1. Introductory Microeconomics
Indifference Curves
Introductory Microeconomics

2. Example:
To encourage education, a government is considering three different options:
A lump-sum cash to kids of school age.
A matching subsidy to each dollar the kids spend on schooling.
Provide education for free.
Which is better?

3. Three Steps Involved In The Study Of Consumer Behavior.
1) We will study consumer preferences.
To describe how and why people prefer one good to another.
2) Then we will turn to budget constraints.
People have limited incomes.
3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices.
What combination of goods will consumers buy to maximize their satisfaction? 4

4. Market basket defined
A market basket is a collection of one or more commodities.
One market basket may be preferred over another market basket containing a different combination of goods. 4

5. Three Basic Assumptions of Consumer Preferences
Preferences are complete.
Give me any two baskets of goods (A and B), I will be able to tell you on of the followings:
I prefer A to B
I prefer B to A
I am indifferent between A and B
Preferences are transitive.
If I prefer A to B and B to C, I must also prefer A to C.
Non-satiation: Consumers always prefer more of any good to less.
Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. 4

6. Preferences over market basket
Units of
Food
Units of
Clothing
Observations based on more good is preferred to less
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
E is preferred to G A H
Similarly, A, E, B, H, D are all preferred to G …
Much easier to see in a graph. 4

7. Preferences over market basket Easier to see in a graph
Clothing
(units per week)
The consumer prefers
A to all combinations
in the blue box, while
all those in the pink
box are preferred to A. 50 G A E H B D 40 30 20 10
Food
(units per week) 10 20 30 40 6

8. Preferences over market basket Easier to see in a graph
Clothing
(units per week)
For example:
Combination B,A, & D
yield the same satisfaction
E is preferred to U1
U1 is preferred to H & G 50 G D A E H B 40 30 20 U1 10
Food
(units per week) 10 20 30 40 6

9. Preferences over market basket
Clothing
(units
per
week)
Indifference curves slope downward to the right.
If it sloped upward it would violate the assumption that more of any commodity is preferred to less. 50 G D A E H B
Any market basket lying above and to the right of an indifference curve is preferred to any market basket that lies on the indifference curve. 40 30 20 U1 10
Food
(units per week) 10 20 30 40 6

10. Indifference map D B A U3 U2 U1
Clothing
(units
per
week)
An indifference map is a set of indifference curves that describes a person’s preferences for all combinations of two commodities.
Each indifference curve in the map shows the market baskets among which the person is indifferent. U3 U2 U1 A B D
Market basket A
is preferred to B.
Market basket B is
preferred to D.
Food
(units per week) 6

11. Indifference Curves Cannot Cross
Clothing
(units per week)
If crossed U1
the consumer should be indifferent between A, B and D. However, B contains more of both goods than D. Thus, given transitivity assumption, the assumption of more is preferred to less is violated. U2 A B D
Food
(units per week) 6

12. The amount of clothing given up for unit of food decreases with amount of food-1 -6 1 -4 -2
Observation: The amount
of clothing given up for
a unit of food decreases
from 6 to 1 A B D E G
Clothing
(units
per week) 16 14 12 10
Question: Does this
relation hold for giving
up food to get clothing? 8 6 4 2
Food
(units per week) 1 2 3 4 5 4

13. Marginal Rate of Substitution
Clothing
(units
per week) 16
The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good 14
MRS = 6 12 -6
MRS is measured by the slope of the indifference curve 10 B 1 8 -4 D
MRS = 2 6 1 E -2
MRS = - C / F 4 G 1 -1 1 2
Food
(units per week) 1 2 3 4 5 5

14. Assumption: Diminishing Marginal Rate of Substitution
Along an indifference curve there is a diminishing marginal rate of substitution.
Clothing
(units
per
week) 16 14
MRS = 6
Example: the MRS for AB was 6, while that for DE was 2 -6 12 10 B
Indifference curves are convex because as more of one good is consumed, a consumer would prefer to give up fewer units of a second good to get additional units of the first one. 1 8 -4 D
MRS = 2 6 1 E -2 4 G 1 -1
That is, consumers prefer a balanced market basket. 1 2
Food
(units per week) 1 2 3 4 5 5

