Indifference Curve Analysis

Chapter 8 Appendix

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Sophies Choice
Sophie eats chocolate bars and drinks soda.  She wants to maximize her utility given a budget constraint.


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Graphing the Budget Constraint

Chocolate bars cost $1 and sodas cost 50 cents each.  Sophie has $10 to spend.  She can buy 10 chocolate bars or 20 sodas or some combination of each.


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Graphing the Budget Constraint

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Graphing the Budget Constraint



The slope of the budget constraint is the ratio of the prices of the two goods.  The slope changes when the prices change.

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Graphing the Indifference Curve

Indifference curve a curve that shows combinations of goods among which an individual is indifferent.  The slope of the indifference curve is the ratio of marginal utilities of the two goods.


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Graphing the Indifference Curve



The absolute value of the slope of an indifference curve is called the marginal rate of substitution.

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Graphing the Indifference Curve



Marginal rate of substitution the rate at which one good must be added when the other is taken away in order to keep the individual indifferent between the two combinations.

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Graphing the Indifference Curve



Indifference curves are downward sloping and bowed inward.

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Graphing the Indifference Curve



Law of diminishing marginal rate of substitution as you get more and more of a good, if some of that good is taken away, then the marginal addition of another good you need to keep you on your indifference curve gets less and less.

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Graphing the Indifference Curve

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A Group of Indifference Curves



Sophie will have a whole group of indifference curves, each representing a different level of happiness.

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A Group of Indifference Curves



If she prefers more to less, she is better off with the indifference curve that is farthest to the right.

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A Group of Indifference Curves

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Why Indifference Curves Cannot Cross



If indifference curves crossed, it would violate the prefer-more-to-less principle.

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Why Indifference Curves Cannot Cross

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Indifference Curves and Budget Constraints



Sophie will maximize her utility by consuming on the highest indifference curve as possible, given her budget constraint.

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Indifference Curves and Budget Constraints



The best combination is the point where the indifference curve and the budget line are tangent.

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Indifference Curves and Budget Constraints



The best combination is the point where the slope of the budget line equals the slope of the indifference curve.
PS MUS MUC MUS ! so that ! PC MUC PC PS

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Indifference Curves and Budget Constraints

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Deriving a Demand Curve from the Indifference Curve



Demand is the quantity of a good that a person will buy at various prices.

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Deriving a Demand Curve from the Indifference Curve



The point of tangency of the indifference curve and the budget line gives the quantity that a person would buy at a given price.

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Deriving a Demand Curve from the Indifference Curve



By varying the price of one of the goods while holding the price of other constant, the points of tangency will change.  This gives alternative price/quantity combinations.

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Deriving a Demand Curve from the Indifference Curve

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Indifference Curve Analysis

End of Chapter 8 Appendix

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2004 The McGraw-Hill Companies, Inc., All Rights Reserved.