1. Consumer Choice Indifference Curve Theory
Lecture 4
Consumer Choice
Indifference Curve Theory

2. Outline Indifference Curve Theory Deriving an indifference curve
The Marginal rate of substitution
The Indifference Map
What happens when things change
Changes in Income
Changes in price
Derivation of the consumer’s demand curve

3. Preferences (Review) An individual
can compare any two options and decide which is best, or if equally attractive
Makes choices that are logically consistent
Prefers more of a good to less

4. An Indifference Curve Graphical Illustration of IC Point G (20M, 1C)
Assuming give Kweku another concert. How many movies would we have to take away in order to leave him as satisfied as point G?
Point H (11M, 2C)
Kweku indifferent between point G and point H
Other points of indifference?

5. Indifference Curve Figure A.1 An Indifference Curve Number of Movies
per Month
Number of Concerts +1
If Max gets another concert… G 20 1 -9
he could give up 9 movies
and be just as satisfied H 11 2 J 6 3 K 4 4 L 3 5

6. Indifference Curve
An IC represents all combinations of two goods that make a consumer equally well off.
Characteristics
An IC slopes downwards
Implication?
IC is convex-shaped i.e. As we move downwards and rightwards, curve becomes flatter
Why?

7. The Marginal Rate of Substitution
Absolute value of IC Slope
Maximum number of movies that Kweku willing to trade for one additional concert
E.g. At G, greatest number of movies Kweku would sacrifice for an extra concert is 9
The MRS tells us the maximum amount of good y (movies) that a consumer would willingly trade for one more unit of good x (concerts)
When the quantity of good y is measured on the vertical axis and the quantity of good x is measured on the horizontal axis

8. The Marginal Rate of Substitution
As we move down the IC, the MRS gets smaller
The number of movies Kweku is willing to give away for an additional concert gets smaller and smaller
Why?

9. Diminishing Marginal Rate of Substitution
MRSm,c (slope of IC) relatively large at G
At G, Kweku has many movies and value them lowly
Willing to give movies away for additional concerts
MRSm,c (slope of IC) relatively small at L
At this point, Kweku has fewer movies and values them more highly.
Therefore, less willing to give movies away for additional concerts

10. The Indifference Map
Consider point R with more movies and more concerts
Develop second indifference curve
Repeat process to trace out indifference map
An Indifference Map is a set of Indifference Curves that describe Kweku’s preferences
Complete characterization of one’s preferences

11. An Indifference Map Figure A.2 An Indifference Map Number of Movies
per Month
Number of Concerts G 20 J 6 1 3 2 H 11 R S
1.Max prefers any point on
this indifference curve…
3.And any point on this curve
is preferred to any point on
the other two.
2.to any point
on this one.

12. The Indifference Map
Any point on a higher IC is preferred to any point below it- How do we know?
Consider points H and S
H has more movies but fewer concerts
S has more concerts but fewer movies
Why, then, is S preferred to H?

13. The Indifference Map S on IC2 is preferred to H on IC1
Examine indifference curves IC1 and IC2
R is preferred to H
Since R has more of both goods
Kweku indifferent between R and S
Since indifferent between R and S, but prefers R to H, Kweku MUST prefer S to H!
Any point on a higher IC is preferred to any point below it

14. Violations of ICs ICs should not ‘curl up’ ICs do not cross
Implications?
ICs do not cross

15. Consumer Decision-Making
Combine information on budget lines and indifference curves
Determine optimal combination of movies and concerts that Kweku should choose
In order to maximise his satisfaction
Kweku will consume at a point on his BL
It will lie on the highest possible IC
Combination on the budget line for which MRSy/x= Px /Py.

16. Consumer Decision-Making
At optimal point,
slope of IC= slope of budget line
Slope of IC
Rate at which Kweku would willingly trade movies for concerts
Slope of BL
Rate at which Kweku is actually able to trade movies for concerts
Graphical Illustration

17. Consumer Decision Making
Figure A.3 Consumer Decision Making with Indifference Curves 15 12 9 6 3 1 2 4 5
Number of
Movies
per Month
Number of Concerts D
2. but point D (also affordable) is preferred because it is on a higher indifference curve. B E
1. Points B and E
are affordable…

18. Consumer Decision-Making
At D,
Slope of IC = slope of BL = 3
Rate at which Kweku is willing to trade movies for an additional concert is equal to rate at which he is able to trade movies for an additional concert

19. Changes in Income Income rises
Normal good - quantity demanded increases
Inferior good - quantity demanded decreases
Depends on the individual’s preferences, as represented by his indifference map.

20. What happens when things change? Changes in Income
If Kweku income increases to Ghc 300
BL shifts outwards
Kweku will shift downwards along his BL until he is tangent with highest IC

21. Changes in Income Figure A.4 An Increase in Income 3
Number of Concerts
per Month 15 6 5
Number of
Movies 30 D
1. When Max's income rises to $300,
his budget line shifts outward. 10
H’’ H’
3.But different preferences
could lead him to other
points like H’ or H’’ 12 6 H
2.If his preferences are shown by
these two indifference curves,
he'll choose point H.

22. Income-Consumption Line
For each level of income, there is an equilibrium position where IC is tangent to BL
Joining up these points of equilibrium, we derive an individual’s income-consumption line
Shows how consumption bundle changes as income changes, holding prices constant
Graphical illustration

23. What happens when things change? Changes in Price
If Price of concerts decreases from Ghc30 to Ghc10
BL rotates

24. Derive the demand curve
Additional decreases in the price of concerts leads to continuous rotation of the budget line
(Graphical Illustration)

25. Appendix: Deriving the Demand Curve
Figure A.5 Deriving the Demand Curve
1.When the price of concerts is $30, MRSm,c=Pc/Pm
at point D. 15 6 3 5 30 10 8 7
Number of Movies per Month
2. But when the price falls to $10, this condition is satisfied at point J. K D J D
Price per Concert
$30 10 5 3 7
Number of Concerts per Month
3. The demand curve shows the quantity Max chooses at each price. J K

26. Price-Consumption line
Change in price of a good changes the slope of the budget line, holding price of other good constant
There is an equilibrium consumption bundle for each price of the goods
Joining up these equilibriums gives the price-consumption line
Line showing how a consumer’s purchases reacts to changes in price of one good, holding other price and income constant

27. Take-home Exercise 1 Using the indifference curve approach
Draw a budget line for Akwesi, who has a monthly income of Ghc100. Assume that he buys chicken and potatoes, and that chicken costs Ghc10 per pound and potatoes cost Ghc2 per pound. Add an indifference curve for Akwesi that is tangent to his budget line at the combination of 5 pounds of chicken and 25 pounds of potatoes.
Draw a new budget line for Akwesi, if his monthly income falls to Ghc80. Assume that potatoes are an inferior good to Akwesi. Draw a new indifference curve tangent to his new budget constraint that reflects this inferiority. What will happen to Akwesi’s potato consumption? What will happen to his chicken consumption?

28. Next Class Income and substitution effects
Individual and market demand
Wrap up