Download Executive MPA Foundation Week II Economics I-IV

Chapter 3: Theory of Consumer Behavior
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Indifference Curves and Budget
Constraints
• Individuals seek to maximize utility by allocating income across a
range of purchases subject to the constraints of their budgets
• Indifference curves represent all the different allocations of
purchases where an individual is equally satisfied
– Shape of the indifference curves describe whether goods are goods or bads
– We usually assume diminishing marginal utility implies convex indifference
curves
• Perfect substitutes and perfect complements are special cases
– Intersecting indifference curves represent inconsistent behavior
• Budget constraints determine the allocations of purchases
available to consumer and the budget line describes the maximum
that can be purchased if consumer expends all his/her income
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Indifference Curves
Good Y
Slope of indifference curves indicates
MRS
Convex shape indicates diminishing
MRS
U3
U2
Utility increases moving up indifference curves in the
northeast direction (U1<U2<U3)
U1
Good X
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The Marginal Rate of Substitution
(MRS)
• The MRS at any point on the IC represents the amount of
one good (on the vertical axis) that a consumer is willing
to trade for another (the good on the horizontal axis) to
make her/him indifferent (same utility function) between
two allocations
– The absolute value of the the slope of the IC at a given point
• The MRS is (usually) different at different points on the
IC because of the law of diminishing marginal utility
(marginal utility declines as consumption of a good
increases)
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Budget Constraints
Good Y
Intercepts where all income is
Spent on one good or the other
I
Py

Budget line shows all
consumption baskets that
are possible with the given
income
I
Px
Good X
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
Utility Maximization With Constraint
Oranges
O*
U3
U2
A*
U1
Apples
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Perfect Substitutes
Darigold
Butter
Note: Indifference curves have a slope of -1 (i.e. a oneto-one trade off)
U3
U2
U1
Land O’ Lakes
Butter
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Perfect Complements
Right Shoes
U3
U2
U1
Left Shoes
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Effect of a Income Change:
Normal Goods
All other goods
apples
9
Effect of a Income Change:
Inferior Goods
All other goods
Spam
10
How Much of Each Good Should a
Consumer Purchase to Maximize Utility
Apples
Oranges
Total
Utility
Marginal
Utility
Marginal
Utility/dollar
Total
Utility
Marginal
Utility
Marginal
Utility /dollar
1
20
20
10
15
15
10
2
35
15
7.5
27
12
8
3
47
12
6
36
9
6
4
55
8
4
39
3
2
5
61
6
3
41
2
1.33
6
65
4
2
42
1
0.67
7
67
2
1
42
0
0
Apples= $2.00/lb
Oranges=$1.50/lb
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The Effect of Changes in Price on
Demand
Apples
Oranges
Total
Utility
Marginal
Utility
Marginal
Utility/dollar
Total
Utility
Marginal
Utility
Marginal
Utility /dollar
1
20
20
8
15
15
10
2
35
15
6
27
12
8
3
47
12
4.8
36
9
6
4
55
8
3.2
39
3
2
5
61
6
2.4
41
2
1.33
6
65
4
1.6
42
1
0.67
7
67
2
.8
42
0
0
Apples= $2.50/lb
Oranges=$1.50/lb
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Sample Problem
P
Qd
Qs
40
5
15
20
15
5
Assume both demand and supply have constant slopes
Questions:
1 What are the demand and supply equations?
2 What are the equilibrium quantity and price levels?
3 What are the new equilibriums if the product is found to be good
for your health such that demand at every price increases by 10?
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