Indifference Curves

Consumer theory uses indifference curves (along with

budget constraints) to understand the consumer demand.
Theory of Consumer Behavior x2 x1  What is an indifference curve?
– An indifference curve is a graph
- showing different combinations
Prof. Sanjay K. Singh of goods that yield the same
level of utility (satisfaction) for
Indian Institute of Management Lucknow x2 the consumer.

x3
I(x’)
Consumer Behavior is best understood in x1 ~ x2 ~ x3
three distinct steps: Consumer Preferences,
Budget Constraints, and Consumer Choices. x1

Indifference Curves Indifference Curves

All bundles in I1 are
I1 strictly preferred to all in I2.
x2 z
p x
p y x2 All bundles in I2 are strictly
x x preferred to all in I3.

z z Higher indifference curves

are preferred to lower ones.
I2 – Consumers usually
prefer more of something
to less of it.
– Higher indifference
y y curves represent larger
I3 quantities of goods than do
lower indifference curves.
x1 x1
 WELL BEHAVED PREFERENCES
WELL BEHAVED PREFERENCES
A preference relation is “well-behaved” if it
is monotonic and convex. Convexity
 Monotonicity: More of any product is always
preferred (i.e. every product is a good, no x2 x
satiation). z is strictly
x2+y2 x+y preferred to both
 Convexity: Mixtures of bundles are (at least z=
weakly) preferred to the bundles themselves. 2 x and y
2
For example, the 50-50 mixture of the
bundles x and y is y
z = (0.5)x + (0.5)y. y2
z is at least as preferred as x or y. x1 x1+y1 y1
2

WELL BEHAVED PREFERENCES WELL BEHAVED PREFERENCES

Convexity Convexity
Preferences are strictly convex
x x when all mixtures z
x2 x2
are strictly
z =(tx1+(1-t)y1, tx2+(1-t)y2) z preferred to their
is preferred to x and y component
for all 0 < t < 1. bundles x and y.
y y
y2 y2
x1 y1 x1 y1
 y Why INDIFFERENCE CURVES are
WELL BEHAVED PREFERENCES
negatively sloped?
Weak Convexity
A consumer is willing to give up one good only if he
x’ Preferences are or she gets more of the other good in order to remain
z’ weakly convex if at equally happy.
least one mixture z – If the quantity of one good is reduced, the
quantity of the other good must increase.
is equally preferred – For this reason, most indifference curves
x to a component slope downward.
z
y bundle, e.g. perfect
y’ substitutes.
•A
I1
x

y Indifference curves never cross each Indifference curves are bowed inward
other. Why?
•Points A and C should make the consumer
 People are more willing to trade away goods that they
equally happy. have in abundance and less willing to trade away goods
•Points C and B should make the consumer of which they have little.
equally happy.
•This implies that A and B would make the  These differences in a consumer’s marginal substitution
rates cause his or her indifference curve to bow inward.
consumer equally happy. (remember,
I2 preferences are also transitive)
I1 •But B has more of both goods compared to
A.
B
• How come more of both goods doesn’t
increase utility (satisfaction)?

•A So, indifference curves will not intersect.

C
•
x
 Indifference curve when goods are Indifference curve when goods are
PERFECT SUBSITIUTES PERFECT COMPLEMENTS
Two goods with straight-line indifference Example: Each of (5,5), (5,9) and (9,5) is equally preferred
x2 curves are perfect substitutes. x2 If a consumer always
If a consumer always regards
45o consumes products
I2 units of products 1 and 2 as 1 and 2 in fixed
equivalent, then the products are proportion (e.g. one-
to-one), then the
perfect substitutes and only the
total amount of the two products 9 products are perfect
complements and
matters. only the number of
I1 5 I1 pairs of units of the
Slopes are constant (-k). two products
matters.
x1 5 9 x1
Two goods with right-angle indifference curves are perfect
complements.

Indifference curves when goods are

PERFECT COMPLEMENTS Indifference Curves: Shape

x2  The indifference curves are not likely to be

45o
9 I2
5 I1
Each of (5,5), (5,9) vertical, horizontal, or upward sloping.
and (9,5) is less
– A vertical or horizontal indifference curve (one of
preferred than the the goods doesn’t provide any utility)
bundle (9,9). – An upward-sloping indifference curve (consumer
is indifferent between a combination of goods
that provides less of everything and another that
provides more of everything)
– Rational consumers usually prefer more to less.

