1. Slides by Alex Stojanovic
ECONOMICS
ELEVENTH EDITION
LIPSEY &
CHRYSTAL
Chapter 5
CONSUMER CHOICE: INDIFFERENCE THEORY
Slides by
Alex Stojanovic

2. Learning Outcomes
Consumers will maximize their overall satisfaction when the marginal utility per pound spent is equal for all products purchased
A theory of demand can be built by focusing on bundles of goods between which the consumer is indifferent
Indifference curves show combinations of goods that give the same level of satisfaction
A budget constraint shows what the consumer could buy with a given income
A consumer optimises by trying to get to the highest indifference curve that is available with a given budget constraint
The response to a price change can be decomposed into an income and a substitution effect
For a good to have a negative sloped demand curve, it is necessary (but not sufficient) that it be an inferior good

3. Total and Marginal Utility Schedules
Number of films
attended per month
Total utility
Marginal utility
0.00 1
15.00
15.00 2
25.00
10.00 3
31.00
6.00 4
35.00
4.00 5
37.50
2.50 6
39.00
1.5 7
40.25
1.25 8
41.30
1.05 9
42.20
0.90 10
43.00
0.80

4. Total and Marginal Utility Schedules
As consumption increases, total utility rises but marginal utility falls.
The marginal utilities are the changes in utility when consumption is altered by one unit.
For example, the marginal utility of 10m, shown in the entry in the last column, arises because with attendances at the second film total utility increase from 15 to 25 a difference of 10.
The data in this table are plotted in the following figure.

5. Total and Marginal Utility Curves50 20 40 15 30
Utility [£]
Utility [£] 10 20 5 10 2 4 6 8 10 2 4 6 8 10
Quantity of films [attendance per month]
[i]. Increasing total utility
[ii]. Diminishing marginal utility

6. Consumer’s Surplus for an Individual
3.00
2.00
Price of milk [£ per glass]
Market price
1.00
0.30 1 2 3 4 5 6 7 8 9 10
Glasses of milk consumed per week

7. Consumer’s Surplus for an Individual
Consumer’s surplus is the sum of the extra valuations placed on each unit above the market price paid for each.
This figure is based on the data in the table.
Ms. Green pays the red area for the 8 glasses of milk she consumes per week when the market price is £0.30 a glass.
The total value she places on these 8 glasses of milk is the entire shaded area (red and green).
Hence her consumer’s surplus is the green area.

8. Consumers’ Surplus for the Market
Price D
Quantity

9. Consumers’ Surplus for the Market
Price
Market price p0 D
Quantity q0

10. Consumers’ Surplus for the Market
The area under the demand curve shows the total valuation that consumers place on all units consumed.
For example, the total value that consumers place on q0 units is the entire area shaded red and green under the demand curve up to q0.
At a market price of p0 the amount paid for q0 units is the red area.
Hence consumers surplus is the green area under the demand curve and above p0.

11. MARGINAL UTILITY
The Utility Theory of Demand
Marginal utility theory distinguishes between the total utility that each consumer gets from the consumption of all units of some product and the marginal utility each consumer obtains from the consumption of one more unit of the product.
The basic assumption in utility theory is that utility the consumer derives from the consumption of successive units of a product diminishes as the consumption of that product increases.
Each consumer reaches a utility-maximising equilibrium when the utility he or she derives from the last £1 spent on each product is equal.

12. MARGINAL UTILITY
Another way of putting this is that the marginal utilities derived from the last unit of each product consumed will be proportional to their prices.
Demand curves have negative slopes because when the price of product X falls, each consumer restores equilibrium by increasing his or her purchases of X.
The increase must be enough to lower the marginal utility of X until its ratio to the new lower price of X is the same as it was before the price fell.
This restores the equality of the ratio to what it is for all other products.

13. MARGINAL UTILITY
Consumers’ Surplus
Consumers’ surplus is the difference between [1] the value consumers place on their total consumption of some product and [2] the actual amount paid for it.
The first value is measured by the maximum they would pay for the amount consumed rather than go without it completely.
The second is measured by market price times quantity.

