Download Session 05 Consumer Choice Flash Format

Session 5: Consumer Choice:
Ch 6 & Appendix
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slide “Lecture Outline”
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
1
End
Illustration Indifference Curve Analysis
How many internet minutes will you
consume when the choices are travel to a
location for free WIFI of pay for a service
on location?
At http://intel.jiwire.com, you can
type in a zip code and get a list of
hotspots within a mile radius. You
can also specify a kind of location
(like "hotel") and/or a service
provider (like T-Mobile or
Boingo). The site also tells you
about any fees, which can run up
to $10 a day. For a list of free
hotspots, WifiFreeSpot.com
covers everything from hotels to
gas stations.
Source: WSJ “Quick Fix” about Dec 30,
2003, Rob Turner
Begin
2 Utility
This diagram shows how the usage changes for
a hypothetical adult as they pass from
unemployed student to working graduate and
their income increases (the budget lines shifts
out when the become employed)
3 U. Max 4 Demand
5 I. Curves
6 U. Max
End
Session 5: Lecture Outline
1 First Slide
2 Definition of Utility
3 Rule for Maximization of Utility:
4 Market Demand Curve:
5 Indifference Curves, Budget Lines
6 Utility Maximization
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
3
End
2.0 Definitions of Utility
2 Definition of Utility
2.1 Utility: Cardinal and Ordinal
2.2 Total Utility (TU) and Marginal Utility
(MU = TU/ q)
2.3 Diminishing Marginal Utility (DMU)
• Example- A Table
• Example: Mr. Cresote
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
4
End
2.1 Cardinal and Ordinal Utility
Cardinal Utility : consumers can assign a
number (say a scale of 1 to 10) that represents
the amount of satisfaction received from
consumption o f a good.
Ordinal Utility. Consumers do not assign
numbers, rather, consumers make relative
comparisons--I prefer this to that.
This economic model is an improvement by the
principle of Occum’s Razor, because it is simpler!
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
5
End
2.2 Total and Marginal Utility
Let’s now distinguish between total utility and
marginal utility
Total utility (TU) is the total satisfaction a
person derives from consumption
Marginal utility (MU) is the change in total
utility resulting from a one-unit change in
consumption of a good
MU = TU/ q
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
6
End
2.3a Law of Diminishing Marginal Utility
The more of a good an individual consumes
per time period, other things constant, the
smaller the increase in total utility from
additional consumption
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
7
End
2.3b: Utility Derived from Water
Units of Water
Consumed
Total Marginal
(8 ounce glass) Utility
Utility
0
0
1
40
40
2
60
20
3
70
10
4
75
5
5
73
-2
The first column lists possible quantities of water a person might consume after
running on a hot day. The second column presents the total utility derived from
that consumption and the third column presents the marginal utility of each
additional glass of water consumed  change in total utility from consuming an
additional unit.
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
8
End
2.3cTotal and Marginal Utility: Mr Creosote
Because of diminishing
marginal, each glass
adds less to total utility
 total utility
increases for the first
four glasses but at a
decreasing rate
In our example,
diminishing marginal
utility begins with the
first unit as seen by the
pattern of marginal
utility
Monty Python The Meaning of Life
Total
Utility
In this clip Mr. Creosote is at an elegant buffet
restaurant
enjoying an fixed price all you can eat dinner.
The law of diminishing utility implies that consumption
has linits. In this clip Mr Creosote eats his way in to the
negative portion of the MU curve. Many people over eat at
buffet restaurants because additional servings are free. But
few eat into the negative region of MU.
Marginal Utility
What about Mr.
Creosote’s 5th glass of
water? (clip 12 is 2:00
mins but is for a fee, the
free link is 6:46 mins,
and fast forward to 5:30
for the illustration
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
9
End
3.0 Utility Maximization
Rule for Maximization of Utility:
3.1 Two goods and an income constraint (1,2,3)
3.2 Law of Demand (1, 2, 3)
3.3 Example: Pizzas and Videos
• Goal: purchase the utility maximizing bundle
• Start out buying 5 pizzas: TU =142
• By trail and error, end up with
2 pizzas and 4 videos: TU = 212
3.4 Utility Maximizing Condition: MU/Price (1,2)
3.5 Derive A Demand Curve (1, 2, 3)
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
10
End
3.1a Utility Maximization with 2 Goods
Now we will learn about an algebraic model using
ordinal utility to show how an ecomomist’s model
of how a consumer chooses a consumption bundle
that maximizes total utility.