15. Perfect Substitutes Perfect Substitutes 4 3
Apple
Juice
(glasses) 4
Perfect
Substitutes 3
Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. 2 1
Orange Juice
(glasses) 1 2 3 4 5

16. Perfect Complements Perfect Complements 4 3
Left
Shoes 4
Perfect
Complements 3
Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. 2 1 1 2 3 4
Right Shoes 5

17. BADS Air pollution Asbestos Things for which less is preferred to more
Examples
Air pollution
Asbestos
How does the indifference curve over
Two bads
One good and one bad
look like? 4

18. Utility and utility functions
Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket.
Utility Functions
Assume: The utility function for food (F) and clothing (C) U(F,C) = F + 2C
Market Baskets: F units C units U(F,C) = F + 2C A (3) = B (4) = C (4) = 12
The consumer is indifferent between A & B
The consumer prefers A & B to C 4

19. Utility Functions & Indifference Curves
Clothing
(units
per week) A B C
Assume: U = FC
Market Basket U = FC
C = 2.5(10)
A = 5(5)
B = 10(2.5)
U1 = 25
U2 = 50 (Preferred to U1)
U3 = 100 (Preferred to U2) 15 10 5
Food
(units per week) 5 10 15 5

20. Ordinal Versus Cardinal Utility
Ordinal Utility Function: places market baskets in the order of most preferred to least preferred, but it does not indicate how much one market basket is preferred to another.
Cardinal Utility Function: utility function describing the extent to which one market basket is preferred to another.
Ordinal Versus Cardinal Rankings
an ordinal ranking is sufficient to explain how most individual decisions are made. 4

21. Budget Constraints
Budget constraints limit an individual’s ability to consume in light of the prices they must pay for various goods and services.
The budget line indicates all combinations of two commodities for which total money spent equals total income. 4

22. The Budget Line Pf F + Pc C = I
Let F equal the amount of food purchased, and C is the amount of clothing.
Price of food = Pf and price of clothing = Pc
Then Pf F is the amount of money spent on food, and Pc C is the amount of money spent on clothing.
Pf F + Pc C = I 4

23. Budget Constraints Market Basket Food (F) Clothing (C) Total Spending
Pf = ($1) Pc = ($2) PfF + PcC = I
A 0 40 $80
B $80
D $80
E $80
G 80 0 $80 5

24. Budget Constraints A (I/PC) = 40 B
Clothing
(units
per week)
Pc = $ Pf = $ I = $80 A B D E G
Budget Line F + 2C = $80
(I/PC) = 40
As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other. 30 20 10
Food
(units per week) 20 40 60
80 = (I/PF) 4

25. Budget Constraints A (I/PC) = 40 B 30 D 20 E 10 G Clothing (units
per week)
The vertical intercept (I/PC), illustrates the maximum amount of C that can be purchased with income I. A
(I/PC) = 40
Pc = $ Pf = $ I = $80 B 30
Budget Line F + 2C = $80 D 20 E 10
The horizontal intercept (I/PF), illustrates the maximum amount of F that can be purchased with income I. G
Food
(units per week) 20 40 60
80 = (I/PF) 4

26. Budget Constraints A (I/PC) = 40 B 30 10 D 20 20 E 10 G Clothing
(units
per week)
Pc = $ Pf = $ I = $80
Budget Line F + 2C = $80 A B D E G
(I/PC) = 40 30
The slope of the line measures the relative cost of food and clothing. The slope is the negative of the ratio of the prices of the two goods. 10 20 20
The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent. 10
Food
(units per week) 20 40 60
80 = (I/PF) 4

27. Effects of Changes in Income
Clothing
(units
per week)
A increase in
income shifts
the budget line
outward
(I = $160) L2 80 60 L3
(I =$40)
A decrease in
income shifts
the budget line
inward 40
(I = $80) L1 20
Food
(units per week) 40 80
120
160 4

