 8 Appendix