So here are the details of a specific illustration:
The price of pizza is $8
The rental price of a movie video is $4
A budget of $40 per week
By trial and error we will continue to make
adjustments as long as utility can be increased 
when no further utility-increasing moves are
possible, we have arrived at the equilibrium
combination
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
11
End
3.1b Two Goods: Pizza & Video Rentals
Marginal
Utility
of Pizza
Pizza
Total Marginal per Dollar Video
Total Marginal
Consumed Utility Utility Expended Rentals Utility of Utility of
Per Week of Pizza of Pizza (price=$8) per Week Videos Videos
(1)
(2)
(3)
(4)
(5)
(6)
(7)
$32
$40
0
1
2
3
4
5
6
0
56
88
112
130
142
150
56
32
24
18
12
8
7
4
3
2¼
1½
1
0
1
2
3
4
5
6
0
40
68
88
100
108
114
40
28
20
12
8
6
Marginal
Utility
of Videos
per Dollar
Expended
(price=$4)
(8)
10
7
5
3
2
1½
$8
To get the process going, suppose you start off spending your entire budget of $40 on pizza  5 pizzas
per week, (5 x$ 8 = $40) at a total utility of 142.
If you give up one pizza, you free up enough money ($8) to rent 2 videos (2 x $4). Would total
utility increase from this reallocation? You give up 12 units of utility – the marginal utility of the
5th unit of pizza, to get 68 units of utility (40 + 28) from the first 2 videos  total utility increases
from 142 to 198 (198 = 130 + 68).
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
12
End
3.1c Two Goods: Pizza & Video Rentals
Marginal
Marginal
Utility
Utility
of Pizza
of Videos
Pizza
Total Marginal per Dollar Video
Total Marginal per Dollar
Consumed Utility Utility Expended Rentals Utility of Utility of Expended
Per Week of Pizza of Pizza (price=$8) per Week Videos
Videos
(price=$4)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
0
1
2
3
4
5
6
0
56
88
112
130
142
150
56
32
24
18
12
8
7
4
3
2¼
1½
1
0
1
2
3
4
5
6
0
40
68
88
100
108
114
40
28
20
12
8
6
10
7
5
3
2
1½
If you reduce consumption of pizza to 3 units, you give up 18 units of utility from the 4th unit of pizza but gain a total
of 32 units (20 + 12) of utility from the 3rd and 4th videos, another utility-increasing move. TU would rise from 198
=( 130 + 68) to 212=(112 + 100).
Further reductions in pizza would reduce total utility because you would give up 24 units of utility from the 3rd pizza
but gain only 14 (8 + 6) from the 5th and 6th video rentals. TU would fall from 212 (112 + 100) to 202 ( 88 + 114).
Thus, by trial and error, we find that the utility-maximizing equilibrium condition is 3 pizzas and 4 videos per week,
for a total utility of 212 and an outlay of $24 on pizza and $16 on videos
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
13
End
3.1d Utility-Maximizing Condition
Consumer equilibrium is achieved when the
budget is completely spent and the last
dollar spent on each good yields the same
utility
MUp MUv

Pv
Pp
Where MUp is the marginal utility of pizza, pp is the price of
pizza, MUv is the marginal utility of videos, and pv the price
of videos
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
14
End
3.1e Two Goods : Pizza & Video Rentals
Marginal
Marginal
Utility
Utility
of Pizza
of Videos
Pizza
Total Marginal per Dollar Video
Total Marginal per Dollar
Consumed Utility Utility Expended Rentals Utility of Utility of Expended
Per Week of Pizza of Pizza (price=$8) per Week Videos
Videos
(price=$4)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
0
1
2
3
4
5
6
0
56
88
112
130
142
150
56
32
24
18
12
8
7
4
3
2¼
1½
1
0
1
2
3
4
5
6
0
40
68
88
100
108
114
40
28
20
12
8
6
10
7
5
3
2
1½
The utility-maximizing bundle is 3 pizzas and 4 videos, a total utility of 212 and a
total outlay of $40 comprised of $24 on pizza and $16 on videos
The return (MUp/Pp ) on the consumption of 3 Pizzas is $3 (24/$3) equals the
return (MUv/Pv ) on the renting of 4 videos, which is $3 (12/$4)
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
15
End
3.2 a Law of Demand and Marginal Utility
The preceding example can be used to generate a
single point on the demand curve for pizzas  at
a price of $8, the quantity demanded is 3 pizzas
per week, based on an income of $40 per week, a .