14. MARGINAL UTILITY
It is important to distinguish between total and marginal values because choices concerning a bit more and a bit less can not be predicted from knowledge of total values.
The paradox of value involves confusion between total and marginal values.
Elasticity of demand is related to the marginal value that consumers place on having a bit more or a bit less of some product; it bears no necessary relationship to the total value that consumers place on all of the units consumed of that product.

15. Bundles Conferring Equal Satisfaction
Clothing
Food
Bundle a 30 5 b 18 10 c 13 15 d 10 20 e 8 25 f 7 30
An Indifference Curve 35 a 30 25 g
Quantity of clothing per week 20 b 15 c d 10 e f h T 5 I 5 10 15 20 25 30 35
Quantity of food

16. Bundles Conferring Equal Satisfaction
None of the bundles in the table are obviously superior to any of the others in the sense of having more of both commodities.
Since each of the bundles shown in the table give the consumer equal satisfaction, he is indifferent between them.
The data in this table are plotted in the corresponding figure.

17. An Indifference Map Quantity of food per week I5 I4 I3 I2 I1
Quantity of food per week

18. An Indifference Map
A set of indifference curves is called an indifference map.
The further the curve from the origin, the higher the level of satisfaction it represents.
Moving along the arrow, is moving to ever-higher utility levels.

19. Shapes of Indifference Curves
Perfect Substitutes
Perfect Complements
A good that gives zero
utility
Left hand gloves
Vegetables
Packs of red pins I1 I1 I1
[i]. Packs of green pins
[ii]. Right hand gloves
[iii]. Meat
A good that confers a negative utility after some level of consumption
A good that is
not consumed
An absolute necessity I1 a
All other goods
All other goods
All other goods I2 I1 f0 w b I1
[iv]. Water
[v]. Food
[vi]. Good X

20. Shapes of Indifference Curves
Perfect Substitutes
Perfect Complements
A good that gives zero
utility I2
Left hand gloves
Vegetables
Packs of red pins I2 I1 I2 I1 I1
[i]. Packs of green pins
[ii]. Right hand gloves
[iii]. Meat
A good that confers a negative utility after some level of consumption
A good that is
not consumed
An absolute necessity I2 I1 a
All other goods
All other goods
All other goods I2 I2 I1 f0 w b I1
[iv]. Water
[v]. Food
[vi]. Good X

21. The Equilibrium of a Consumer35 30 25
Quantity of clothing per week 20 15 10 5 5 10 15 20 25 30 35
Quantity of food per week

22. The Equilibrium of a Consumer35 30 a 25
Quantity of clothing per week 20 15 10 5 f I1 5 10 15 20 25 30 35
Quantity of food per week

23. The Equilibrium of a Consumer35 30 a b 25
Quantity of clothing per week 20 15 10 5 e I2 f I1 5 10 15 20 25 30 35
Quantity of food per week

24. The Equilibrium of a Consumer35 30 a b 25 c
Quantity of clothing per week 20 15 10 d 5 e I3 I2 f I1 5 10 15 20 25 30 35
Quantity of food per week

25. The Equilibrium of a Consumer35 30 a b 25 c
Quantity of clothing per week 20 E 15 10 d I4 5 e I3 I2 f I1 5 10 15 20 25 30 35
Quantity of food per week

26. The Equilibrium of a Consumer35 30 a b 25 c
Quantity of clothing per week 20 E 15 10 I5 d I4 5 e I3 I2 f I1 5 10 15 20 25 30 35
Quantity of food per week

27. The Equilibrium of a Consumer
Paul has an income of £150 a week and faces prices of £5 a unit for clothing and £6 a unit for food.
A bundle of clothing and food indicated by point a is attainable.
But by moving along the budget line to points such as b and c, higher indifference curves can be reached.
At E, where the indifference curve I4 is tangent to the budget line, Paul cannot reach a higher curve by moving along the budget line.
If he did alter his consumption bundle by moving, for example, from E to d, he would move to the lower indifference curve I3 and thus to a lower level of satisfaction.

