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Chapter 6

# Appendix to Chapter 6.docx

Department
Economics
Course Code
ECON 101
Professor
Robert Gateman
Chapter
6

Page:
of 4 Appendix to Chapter 6: Indifference Curves
Indifference Curves
- Marginal utility theory (distinguishing total and marginal values and can
explain the so-called paradox of value) + Indifference theory (showed that
the stringent assumption of measurable utility that required for marginal
utility theory, could be dispensed with = demand theory
- Indifference theory is based on the much weaker assumption that consumers
can always say which of two consumption bundles they prefer without
having say by how much they prefer it
- Indifference curve shows all combinations of products that yield consumer
the same utility
- The consumer is indifferent between the combinations indicated by any two
points on one indifference curve
- All points on the curve are equal so any point above the curve must be
superior to all points on the curve
- All points below and to the left of the curve represent bundles that are
inferior to bundles represented by points on the curve
- Any point above an indifference curve is preferred to any point along that
same indifference curve; any point on the curve is preferred to any point
below it
- The indifference curve shows combinations of goods that yield equal utility
and between which consumer is indifferent
- All combinations on indifference curve has equal utility
- Tangent line of the point means marginal rate of substitution at that point
Diminishing Marginal Rate of Substitution
- The marginal rate of substitution (MRS) is the amount of one product that a
consumer is willing to give up to get one more unit of another product
- The first basic assumption of indifference theory is that the algebraic value of
the MRS between two goods is always negative
- Negative MRS means the consumption of one product increases and another
decreases
- The negative value of the marginal rate of substitution = the negative slope of
indifference curves
- The hypothesis of diminishing marginal rate of substitution = less of one
product and more of another product
- Marginal rate of substitution changes when the amounts of two products
consumed change = indifference curve becomes flatter as the consumer
moves downward and the right along the curve
- Diminishing MRS is the second basic assumption of indifference theory
- Marginal Rate of Substitution (absolute value) = Change in A / Change in B
- The marginal rate of substitution of A for B declines as the quantity of B
increases
The Indifference Map
- Starting at any other point, there will be another combinations that will give
consumer equal utility
- The farther any indifference curve is from the origin, the higher will be the
level of Hugh’s utility given by any of the points on the curve
- A set of indifference curves in an indifference map
- When economists say that a consumer’s tastes are given, they do not mean
that the consumer’s current consumption pattern is given; rather, they mean
that the consumer’s entire indifference map is given
- The farther the curve is from the origin, the high is the level of utility it
represents
The Budget Line
- Indifference curves illustrate consumers’ tastes
- Budget line shows all the combinations of A and B that consumer can but if
he spends a fixed amount of money (fixed prices of products and income)
- Points above the budget line are not attainable
Properties of the Budget Line
- Points on the budget line indicate bundles of products that use up the
consumer’s entire income
- Points between the budget line and the origin indicate bundles of products
that cost less than the consumer’s income
- Points above the budget line indicate combinations of products that cost more
than the consumer’s income
- The budget line shows all combinations of products that are available to the
consumer given his money income and the prices of the goods that he
purchases
- E = Pf x F + Pc x C (Money income must be equal to his total expenditure on
products)
The Slope of the Budget Line
- Negative slope of budget line means the increases of A the decreases of B
- The numerical value of the slope indicates how much of one good must be
given up to obtain an additional unit of the other
- The relative price determines the slope of the budget line (Pa/Pb)
- Slope of budget line reflects consumer’s opportunity cost of A in terms of B
- The opportunity cost of A in terms of B is measured by the (absolute value of
the) slope of the budget line, which is equal to the relative price ratio, Pa/Pb
- Relative price is consistent with an infinite number of absolute prices, thus
relative, not absolute, prices determine opportunity cost
The Consumer’s Utility-Maximizing Choices
- An indifference map describes the preferences of a consumer, and a budget
line describes the possibilities available to a consumer
- To maximize utility, consumer wants to reach the highest attainable
indifference curve
- The consumer’s utility is maximized at the point where an indifference curve
is tangent to the budget line. At that point, the consumer’s marginal rate of
substitution for the two goods is equal to the relative prices of the two goods
- If consumer values goods differently from the way the market does, there is
room for profitable exchange, when consumer exchanges goods at the same
rate as they can be traded on the market than the consumer maximizes his
utility
- With a given income, consumer can afford much less of each at these higher
money prices, but the opportunity cost of A in terms of B remains unchanged
The Consumer’s Reaction to a Change in Income
- A change in income will, ceteris paribus, parallel shift the budget line
- If join all the utility-maximizing points we can trace out an income-
consumption line, which shows how consumer’s consumption bundle
changes as his income changes, with relative prices being held constant.
The Consumer’s Reaction to a Change in Price
- A change in the relative prices of the two goods changes the slope of the
budget line