price of $4 per video rental.
To generate another point on the demand curve
for pizza, lets reduce the price of pizza to $6 
Exhibit 4 is the same as Exhibit 3 except that the
price of pizza has been reduced
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
16
End
3.2b Two Goods
: Pizza & Video Rentals
Marginal
Utility
of Pizza
Pizza
Total Marginal per Dollar
Consumed Utility Utility
Expended
Per Week of Pizza of Pizza (price=$6)
(1)
(2)
(3)
(4)
0
1
2
3
4
5
6
0
56
88
112
130
142
150
56
32
24
18
12
8
9 1/3
5 1/3
4
3
2
1 1/3
Marginal
Utility
of Videos
Video
Total Marginal per Dollar
Rentals Utility of Utility of Expended
per Week Videos Videos
(price=$4)
(5)
(6)
(7)
(8)
0
1
2
3
4
5
6
0
40
68
88
100
108
114
40
28
20
12
8
6
10
7
5
3
2
1½
The above table is the original example, except column 4 is recomputed at a price of $6 per pizza.
For the original consumer equilibrium of 3 pizzas and 4 video rentals, the marginal utility per dollar
expended on the third pizza rises to 4, while the marginal utility per dollar on the fourth video remains
at 3.
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
17
End
3.2c Two Goods
: Pizza & Video Rentals
Marginal
Marginal
Utility
Utility
of Pizza
of Videos
Pizza
Total Marginal per Dollar Video
Total Marginal per Dollar
Consumed Utility Utility
Expended Rentals Utility of Utility of Expended
Per Week of Pizza of Pizza (price=$6) per Week Videos Videos
(price=$4)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
0
1
2
3
4
5
6
0
56
88
112
130
142
150
56
32
24
18
12
8
9 1/3
5 1/3
4
3
2
1 1/3
0
1
2
3
4
5
6
0
40
68
88
100
108
114
40
28
20
12
8
6
10
7
5
3
2
1½
Additionally, based on the new lower price of pizza we would have $6 unspent, because 3
pizzas cost $18 (3x$6) and 4 videos cost $16 (4x$4) for a total of $34 instead of $40
Based on this new lower price for pizza, we would increase our consumption to 4 pizzas per week 
total utility increases by the 18 units derived from the 4th pizza, and we are now spending $40 ($24 +
$16). ($6 x4 pizzas + $4x4 videos). We are once again in equilibrium and the MU/P ratios are equal..
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
18
End
3.2d Demand Curve for Pizza
Demand Curve Generated from Marginal Utility Model
After the price of pizza
declines to $6, the
consumer purchases 4
units of pizza as shown by
point b.
2 Utility
b
6
4
2
0
Begin
a
$8
Price per pizza
The original position of
consumer equilibrium
at the price of $8 is
shown as point a where
the consumer
purchased 3 units of
pizza.
D
1
2
3 U. Max 4 Demand
3
4
5 I. Curves
Pizzas per week
6 U. Max
19
End
4.0 Market Demand
4.1 Market Demand Curve
Horizontal Summation
4.2 Consumer Surplus
The Diagram
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
20
End
4.1a Market Demand
We can now talk more generally about the
market demand for a good
The market demand is simply the horizontal
sum of the individual demand curves for all
consumers in the market
Tne next slide shows this process for three
consumers
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
21
End
4.1b Summing Individual Demands to Derive Market
Demand
The market demand shows the total quantity demanded
per period by all consumers at various prices.