28. An Income-consumption Line
Quantity of clothing per week
Quantity of food per week

29. An Income-consumption Line
Quantity of clothing per week E1 I1
Quantity of food per week

30. An Income-consumption Line
Quantity of clothing per week E2 E1 I2 I1
Quantity of food per week

31. An Income-consumption Line
Quantity of clothing per week E3 E2 E1 I3 I2 I1
Quantity of food per week

32. An Income-consumption Line
This line shows how a consumer’s purchases react to changes in income with relative prices held constant.
Increases in income shift the budget line out parallel to itself, moving the equilibrium from E1 to E2 to E3.
The blue income-consumption line joins all these points of equilibrium.

33. The Price-consumption Line
Quantity of clothing per week I1
Quantity of food per week

34. The Price-consumption Linea E1
Quantity of clothing per week I1 b
Quantity of food per week

35. The Price-consumption Linea E1
Quantity of clothing per week E2 I2 I1 b c
Quantity of food per week

36. The Price-consumption Linea E1
Quantity of clothing per week E2 E3 I3 I2 I1 b c d
Quantity of food per week

37. The Price-consumption Linea
Price-consumption
line E1
Quantity of clothing per week E2 E3 I3 I2 I1 b c d
Quantity of food per week

38. The Price-consumption Line
This line shows how a consumer’s purchases react to a change in one price with money income and other prices held constant.
Decreases in the price of food (with money income and the price of clothing constant) pivot the budget line from ab to ac to ad.
The equilibrium position moves from E1, to E2 to E3.
The blue price-consumption line joins all such equilibrium points.

39. Value of all other goods
Derivation of an Individual’s Demand Curve
Value of all other goods
[£ per month] E0 I0 60
120
220
267
400
800
[i] Petrol [litres per month] x
0.75
Price of petrol [£ per month]
0.50
0.25 60
120
220
[ii] Petrol [litres per month]

40. Value of all other goods
Derivation of an Individual’s Demand Curve E1
Value of all other goods
[£ per month] E0 I1 I0 60
120
220
267
400
800
[i] Petrol [litres per month] x
0.75
Price of petrol [£ per month] y
0.50
0.25 60
120
220
[ii] Petrol [litres per month]

41. Value of all other goods
Derivation of an Individual’s Demand Curve E2
Value of all other goods
[£ per month] E1 E0 I2 I1 I0 60
120
220
267
400
800
[i] Petrol [litres per month] x
0.75
Price of petrol [£ per month] y
0.50 z
0.25 60
120
220
[ii] Petrol [litres per month]

42. Value of all other goods
Derivation of an Individual’s Demand Curve
Price-consumption line E2
Value of all other goods
[£ per month] E1 E0 I2 I1 I0 60
120
220
267
400
800
[i] Petrol [litres per month] x
0.75
Price of petrol [£ per month] y
0.50
Demand curve z
0.25 60
120
220
[ii] Petrol [litres per month]

43. Derivation of an Individual’s Demand Curve
The points on a price-consumption line provide the information needed to draw a demand curve.
In part (i) Mr. Phillip has an income of £200 per month and alternatively faces prices of £0.75, £0.50, and, £0.25 per litre of petrol, choosing positions E0, E1, and E2.
The information for the number of litres he demands at each price is then plotted in part (ii) to yield his demand curve.
The three points x, y, and z in (ii) correspond to the three equilibrium positions E0, E1 and E2 in part (i).

44. The Income and Substitution Effects
Value of all other goods [£ per week] I1
Quantity of petrol [litres per week]

45. The Income and Substitution Effects
Value of all other goods [£ per week] I1 b
Quantity of petrol [litres per week]

46. The Income and Substitution Effects
Value of all other goods [£ per week] I1 b q0
Quantity of petrol [litres per week]

47. The Income and Substitution Effects
Value of all other goods [£ per week] I1 b j1 q0 q1 q2
Quantity of petrol [litres per week]

48. The Income and Substitution Effects
Value of all other goods [£ per week] E1
Substi
tution
effect I1 b j1 q0 q1 q2
Quantity of petrol [litres per week]