Download indifference_curve_approach

Indifference Curve Approach
Topic 3
Outline
•
•
•
•
•
•
•
•
•
•
•
Concepts—definition/illustration
Indifference map
Slope of indifference Curve/MRTS
DMRTS/reasons
Assumptions of Indifference curve
Properties of Indifference Curve
Budget line
Equilibrium of the consumer
Income Consumption Curve/Engel Curve
Price Consumption Curve/Demand Curve
Income and Substitution Effect
Concepts and illustration
• Indifference curve as an ordinal measure of
utility
– Utility is a psychological feeling
• IC is the locus of all commodity combinations,
from which the consumer derives the same
level of satisfaction
Illustration
• IC Schedule
• IC Graph
Indifference Map
Meaning of Indifference Map
• A set or family of
indifference curve is IM.
• A lower level of IC
represents a lower level of
satisfaction
Indifference Map
Marginal Rate of Technical
Substitution/Slope of IC
• (MRS) may be defined as the rate at which a
consumer will exchange successive units of
one commodity for another
• The MRS of good X for Y is given as:
Diminishing MRS
• The Principle of
DMRTSXY States that:
as the consumer has
more and more of good
X, he is prepared to
forego less and less of
good Y.
• Graphical Illustration
Reasons for DMRTS
• The want of a particular good is satiable—the
more of a good consumer have, the less is the
intensity of want
• The goods are imperfect substitutes to one
another.
Assumptions of IC
• More of a good is better—the consumer has
not reach the point of sateity.
• Preferences are transitive, i.e. consumer’s
taste is consistent, A = B, B = C, then, A = C.
• Diminishing Marginal Rate of Substitution
Properties of Indifference Curve
• IC slopes downward to the right—when more
of a good is increased, the other is reduced.
(negative slope)
Property 2
• Indifference curve is
convex to the origin—
this is based on the
principle of DMRSIllustrate with diagram
• Graphical illustration
Property 3
• Indifference Curve
cannot intersect
Property 4
• Higher level of
indifference curve
represents a higher
level of satisfaction than
a lower level of IC
Budget Line
• A budget line refers to the combinations of
commodities that a consumer is able to
purchase given his income and the prices of
the commodities.
BL Continues
• From the budget
constraint, Qx and Qy
can be obtained as
The Slope of the Budget Line
• The slope of the budget
line is the ratio of the
prices of the two
commodities.
Geometrically the slope
of the budget line is:
Slope of the Budget line Cont.
• Mathematically, the slope is the derivative of
the budget line
Derivation of Equilibrium
• The necessary condition of maximum
satisfaction is that the slope of the
indifference curve (MRS) be equal to the ratio
of commodity prices which is the slope of
indifference curve.
Consumer Equilibrium
• Point of equilibrium
Effects of Changes in Income (ICC)
• Income Changes results
in ICC
• ICC is the locus of
points representing
various combinations of
two commodities
purchased by the
consumer as his income
changes, all other
things remaining
constant
• Graphical Illustration
Engel Curve—derived from ICC
• An Engel curve is a
schedule or function
showing the
relationship between
equilibrium quantity
purchased of a
commodity and the
levels of income.
• The shape of the Engel
curve depens on the
shape of the ICC
Effect of Changes in Price--PCC
• Price Consumption
Curve (PCC) is a locus of
points of equilibrium on
indifference curves,
resulting from the
change in the price of a
commodity
PCC and Demand Curve
Income and Substitution Effects
• Price Effect = Income Effect + Substitution Eff.
• Income Effect = Increase in real income due to
a fall in the price of the commodity
• Substitution Effect = tendency to substitute
cheaper goods for the more expensive one
• Income effect causes a movement along the
ICC which has a positive slope
• Substitution effect causes a movement along
the PCC which has a negative slope
Derivation of Income & Substitution
Effect—Hicks Approach
• Substitution effect is the
change in quantity
demanded, resulting from
a change in relative price
after real-income effect of
price change is eliminated
• Income effect is the
change in quantity
demanded resulting
exclusively from change in
real income, all other
things remaining the
same.
Derivation of Income and Substitution
Effect Slutsky Approach