(d) Market demand
(b) Brittany
(c) Chris
for Subways
Price
(a) You
$6
$6
$6
$6
4
4
4
4
2
0
dY
2
0
2 4 6
Subways per month
dB
2 4
2
0
dC
2
dA + dB + dC = D
2
0
2
6
12
At a price of $6, you demand 2 per month, Brittany 0, and Chris 0.
 market demand is 2
At a price of $4, you demand 4 Subways, Brittany 2, and Chris none.
 the market demand at a price of $4 is 6.
At a price of $2, you demand 6 per month, Brittany 4, and Chris 2.
 market demand is 12
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
22
End
4.2a Consumer Surplus: What is it?
Consumer surplus is the net benefit consumers get
from market exchange
That is, it a measure of the consumer satisfaction
from a good in excess of the price they have to
pay for the good.
It is used to measure economic welfare and to
compare the effects of such concepts as
Different market structures: competition v monopoly
Different tax structures: sales taxes v income taxes
Different public expenditure programs: voting models
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
23
End
4.2b Consumer Surplus
At price = $8, the marginal utility of other
goods is higher than the marginal utility
of a Subway  no Subways are
purchased. At price = $7, the consumer is
willing and able to buy one per month, at
price = $6, 2 are purchased  the second
is worth at least $6. At price = $5, 3 are
purchased, and so on. In each case, the
value of the last subway purchased must
at least equal the price, otherwise it would
not be purchased.
Along the demand curve, the price reflects
the marginal valuation of the good, or the
dollar value of the marginal utility derived
from consuming each additional unit.
$8
7
6
5
4
3
2
1
D
0
1
2
3
4
5
6
7
8
Subways per month
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
24
End
4.2c Consumer Surplus
When price = $4, each of the four
Subways can be purchased at this price,
even though the consumer would have
been willing to pay more for each of the
first three.
For the first sandwich the consumer
surplus is $3, i.e. ($7-$4), $2 for the
second, i.e. ($6-$4), and $1 for the third.
Thus, the dollar value of the total
consumer surplus of the first four
sandwiches is $3 + $2 + $1 + $0 = $6.
A price of $4 confers a consumer surplus of $6,
equal to the difference between the maximum
amount we would have been willing to pay
($22=$7+$6+5+$4) rather than go without
Subways and what we actually paid
($16=$4x4)).
$8
7
6
5
4
3
2
1
Later on we will show that in the continuous case
the consumer surplus is represented by the red
0
triangle formed by the area below demand and
above price and its area of that triangle would be
8=(.5)($4x4subs)
Begin
2 Utility
D
1
2
3 U. Max 4 Demand
3
4
5
6
5 I. Curves
7
Subways per
8 month
6 U. Max
25
End
4.2d Consumer surplus from sub sandwiches
At P=$4:
•1st sub valued at $7
•2nd sub valued at $6
•3rd sub valued at $5
•4th sub valued at $4
•Willing to pay $22 for 4 subs
•Pays only $16 for 4 subs
•Consumer surplus
$22-$16 = $6
Price per subs
$8
7
6
5
4
3
2
1
0
D
1
2
3
4
5
6
7
8
Subs per
month
When P drops to $3, consumer surplus increases by $4
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
26
End
4.2e Market demand and consumers surplus,
continuous case
Price per unit
Consumer surplus at a price of $2 is
shown by the blue area.
If the price falls to $1, consumer surplus
increases to include the green area.
At a zero price, consumer surplus increases
to the entire area under the D curve.
$2
1
D
0
Quantity per period
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
27
End
4.2f Consumer Surplus: Exercise
Price
$40
$30
$25
$20
To do this exercise you need to leave the “slide
show” view, by striking the “Esc” key.
Question: Resize and
use the triangle below
K
to identify the
Z
consumer surplus at
G the price of $20
900
at the price of $20,
the area of the
triangle
representing the
consumer surplus is
one-half base time
height, or (.5) times
($20 times 600
units) which equals
$6,000.
5 I. Curves
6 U. Max
H
$10
Demand
300
Your yellow triangle should fill the area
between the price of $20 and up to the demand
curve.
