The Ordinal Theory: Indifference Curve Approach (Consumer Choice)
The Ordinal Theory: Indifference Curve Approach (Consumer Choice)
The Ordinal Theory: Indifference Curve Approach (Consumer Choice)
UNIT 8
The budget constraint depicts the consumption bundles that a consumer can afford.
People consume less than they desire because
It shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods.
Any point on the budget constraint line indicates the consumers combination or trade-off between two goods. For example, if the consumer buys no pizzas, he can afford 500 litres of Pepsi. If he buys no Pepsi, he can afford 100 pizzas.
250
50
100
Quantity of Pizza
250
50
A 100
Quantity of Pizza
250
50
Quantity of Pizza
Alternately, the consumer can buy 50 pizzas and 250 litres of Pepsi.
250
50
Quantity of Pizza
The slope of the budget constraint line equals the relative price of the two goods, that is, the price of one good compared to the price of the other.
It measures the rate at which the consumer will trade one good for the other.
A consumers preference among consumption bundles may be illustrated with indifference curves.
An indifference curve shows bundles of goods that leave the consumer equally satisfied. Indifference Curve Approach developed by Hicks and Allen.
Indifference Curves
Quantity of Pepsi
Quantity of Pizza
Indifference Curves
Quantity of Pepsi
Indifference Curves
The consumer is indifferent, or equally happy, with the combinations shown at points A, B, and C because they are all on the same curve.
Indifference Curves
Quantity of Pepsi
Indifference Curves
Quantity of Pepsi C
A 0
The slope at any point on an indifference curve is the marginal rate of substitution. It is the rate at which a consumer is willing to trade one good for another. It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.
Indifference Curves
Quantity of Pepsi
Indifference Curves
Quantity of Pepsi
Indifference curves are downward sloping. Indifference curves do not cross. Indifference curves are bowed inward.
Consumers usually prefer more of something to less of it. Higher indifference curves represent larger quantities of goods than do lower indifference curves.
Indifference Curves
Quantity of Pepsi
Indifference Curves
Quantity of Pepsi
Indifference Curves
Quantity of Pepsi C
Indifference Curves
Quantity of Pepsi C
A consumer is willing to give up one good only if he or she gets more of the other good. If the quantity of one good is reduced, the quantity of the other good must increase. For this reason, most indifference curves slope downward.
In order for preference rankings to be consistent, indifference curves cannot intersect or cross. If indifference curves were to cross the assumption that more is preferred to less would be violated.
C A B
Quantity of Pizza
People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little. These differences in a consumers marginal substitution rates causes his or her indifference curve to bow inward.
Quantity of Pizza
4 3 0 2 3 6 7
4 3 0 2 3
MRS = 1
1
6 7
Perfect Substitutes
Two goods with straight-line indifference curves are perfect substitutes. The marginal rate of substitution is constant.
Perfect Substitutes
10-cent coins
6
2 I1 0 1 I2 2 I3 3 20-cent coins
Perfect Complements
Perfect Complements
Left Shoes
7 5
I2 I1
Right Shoes
Consumers want to get the combination of goods on the highest possible indifference curve. However, the budget constraint may restrict or limit the consumer to a lower indifference curve.
Combining the indifference curve and the budget constraint determines the consumers optimal choice.
Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent.
The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.
The consumers valuation of the two goods equals the markets valuation.
An increase in income shifts the budget constraint outward. The consumer is able to choose a better combination of goods on a higher indifference curve.
Quantity of Pizza
I1 0 Quantity of Pizza
I1 0 Quantity of Pizza
I1 0 Quantity of Pizza
I2
I1 0 Quantity of Pizza
New optimum
I2
I1 0 Quantity of Pizza
I2
I1 0 Quantity of Pizza
I2
If a consumer buys more of a good when his or her income rises, the good is called a normal good. If a consumer buys less of a good when his or her income rises, the good is called an inferior good.
An Inferior Good
Quantity of Pepsi
Quantity of Pizza
An Inferior Good
Quantity of Pepsi
I1 0 Quantity of Pizza
An Inferior Good
Quantity of Pepsi
An Inferior Good
Quantity of Pepsi
Initial optimum
An Inferior Good
Quantity of Pepsi New budget constraint
Initial optimum
An Inferior Good
Quantity of Pepsi New budget constraint
Initial optimum
An Inferior Good
Quantity of Pepsi New budget constraint
An Inferior Good
Quantity of Pepsi New budget constraint
Initial optimum
An Inferior Good
Quantity of Pepsi New budget constraint
Initial optimum
New optimum Initial budget constraint I1 0 2. ... pizza consumption rises, making pizza a normal good... I2 Quantity of Pizza
An Inferior Good
Quantity of Pepsi New budget constraint
Initial optimum
New optimum
I1 0
I2 Quantity of Pizza
A fall in the price of any good rotates the budget constraint outward and changes the slope of the budget constraint.
Quantity of Pizza
500
500
500
Initial optimum I1 100 Quantity of Pizza
500
500
500
I1 100
I2 Quantity of Pizza
New optimum
500
I1 100
I2 Quantity of Pizza
New optimum
500
I1
I2
New optimum
500
3. and raising Pepsi consumption. Initial budget constraint 0 I1
I2
A price change has two effects on consumption. An income effect A substitution effect
The income effect is the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve. The consumer is... ...worse off when prices increase. ...better off when prices decrease.
The substitution effect is the change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution.
When the price of a good increases, the amount of other goods that must be given up increases.
A price change first causes the consumer to move from one point on a indifference curve to another on the same curve. Illustrated by movement from point A to point B.
After moving from one point to another on the same curve, the consumer will move to another indifference curve. Illustrated by movement from point B to point C.
Quantity of Pizza
I1 Quantity of Pizza
Initial optimum A
I1 Quantity of Pizza
Initial optimum A
I1 Quantity of Pizza
B A
Initial optimum
I1 Quantity of Pizza
B Substitution effect A
Initial optimum
I1 Quantity of Pizza
B Substitution effect A
Initial optimum
I1 Quantity of Pizza
B Substitution effect A
Initial optimum
I1 Quantity of Pizza
B Substitution effect A
Initial optimum
I2 I1 Quantity of Pizza
C New optimum B Substitution effect A I2 I1 0 Substitution effect Quantity of Pizza Initial optimum
C New optimum B A I2 I1 0 Substitution effect Income effect Quantity of Pizza Initial optimum
If the substitution effect is greater than the income effect for the worker, he or she works more. If income effect is greater than the substitution effect, he or she works less.
Conclusion
A consumers budget constraint shows the possible combinations of different goods he or she can buy given his or her income and the prices of the goods. Indifference curves represent a consumers combinations of preferences between two goods.
Conclusion
Consumers prefer higher indifference curves to lower indifference curves. The consumer optimises by choosing the point on his budget constraint that lies on the highest indifference curve.
Conclusion
Income effect is the change in consumption that arises because a lower price makes the consumer better off. Substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper.
Conclusion
Income effect is reflected by the movement from a lower to a higher indifference curve. Substitution effect is reflected by a movement along an indifference curve to a point with a different slope.
Exercise
Q.1. Illustrate properties of an indifference curve with help of diagrams. Q.2. Draw the indifference curves: (a). between perfect substitutes like 250 ml Pepsi bottles and 1 litre Pepsi bottles. (b). between perfect complementary like left shoe and right shoe. Q.3. Illustrate income effect for normal and inferior goods (Pizza and Pepsi) with a diagram.
Harcourt