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INDIFFERENCE CURVE
ANDUTILITY ANALYSES
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INDIFFERENCE CURVEANALYSIS
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Consumers Preferences
A B C
5 Cokes 2Sprite
2 Cokes 6Sprites
4 Cokes 4Sprites
2nd Choice 1st Choice 2nd Choice
Assume Only Two Goods Sprite and Coke
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Assumptions
1. Individual can rank their preference:
B preferred to A and C. A and C indifferent.
2. Non Satiation:
Individuals are better off if they have more.
D = 5 cokes + 7 spritesD preferred to B
3. Transitivity:
If D is preferred to B
and B is preferred to A and C
then D is preferred to A and C
4. Individuals are willing to give up successively smalleramounts of onegood in order to get additional units of othergoods.
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How to Draw
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Key Concepts
Indifference Curves are downward sloping,
Convex and do not intersect,
Higher indifference curve reflects greater level
of satisfaction,
Slope is called Marginal Rate of Substitution
Convex curve means declining marginal rate of
substitution
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Declining Marginal Rate of
Substitution
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INDIFFERENCE CURVES
What is Preferred
Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 12
2 9 120 12 12An Indifference
ScheduleCombi-
nation
Units
of A
Units
of B
j 12 2
j
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Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 12
2 9 120 12 12An Indifference
ScheduleCombi-
nation
Units
of A
Units
of B
j 12 2k 6 4
j
k
INDIFFERENCE CURVES
What is Preferred
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Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 12
2 9 120 12 12An Indifference
ScheduleCombi-
nation
Units
of A
Units
of B
j 12 2k 6 4l 4 6
j
k
l
INDIFFERENCE CURVES
What is Preferred
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Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 12
2 9 120 12 12An Indifference
ScheduleCombi-
nation
Units
of A
Units
of B
j 12 2k 6 4l 4 6
m 3 8
j
k
lm
INDIFFERENCE CURVES
What is Preferred
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Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 12
2 9 120 12 12An Indifference
ScheduleCombi-
nation
Units
of A
Units
of B
j 12 2k 6 4l 4 6
m 3 8
j
k
lm
I
INDIFFERENCE CURVES
What is Preferred
http://highered.mcgraw-hill.com/sites/0072819359/student_view0/chapter21/origin_of_the_idea.html -
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I2
Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 12
2 9 120 12 12An Indifference
ScheduleCombi-
nation
Units
of A
Units
of B
j 12 2k 6 4l 4 6
m 3 8
j
k
lm
The sloperepresents
the marginalrate of substi-tution, (MRS)
I1
INDIFFERENCE CURVES
What is Preferred
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Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 12
2 9 120 12 12An Indifference
ScheduleCombi-
nation
Units
of A
Units
of B
j 12 2k 6 4l 4 6
m 3 8
I1
INDIFFERENCE CURVES
When Income Changes
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Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 12
2 9 120 12 12An Indifference
ScheduleCombi-
nation
Units
of A
Units
of B
j 12 2k 6 4l 4 6
m 3 8
I1
I2
I3
I4
INDIFFERENCE CURVES
A higher combination is Preferre
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Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 12
2 9 120 12 12An Indifference
ScheduleCombi-
nation
Units
of A
Units
of B
j 12 2k 6 4l 4 6
m 3 8
I1
I2
I3
I4
An
Indifference
Map
INDIFFERENCE CURVESA family of Curves is a Map
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THE BUDGET LINE:What is Attainable
Units ofA Price$1.50
Units of
B Price$1.00
TotalExpenditures
8 0 $126 3 12
4 6 122 9 120 12 12
Quantityof
A
Quantity of B
12
10
8
6
4
2
0 2 4 6 8 10 1
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Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 122 9 12
0 12 12
(Attainable)Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
(Unattainable)
THE BUDGET LINE:
What is Attainable
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Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 12
2 9 120 12 12An Indifference
ScheduleCombi-
nation
Units
of A
Units
of B
j 12 2k 6 4l 4 6
m 3 8
I1
I2
I3
I4
INDIFFERENCE CURVES
A higher combination is Preferre
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Key Concepts
The utility maximizing point occurs where thehighest indifference curve is tangent to thebudget constraint
At the utility-maximizing point, the rate thatproducts must be traded in the market is justequal to the rate at which the individual iswilling to substitute one good for the other.
P i Ch d Utilit M i i ti
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Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 12
2 9 120 12 12An Indifference
ScheduleCombi-
nation
Units
of A
Units
of B
j 12 2k 6 4l 4 6
m 3 8
I1
I2
I3
I4
Price Changes and Utility MaximizationA higher combination is Preferred
Ch i D d
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Quantityo
fA
Quantity of B
12
10
8
6
4
2
02 4 6 8 10 12
Units ofA Price
$1.50
Units ofB Price
$1.00
Total
Expenditures
8 0 $126 3 124 6 12
2 9 120 12 12An Indifference
ScheduleCombi-
nation
Units
of A
Units
of B
j 12 2k 6 4l 4 6
m 3 8
I1
I2
I3
I4
Changes in Demand
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UTILITY THEORY
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Chapter 21 - Consumer Choice
24
Utility Theory
What is Utility
The want-satisfying power of a good or service
Utility Analysis
The analysis of consumer decision making based onutility maximization
Util
A representative unit by which utility is measured
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Assumptions of utility analysis
1. Cardinal Measurement: Satisfaction can bemeasured. Numbers can be assigned tomeasure satisfaction.
2. Independent: Utility of one commodity isindependent of other.
3. Constant Marginal Utility of Money: Marginalutility of money remains constant. More and
more money you get you will not be less andless satisfied.
4. From ones own experience it is possible to
guess satisfaction level of another person.
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Chapter 21 - Consumer Choice
26
Utility Theory
Marginal Utility
Definition: The change in total utility due to a one-unit change in the quantity of a good or service
consumed is called marginal utility.
Marginal utility = Change in total utilityChange in number of units consumed
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Some Maths
U = f(Q) dU/dQ = marginal utility
Suppose U = a + bQ + cQ2
How to maximize utility
du/dQ = b+2Q
And setting it to zero
b+2Q = 0
Q= -b/2 When Q is equal to -b/2 then it is maximum
Second derivative has to be negative
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Chapter 21 - Consumer Choice
28
Graphical Analysis
We can appreciate total and marginal utility byusing graphical analysis.
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Chapter 21 - Consumer Choice
29
Total and Marginal Utilityof Downloading and Listening to Digital
Music Albums
T t l d M i l Utilit
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Chapter 21 - Consumer Choice
30
Total and Marginal Utility
of Downloading and Listening to Digital
Music Albums
T l d M i l U ili
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Chapter 21 - Consumer Choice
31
Total and Marginal Utility
of Downloading and Listening to Digital
Music Albums
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Chapter 21 - Consumer Choice
32
Total and
Marginal Utility
of Downloadingand Listeningto Digital
Music Albums
Total utility ismaximized...
where marginalutility equals zero.
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Chapter 21 - Consumer Choice
33
Graphical Analysis
Observations
Marginal utility falls as more is consumed.
Marginal utility equals zero when total utility is atits maximum.
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Chapter 21 - Consumer Choice
34
Diminishing Marginal Utility
Diminishing Marginal Utility
The principle that as more of any good or serviceis consumed, its extra benefit declines
Increases in total utility from consumption of agood or service become smaller and smaller asmore is consumed during a given time period.