Begin
2 Utility
600
Quantity
3 U. Max 4 Demand
28
End
5.0 Indifference Curves
5.1 Ordinal Utility
5.2 Indifference Curves (ICs) pic
5.3 The Marginal Rate of Substitution
Pic, formula
5.4 The Indifference Curve Map
5.5 Non-intersecting
5.6 Summary ICs
5.7 The budget line
5.8 Summary ICs and Budget Lines
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
29
End
5.1. Ordinal Utility: I prefer this to that
All this new approach requires is that consumers be
able to rank their preferences for various
combinations of goods
Specifically, the consumer should be able to say
whether
Combination A is preferred to combination B
Combination B is preferred to combination A. or
Both combinations are equally preferred
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
30
End
5.2.a Indifference Curves & Properties
An Indifference Curve is defined as showing all
combinations of goods that provide the consumer
with the same satisfaction, or the same utility
In other words, along the indifference curve, the
consumer finds all combinations on the curve
equally preferred
Since each of the alternative bundles of goods
yields the same level of utility, the consumer is
indifferent about which combination is actually
consumed
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
31
End
Video rentals per week
5.2b Here is an indifference curve
An indifference curve (I) shows all
combinations of two goods that
provide a particular consumer with
the same total utility.
10
a
8
5
4
3
2
0
Indifference curve:
• negative slope
• convex to origin
b
c
d
1 2 3 4 5
Begin
2 Utility
I
10
Pizzas per week
3 U. Max 4 Demand
5 I. Curves
6 U. Max
32
End
5.3.a Indifference Curves Slope Down Because…
For a person to remain indifferent among consumption
combinations, the increase in utility from eating more
pizza must just offset the decrease in utility from
watching fewer videos
Thus, along an indifference curve, there is an inverse
relationship between the quantity of one good consumed
and the quantity of another consumed  indifference
curves slope down
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
33
End
5.3.b Moving along an Indifference Curve
We will show the MRS is:
“what you give up”
/
“what you get”
which is the same calculation
•Suppose there are only two goods
available: pizzas and movie videos
•On the indifference curve Point a shows
the consumption bundle consisting of 1
pizza and 8 video rentals
•On the indifference curve the consumer
is indifferent between point a and the
other points b,c, and d.
10
“a” to “b” trade 4
videos for 1 pizza
•Question: Holding utility
constant, how many video rentals
would a person be willing to give
up to get a second pizza?
5
4
3
•Answer: Moving from point a to point b, she is
willing to give up 4 videos to get a second pizza
(total utility is the same at points a and b); the
marginal utility of another pizza per week is just
sufficient to compensate for the utility lost from
decreasing video purchases by 4 movies per week.
2
Begin
2 Utility
a
8
b
c
d
I
0
1 2 3 4 5
3 U. Max 4 Demand
Pizzas per week
5 I. Curves 6 U. Max
10
34
End
5.3.c Moving along an Indifference Curve
Question: In moving from point b to c,
how many video rentals would a person be
willing to give up to get a second pizza?
Answer: the person is willing to give
up 1 video for another pizza.
Once at point c, the person is willing
to give up another video only if they
get two more pizzas in return, and
combination d consists of 5 pizzas and
2 videos
Points a, b, c, and d can be connected to
form the indifference curve, I, which
represents possible combinations of pizza
and videos that would keep the person at
the same level of total utility.
10
a
8
5
4
3
“b” to “c” ?
Trade 1 video
for 1 pizza
b
c
d
2
I
0
1 2 3 4 5
10
Pizzas per week
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
35
End
5.3.d Marginal Rate of Substitution Defined
The marginal rate of substitution, or MRS
measures the consumers willingness to trade one
good for another.
The MRS P,V , between pizza and videos indicates
the number of videos that the consumer is willing
to give up to get one more pizza, while
maintaining the same level of total utility.
MRS P,V =V/P = slope of IC
Alternatively, The marginal rate of substitution of
pizzas for video rentals can be found from the
marginal utilities of pizza and video
MRS P,V = MUP / MUV
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
36
End
5.3.e Marginal Rate of Substitution Graphed
Mathematically, the
MRS is equal to the
absolute value of the
slope of the indifference
curve
For example, in moving from
combination a to
combination b, the consumer
is willing to give up 4 videos
to get 1 more pizza  slope
between these two points
equals “–4”  MRS P,V =
4;
by the same
logic from b to c, MRS = 1
10
a
8
“a” to “b” MRS=4
5
4
3
“b” to “c” MRS=1
b
c
d
2
I
0
1 2 3 4 5
Begin
2 Utility
3 U. Max 4 Demand
Pizzas per week
5 I. Curves 6 U. Max
10
37
End
5.3.f Marginal Rate of Substitution Declines
The law of diminishing marginal rate of substitution
says that as a person’s consumption of pizza
increases, the number of videos that they are willing
to give up to get another pizza declines.