5 9 x1
 Shapes of Indifference Curves
Indifference Curve Shapes

CDs don’t provide any utility Gasoline provides no utility More is not good

Moreover, bad goods can be converted into good goods to have

convex indifference curve. E.g., use ‘clean air’ in place of ‘air pollution’;
more clean air means less air pollution.

Indifference Map SLOPE OF AN INDIFFERENCE CURVE

 The slope of an indifference curve is referred
 An indifference map is
to as the marginal rate-of-substitution (MRS).
a complete set of
indifference curves. x2  MRS of good 1 for good 2 is the maximum
amount of good 2 that a person is willing to
 It indicates the give up to obtain one additional unit of good 1
consumer’s (while maintaining the same level of utility).
preferences among all
 How do we calculate MRS?
combinations of goods
and services.
x* MRS at x* is the slope of
 The farther from the the indifference curve at x*.
origin the indifference
curve is, the more the
combinations of goods
along that curve are
preferred.
x1
 MRS
MRS
MRS is the amount of
x2 x2 product 2 an individual is
MRS at x* is lim {Dx2/Dx1}
as Dx1  0 willing to exchange for an
= dx2/dx1 at x* extra unit of product 1
Dx2 x* dx2 x*
dx1
Dx1

x1 x1

MRS Diminishing MRS

 In general, people tend to value more what they
Good 2 MRS decreases (in have less of:
absolute terms) as If you have 30 breads and 1 butter, you’ll be
MRS = (-) 5 x1 increases and x2 willing to give up breads for another butter. If
decreases … you have 10 breads and 3 butters, you’ll be
less willing to give up breads for butter.
 Therefore MRSx1,x2 diminishes as x1 increases
along the indifference curve.
 Since MRS diminishes along the curve, an
MRS = (-) 0.5 Good 1 indifference curve is convex (i.e., slope of the
indifference curve increases (becomes less
negative) as we move down along the curve).
 UTILITY AND UTILITY FUNCTIONS UTILITY FUNCTION
 An indifference curve depicts different bundles that
yield the same level of utility (satisfaction). Preferences can be represented by a utility
function if the functional form has certain
 For a better description of the consumer’s “nice” properties:
preferences, we require a large collection of
indifference curves (each curve representing a
particular level of utility). Example: Consider U(x1,x2)= x1.x2
 The complete collection of indifference curves
completely represents the consumer’s preferences. 1. u/x1>0 and u/x2>0
2. Along a particular indifference curve
 The collection of all indifference curves for a given
preference relation is an indifference map.
x1.x2 = constant  x2=c/x1
as x1   x2 
 An indifference map is equivalent to a utility
i.e. downward sloping indifference curve
function.

UTILITY FUNCTION UTILITY FUNCTION

3. As X1  MRS  (in absolute terms),  Utility is an ordinal (i.e. ordering or ranking)
concept.
i.e convex preferences
Example U(x1,x2)= x1.x2 =16  Ordinal utility theory states that while utility
cannot be measured using an objective scale, a
X1 X2 MRS consumer is capable of ranking different
alternatives available.
1 16
 For example, does individual A prefer 3 apples
2 8 (-) 8 and 2 oranges or 3 oranges and 2 apples?
3 5.3 (-) 2.7
 Suppose, U(1) = 6 and U(2) = 3. Then, consumer
4 4 (-) 1.3 prefers bundle 1 over 2. However, 1 is not
necessarily “two times better” than 2.
5 3.2 (-) 0.8
 UTILITY FUNCTIONS COBB DOUGLAS UTILITY FUNCTION

Cobb-Douglas Utility Function  Any utility function of the form

Ux , x   x x (a  0, b  0)
1 2
a b
1 2 U(x1,x2) = x1a x2b

Perfect Substitutes Utility Function with a > 0 and b > 0 is called a Cobb-
U  x1 , x 2   ax1  bx 2 Douglas utility function.
 Examples

