Microeconomics

PGP-I

Sessions 3
 Indifference Curves
y
Example: Graphing Indifference
Curves

Preference direction

IC2

IC1
2
x
 Key Definitions

Budget Set:
The set of baskets that are affordable

Budget Constraint:
The set of baskets that the consumer may purchase
given the limits of the available income.

Budget Line:
The set of baskets that one can purchase when
spending all available income.

3
 The Budget Constraint

Assume only two goods available: X and Y

Price of X: Px ; Price of Y: Py
Income: I
Total expenditure on basket (X,Y): PxX + PyY

The Basket is Affordable if total expenditure

does not exceed total Income:

PPXXX
X ++ PPYYY
Y II
4
 A Budget Constraint Example
Y

Budget line = BL1

I/PY

-PX/PY

C

I/P
X
5X
 A Budget Constraint Example
Y Shift
Shiftof
ofaabudget
budgetline
line

If income rises, the budget line shifts parallel

to the right (shifts out)

If income falls, the budget line shifts parallel

to the left (shifts in)

BL2

BL1

X
6
 A Budget Constraint Example

Y Rotation
Rotationof
ofaabudget
budgetline
line

If the price of Y rises, the budget

line gets flatter and the vertical
intercept shifts in (BL2 )

If the price of Y falls, the budget

line gets steeper and the vertical
BL1 intercept shifts out (BL1 )

BL2

7 X
 Consumer Choice

Assume:

Only non-negative quantities

"Rational choice: The consumer chooses
the basket that maximizes his satisfaction given
the constraint that his budget imposes.

Consumers
ConsumersProblem:
Problem:

Max
MaxU(X,Y)
U(X,Y)

Subject
Subjectto:
to:PPxxXX++PPyyYY<<II

8
 Interior Consumer Optimum
(an optimum at which the consumer purchases both commodities
(X > 0 , Y > 0)
Y
B
Preference Direction

Optimal Choice (interior solution)

IC
C
BL
0 X
9
 Interior Optimum

Interior Optimum: The optimal consumption basket is

at a point where the indifference curve is just tangent to
the budget line.

Tangency Equal Slope

MRSx,y = =

The
The rate
rate atat which
which thethe consumer
consumer would
would be be willing
willing to
to
exchange
exchange XX for forYYisis the
the same
same as
as the
the rate
rate atat which
which they
they
are
areexchanged
exchangedin inthe
themarketplace.
marketplace.
10
 Equal Slope Condition

At the optimal basket, each good gives

equal bang for the buck
Now, we have two equations to solve for two unknowns
(quantities of X and Y in the optimal basket):

1.
1. ==

2.2. PPxxXX++PPyyYY==II
11
Consumers optimal basket.

Thus, we can tell for a given income and prices of

other goods how much a consumer will demand of
X for a given price of X.

We can find different amounts of X demanded by

changing the price of X(PX) and determining how
much of X the consumer will demand prices of other
goods and income are held constant.

12
 Price Consumption Curves
Y (units)
The price consumption curve for
PPYY==44
good x can be written as the
II==40
40 quantity consumed of good x for
any price of x.
10
Price Consumption Curve


PX = 1

PX = 4 PX = 2
0 XA=2 XB=10 XC=16 20 X (units)
13
 Price Consumption Curves

The
The Price
Price Consumption
Consumption Curve
Curve of
ofGood
Good X:
X:

Is the set of optimal baskets for

every possible price of good x,
holding all other prices and
income constant.

14
 Individual Demand Curve

PX

Individual
Individual
Demand
DemandCurve
Curve
For
ForXX

PX = 4

PX = 2 U increasing
PX = 1
X
XA XB XC
15
Impact of Change in the Price of a Good

If price of a good falls consumer substitutes

into the other good to achieve the same level of
utility

When price falls purchasing power increases

the consumer can buy the same amount and still
have money left

16
Impact of Change in the Price of a Good
Pizza-Pepsi Story

Reduction in price of Pepsi

Now that the price of Pepsi has fallen, I get more Pepsi for
every Pizza that I give up. Because Pizza is now relatively more
expensive, I should buy less Pizza and more Pepsi
(Substitution Effect, change in consumption on the same IC
with a different MRS )

Now that Pepsi is cheaper, my income has greater purchasing

power. I am, in effect, richer than I was. Because I am richer, I
can buy both more Pizza and more Pepsi (Income Effect,
change in consumption that results from the movement to a
higher IC)
17
 Change in Income & Demand

Income Consumption Curve

The
The income
income consumption
consumption curvecurve of
of
good
good X X isis the
the set
set of
of optimal
optimal baskets
baskets
for
for every
every possible
possible level
level of
of income.
income.

18
Income Consumption Curve

19
 Engel Curves

The income consumption curve for

good X also can be written as the
quantity consumed of good X for any
income level. This is the individuals
Engel Curve for good X. When the
income consumption curve is
positively sloped, the slope of the
Engel Curve is also positive.

20
 Engel Curves
I

Engel Curve
X
Xisisaanormal
normalgood
good
92

68

40

0 X
10 18 24
21
 Definitions of Goods
If the income consumption curve shows that the consumer
purchases more of good X as her income rises, good X is a
normal good.

Equivalently, if the slope of the Engel curve is positive, the

good is a normal good.

If the income consumption curve shows that the consumer

purchases less of good X as her income rises, good X is an
inferior good.

Equivalently, if the slope of the Engel curve is negative, the

good is an inferior good.
22
 Impact of Change in the Price of a Good

Substitution Effect: Change in relative

price affects the amount of good that is
bought as consumer tries to achieve the same
level of utility

Income Effect: Consumers purchasing

power changes and affects the consumer in a
way similar to effect of a change in income

23
 The Substitution Effect

As the price of X falls, all else constant, good X

becomes cheaper relative to good Y
This change in relative prices alone causes the
consumer to adjust his/ her consumption basket.
This effect is called the substitution effect.
The substitution effect always is negative.

24
 Impact of Change in the Price of a Good

Definition: As the price of X falls, all else

constant, purchasing power rises. As the price
of X rises, all else constant, purchasing power
falls.

This is called the income effect of a change in

price.

The income effect may be positive (normal

good) or negative (inferior good).
25
 The Substitution and Income Effects
Clothing

Initial Basket
Y

Final Basket
Decomposition
Basket
A C
BLd
B U2
U1
BL1 BL2

XA X
XB XC
Food
The Substitution and Income Effects

27
The Substitution and Income Effects

28
Giffen Goods Income and Substitution Effects

29
 Giffen Goods
If a good is so inferior that the net effect of a price
decrease of good X, all else constant, is a decrease in
consumption of good X, good X is a Giffen good.

For Giffen goods, demand does not slope down.

When might an income effect be large enough to offset

the substitution effect?

The good would have to represent a very large

proportion of the budget.

A Giffen good has to be an inferior one, but the

converse is not necessarily true. 30