MRS P,V =V/P falls as pizza consumption
increases
This implies that the indifference curve has a
diminishing slope  as we move down the
indifference curve, the consumption of pizza
increases and the marginal utility of additional
pizza declines
MRS P,V = MUP / MUV falls as pizza consumption
increases
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
38
End
5.4.a Higher Preferred to Lower: Indifference Map
We can use the same approach to generate
a series of indifference curves, called an
indifference map  graphical
representation of a consumer’s tastes
Each curve in the map reflects a different
level of utility
The next slide illustrates an indifference
map for a particular consumer
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
39
End
Video rentals per week
5.4.b An indifference curve map
Indifference curves I1 through
I4 are examples from a
consumer’s particular
indifference map.
10
5
I4
I2
I3
Indifference curves farther
from origin depict higher
levels of utility.
I1
0
5
10
Pizzas per week
A line intersects each higher indifference curve, reflecting more of both goods.
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
40
End
If indifference curves
crossed, such as point i,
then every point on
indifference curve I and
every point on curve I',
would have to reflect the
same level of utility as at
point i
But point k is a combination
with more pizza and more
videos than point j  must
represent a higher level of
utility
Video rentals per week
5.5. Indifference Curves Do Not Intersect
k
j
i
I'
I
0
Begin
2 Utility
3 U. Max 4 Demand
Pizzas per week
5 I. Curves
6 U. Max
41
End
5.6 Summary: Indifference Curves
A particular indifference curve reflects a constant
level of utility  the consumer is indifferent
among all consumption combinations along a
given curve
Because total utility is to constant along an IC, an
increase in the consumption of one good must be
offset by a decrease in the consumption of the
other good  indifference curves slope
downward
Reflects the law of diminishing marginal rate of
substitution
Higher indifference curves represent higher levels
of utility. Indifference curves do not intersect
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
42
End
5.7a The Budget Line
Now that we have the consumer’s
indifference may, we now need to
depict the consumer’s budget.
To answer this question, we must
consider the relative prices of the
two goods and the consumer’s
income
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
43
End
5.7b The Budget Line Defined
The Budget line depicts all possible combinations of
movies and pizzas, given prices and your budget
It is drawn from the point of intersection with the
vertical axis to the point of intersection with the
horizontal axis.
Suppose videos rent for $4 and are represented on the
vertical axis, and pizza sells for $8 and is represented
on the horizontal axis. Suppose the budget is $40 per
week.
 if you spend the entire $40 on videos, the consumer
can purchase ($40/$4) = 10 videos—this is the
vertical intercept
 if you spend the entire $40 on pizzas, the consumer
can purchase ($40/$8) = 5 pizzas—this is the
horizontal intercept
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
44
End
Given the prices and budget, the
budget line meets the vertical
axis at 10 videos and meets the
horizontal axis at 5 pizzas
These two intercepts are then
connected to form the budget
line.
The budget line defines all
possible combinations of the
two goods, pizza and videos,
that can be purchased, given
prices and income  can be
thought of as a consumption
possibilities frontier
Video rentals per week
5.7c Slope of Budget Line
10
5
0
Slope of the budget line indicates
what it costs the consumer in terms
of foregone video rentals to get
another pizza
=rise/run
= -(I / pv )/ (I / pp )
= - pP / pV
–pp –$8
Slope =
=
= –2
pv
$4
5
10
Pizzas per week
At the point where the budget line meets the vertical axis, the
maximum number of videos you can rent equals income divided by
the video rental price = I / pv and for the horizontal axis is I / pp .
