INDIFFERENCE CURVES

 Indifference curves = represent the various combinations of two goods that

yield the same level of utility
 Maximization point = point at which a certain combination of two goods
yields the most utility

ECONOMIC GOODS AND BADS

 Economic “goods”
o Consuming more leads to higher total utility
o Marginal utility is positive
 Economic “bads”
o Consuming more leads to lower total utility
o Marginal utility is negative

INDIFFERENCE CURVES
 Indifference curves are usually bowed inward:
o Quadrant I of previous figure
o Based on assumption that averages are preferred to extremes
 The slope of the indifference curve is the marginal rate of substitution
(MRS) = rate at which a consumer is willing to purchase one good instead of
another
INDIFFERENCE CURVES
 Indifference curves cannot be “thick”
o This would violate “more is preferred to less”

 Indifference curves cannot intersect

o This would violate the assumption of transitivity
o If consumer preferences show A ~ B, B ~ C, then A ~ C
PERFECT SUBSTITUES
 Consumer is completely indifferent between two goods
 Will exhibit a constant MRS
PERFECT COMPLEMENTS
 Consumer is interested in consuming two goods in fixed proportions
 Results in L-shaped indifference curves

BUDGET CONSTRAINTS
 Set of consumption bundles that represent the maximum amount the
consumer can afford
 Depends on prices of goods and consumer income
INDIFFERENE CURVE and OPTIMUM
 Utility maximization is a constrained optimization problem
o Goal is to optimize (maximize) utility; we want to make ourselves as
happy as possible
o Constraint is the budget constraint based on our current income and
the prices of the goods we wish to purchase
 Graphically, we an think like this
o Goal is to get on the highest indifference curve possible
o Constraint is to be ON the budget constraint

INCOME and SUBSTITUTION effects

 Substitution effect (SE):
o If good X becomes expensive, we’ll buy relatively less X and relatively
more Y
 Real-income effect (IE):
o A change in price causes a change in real purchasing power
o If the price of one good falls, we have less purchasing power, and we
might choose to buy less of both goods
SEPERATING THE SE AND IE
 When the price of Pepsi increases:
o Purchasing power (real income) falls
o All else being equal, the consumer will buy less Pepsi, and less pizza
o But, now pizza is relatively cheaper than Pepsi
o All else being equal, the consumer will buy less Pepsi, but more pizza