28. Effects of Changes in Prices
Clothing
(units
per week)
An increase in the
price of food to
$2.00 changes
the slope of the
budget line and
rotates it inward. L3
(PF = 2)
(PF = 1/2) L2
A decrease in the
price of food to
$.50 changes
the slope of the
budget line and
rotates it outward. 40
(PF = 1) L1
Food
(units per week) 40 80
120
160 4

29. Effects of Changes in Prices
Clothing
(units
per week)
If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change.
Same as an increase in income 80
Pc = $ Pf = $ I = $80 60
If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change.
Same as a decrease in income. 40 L1 20 L3 L2
Pc = $4, Pf =$2
Pc = $1, Pf=$0.5 40 80
120
160
Food (units per week) 4

30. Consumer Choice
Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.
The maximizing market basket must satisfy two conditions:
1) It must be located on the budget line.
2) Must give the consumer the most preferred combination of goods and services. 4

31. Consumer Choice 40 D 30 20 U3 Pc = $2 Pf = $1 I = $80 Market basket D
Clothing
(units per
week)
Pc = $2 Pf = $1 I = $80 U3 D
Market basket D
cannot be attained
given the current
budget constraint. 40
Budget Line 30 20 20 40 80
Food (units per week) 4

32. Consumer Choice 40 30 A 20 U1 Budget Line Pc = $2 Pf = $1 I = $80 B 20
Clothing
(units per
week)
Budget Line
Pc = $2 Pf = $1 I = $80
Point B does not maximize satisfaction
because there exist a point A which is attainable and yields a higher satisfaction. U1 40 B
Note that the MRS -(-10/10) = 1
is greater than the price ratio (1/2). 30
-10C A 20
+10F 20 40 80
Food (units per week) 4

33. Consumer Choice Recall, the slope of an indifference curve is:
Further, the slope of the budget line is:
Therefore, it can be said that satisfaction is maximized where: 4

34. Example: Matching vs. Non-matching grant from the federal government
Local official has a preference on police spending (by taxing its citizens) and private consumption (by its citizens).
The budget line represents the total amount of resources available for the public spending and private spending.
A non-matching grant from the federal government is simply a check from the federal government.
A matching grant from the federal government is offered as a subsidy of the local spending.

35. Choosing between a non-matching and matching grant to fund police expenditures
Non-matching Grant
Private
Expenditures ($)
Before Grant
Budget line: PQ
A: Preference maximizing
market basket
Expenditure
OR: Private
OS: Police V T U1 U3 P
After Grant
Budget line: TV
B: Preference maximizing
market basket
Expenditure
OU: Private
OZ: Police B U Z A R
Police
Expenditures ($) O S Q 4

36. Choosing between a non-matching and matching grant to fund police expenditures
Private
Expenditures ($) T
Before Grant
Budget line: PQ
A: Preference maximizing
market basket U1 P R U2
After Grant
C: Preference maximizing
market basket
Expenditures
OW: Private
OX: Police C X W A R O S Q
Police ($) 4

37. Matching vs. Non-Matching Grant
Choosing between a non-matching and matching grant to fund police expenditures
Private
Expenditures ($)
Matching vs. Non-Matching Grant
Nonmatching Grant
Point B
OU: Private expenditure
OZ: Police expenditure
Matching Grant
Point C
OW: Private expenditure
OX: Police expenditure T U1 U3 P U B W A C
Note that the amount of grant at point B and C are the same. U2 O Z X Q R
Police ($) 4

38. Example: A College Trust Fund
Suppose Jane Doe’s parents set up a trust fund for her college education.
Originally, the money must be used for education.
If part of the money could be used for the purchase of other goods, her preferred consumption bundle changes. 10

39. A College Trust Fund A College Trust Fund C U3 B A U2 U1
Other
Consumption
($)
The trust fund shifts the budget line A U1
A: Consumption before the trust fund U2 B
B: Requirement that the trust fund
must be spent on education C U3
C: If the trust could be spent on
other goods P Q
Education ($) 10

40. End