Begin 2 Utility 3 U. Max 4 Demand
5 I. Curves
6 U. Max
45
End
5.8 Summary: Indifference Curve & Budget Line
The indifference curve indicates what the
consumer is willing to buy
The budget line shows what the consumer is able
to buy
When the indifference curve and the budget line
are combined, we find the quantities of each good
the consumer is both willing and able to buy
When they are tangent this is the point of Utility
Maximization as shown in the next section
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
46
End
6.0 Utility Maximization
6 .1 Utility Maximization:
• Tangent, when slopes are equal, MU/P = across all goods
6.2 Deriving a Demand Curve
6.3 The Substitution and Income Effects (challenging)
6.4 Summary Substitution and Income Effects (challenging)
6.5 Exercise (only works in PPT file)
6.5 Self-Review of 6.3 & 6.4 (challenging)
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
47
End
The utility-maximizing consumer
will select a combination along the
budget line that lies on the highest
attainable indifference curve
Given prices and income, this
occurs at point e, where I2 just
touches, or is tangent to, the
budget line  buy 3 pizzas at $8
each and rent 4 videos at $4 each
(3x$8 = 4x$4) = $40
Other attainable combinations
along the budget line reflect
lower levels of utility. For
example, point a is on the budget
line  a combination that can be
purchased. However, point a lies
on a lower indifference curve.
Begin
2 Utility
Video rentals per week
6.1a Utility Maximization
10
a
5
4
e
I1
0
3 U. Max 4 Demand
3
5
I2
I3
10
Pizzas per week
5 I. Curves
6 U. Max
48
End
6.1b Consumer Equilibrium & Utility
Maximization
Consumer equilibrium occurs where the slope of
the indifference curve is equal to the slope of the
budget line
Recall that the absolute value of the slope of the
indifference curve is the marginal rate of
substitution,
MRS P,V = MUP / MUV
and the absolute value of the slope of the budget
line equals the price ratio
slope = PP / PV
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
49
End
6.1c Consumer Equilibrium & Utility Maximization
Thus, the utility maximization
condition
MUP  PP
MUV PV
Or rearranging terms,
MUP  MUV
PP
PV
Which you will recall is the rule we used earlier, spend
income until the per unit return from consumption (MU/P) is
equalized across all items!
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
50
End
6.2a Deriving the Demand Curve
The Indifference Curve analysis is used to derive a
demand curve
The derivation begins with the question: What
happens to the consumer’s equilibrium
consumption when there is a change in price?
The next slide illustrates the derivation
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
51
6 U. Max
End
Recall the initial equilibrium is at
point e with 3 pizzas ($8 each) and 4
videos ($4 each) with budget of $40.
Suppose the price of pizza falls from $8
to $4, other things constant 
consumer can now purchase a
maximum of 10 pizzas with a budget of
$40.
The budget intercept line rotates out
from 5 to 10 pizzas.
Since the rental price of videos has not
changed, the maximum number of
videos that can be rented remains the
same at 10.
Video rentals per week
6.2b Deriving the Demand Curve: I
10
e*
5
4
e
I*
I
0
3
5
10
Pizzas per week
With the decrease in price, the new equilibrium
occurs at e*, where pizza purchases increase from 3
to 5, and video rentals rises to 5.
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
52
End
6.2c Deriving the Demand Curve: II
(a) 10
Videos per week
To recap, as the price of pizza fell from $8 per
unit to $4 per unit, other things assumed
constant, the budget line rotates out and the
quantity d increases from 3 to 5 .
5
4
e"
e
I
0
In the price quantity space we plot the
information for the indifference curve
analysis. Point “e” is the initial point of $8
and 3 pizzas. Point e” is the new equilibrium
of $4 and 5 pizzas. Thus, from the
indifference curve model we have shown how
to derive a down ward sloping demand curve.
Price per pizza
(b)
3 4 5
7
10
Pizzas per week
e
$8
e"
D
4
0
3 4 5
7
10
Pizzas per week
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
53
End
6.3a Substitution and Income Effects
The law of demand was initially explained in
terms of a substitution effect and an income effect
With indifference curve analysis we have the
analytical tools to examine these two effects more
precisely
The next slide illustrates this process
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
54
End
Suppose the price of pizza falls from $8 to
$4, other things constant  consumer can
now purchase a maximum of 10 pizzas with
a budget of $40.
The budget intercept line rotates out from
5 to 10 pizzas.
The increase in the quantity of pizzas
demanded can be broken down into the
substitution and the income effect of a price
change. When the price of pizza falls, the
change in the ratio of the price of pizza to the
price of video rentals shows up through the
change in the slope of the budget line.
Video rentals per week
6.3b Substitution and Income Effects
10
e*
5
4
e
I*
I
0
3
5
10
Pizzas per week
To derive the substitution effect, let’s assume that you must maintain the same level of
utility after the price change as before  consumer’s utility level has not changed but the
relative prices you face have changed.
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
55
End
A new budget line reflecting the change in
relative prices, and holding utility constant,
can be shown by constructing the dashed
line CF.
Given the new set of relative prices, the
consumer increases the quantity of pizza
demanded to the point on the indifference
curve I that is just tangent to the dashed
budget line e’ by constraining utility to its
initial level (I) and using the new relative
prices, we have eliminated the change in real
income caused by the price change.
 The consumer moves down along the
indifference curve I to point e', renting fewer
videos but buying more pizzas. These
changes reflect the substitution effect of
lower prices of pizza
Video rentals per week
6.3c The Substitution Effect
10
C
e*
5
4
e
I*
e'
I
3 4 5
0
F
10
Pizzas per week
Substitution
effect
Since consumption bundle e' represents the same level of utility as consumption bundle e, the
consumer is neither better or worse off at point e'.
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
56
End
But at point e', the consumer has not spent
the full budget. The consumer’s real income
has increased because of the lower price of
pizza  he is able to attain point e* on
indifference curve I*.
At this point, the consumer buys 5 pizzas and
rent 5 videos. Because prices are held
constant during the move from e’ to e*, the
change in consumption is due solely to a
change in real income  the change in the
quantity demanded from 4 to 5 reflects the
income effect of the lower pizza price
HENCE: The substitution effect is the move
from point e to point e' in response to a change
in the relative price of pizza, with utility held
constant along I. The income effect is shown
by the move from e' to e* in response to a
change in real income with relative prices
constant
Begin
2 Utility
Video rentals per week
6.3d The Income Effect
10
C
e*
5
4
e
I*
e'
I
3 4 5
0
Substitution
effect
3 U. Max 4 Demand
F
10
Pizzas per week
Income
effect
5 I. Curves
6 U. Max
57
End
Video rentals per week
6.3e
One more time: Substitution and income effects of a drop in P
A reduction in the price of pizza moves the
consumer from e to e*.
10
Substitution effect: e to e’; consumer’s reaction
to a change in relative prices along the
original indifference curve.
C
5
4
e*
e
I*
e’
I
0
3 4 5
Substitution
effect
Begin
F
Income
effect
2 Utility
Income effect: e’ to e*; moves the
consumer to a higher indifference
curve at the new relative price ratio.
10
Pizzas per week
3 U. Max 4 Demand
5 I. Curves
6 U. Max
58
End
Video rentals per week
6.4 Summary of Substitution and Income Effects
10
C
5
4
3
e*
e
I*
e'
I
3 4 5
F
10
Pizzas per week
Substitution
Income
Substitution effect: holding real effect
income (total Income
effecteffect: holding relative prices constant (after
the price of pizza falls), the switch to a higher
utility) constant, the switch from videos to
indifference curve (more real income). (e’ to e* )
pizza as the price of pizza falls. (e to e’)
0
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
59
End
6.5 Exercise
To do this exercise you need to leave the “slide
show” view, by striking the “Esc” key.
(Not functional in the Flash Format file.)
Y
A
B
C
Xin good
In the graph above represent the income and substitution effects of the price decrease
X: Use A to B as the substitution effect B to C as the income effect
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
60
6 U. Max
End
6.6 Self-Review
of The Inc. and Sub. Effects
Below is a Flash Module that can be used for review. (Note
Questions 3 and 4 have incorrect diagrams!)
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
61
End
Another Flash Module that can be used for self-review
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
End
END OF PRESENTATION
Click a pic to review
63
Begin
2 Utility
3 U. Max 4 Demand
5 I. Curves
6 U. Max
63
End