Perfect Complements Utility Function U(x1,x2) = x11/2 x21/2 (a = b = 1/2)

U  x1 , x2   minx1, x2 
V(x1,x2) = x1 x23 (a = 1, b = 3)

COBB DOUBLAS INDIFFERENCE CURVES PERFECT SUBSITITUTES

 Goods that are
perfect substitutes
x2 x2 can always be
substituted for
x1 + x2 = 5
All curves are “hyperbolic”, each other on a 1-
13 to-1 basis (or in
asymptoting to, but never x1 + x2 = 9 certain proportion)
touching any axis. 9
– If a restaurant
doesn’t carry
x1 + x2 = 13 Pepsi, you order a
Coke instead
5
U(x1,x2) = x1 + x2

x1 5 9 13 x1
All are linear and parallel.
 PERFECT COMPLEMENTS MARGINAL UTILITY
U(x1,x2) = min{x1,x2}  Some goods are
 Marginal means “incremental”.
x2 only useful in a set
ratio to each other;  The marginal utility of product i is the rate of-
45o extra of one good is change of total utility as the quantity of
useless without
product i consumed changes by one unit; i.e.
extra of the other:
min{x1,x2} = 8 U
8 – Shoes: 1 Left MU i 
min{x1,x2} = 5 shoe for every  xi
5 Right shoe  The general equation for an indifference curve
min{x1,x2} = 3 – Cars: 4 full-size is: U(x1,x2)  k, a constant
3 tires for every  Totally differentiating this gives
car
3 5 8 x1
All are right-angled with vertices/corners on a ray
from the origin.

MARGINAL UTLITIES AND

MARGINAL RATE OF SUBISITUTION MUs and MRS: An example
U U
 dx2   dx1 x
 x2  x1
x2 U(x1,x2) = x1x2; MRS   2
dx  U /  x1 MU1
x1
So, MRS  2    This is the MRS.
d x1  U /  x2 MU 2 8 MRS(1,8) = - 8/1 = -8
Example: COBB DOUBLAS Utility Function MRS(6,6) = - 6/6 = -1.
6
U(x1,x2) = x1x2, Then,

U = 36

U=8
1 6 x1
 What would be MRS of Perfect Substitutes
Utility Function?
Perfect Substitutes: U = Ax1 + Bx2
where: A and B are positive constants.
MU1 = A
MU2 = B
MRS = -A/B
So, if you want to increase consumption of good
1 by 1 unit, you have to reduce consumption of
good 2 by A/B units (constant MRS).
POSITIVE MONOTONIC TRANSFORMATIONS AND MRS
 These are simply increasing functions
– E.g., for u(x1, x2) > 0, f(u) = u2; h(u) = ln(u)
– If f(u) is a positive-monotonic transformation of u
then as u increases f(u) also increases.
 Any positive monotonic transformation of a utility
function represent the same preference.
 That is, if U is a utility function that represents a
preference relation and f is a strictly increasing
function, then V = f(U) is also a utility function
representing the same preference relation.
What would be MRS of Perfect Complements
Utility Function?
Perfect Complements: U = min(x1,x2)
where:  is a positive constant.
MU1 = 0 or 
MU2 = 0 or 
MRS is 0 or minus infinite or undefined (corner)
POSITIVE MONOTONIC TRANSFORMATIONS AND MRS
 Note: The negative-monotonic transformation will
not represent the same preferences; f(u) would
not be a utility but a “disutility” function.
 What will happen to the marginal rates-of-
substitution when a positive monotonic
transformation is applied on a utility function?
(Hopefully, nothing)
POSITIVE MONOTONIC TRANSFORMATIONS AND MRS POSITIVE MONOTONIC TRANSFORMATIONS AND MRS

 For U(x1,x2) = x1x2, the MRS = (-) x2/x1 (recall

previous example)  More generally, if V = f(U) where f is a strictly
increasing function, then
 Create V = U2; i.e., V(x1,x2) = x12x22, What is
the MRS for V?
 V /  x1 2x x 2 x
 MRS    1 2  2
 V /  x2 2 x12 x2 x1

which is the same as the MRS for U.

MRS is unchanged by a positive monotonic
transformation.

The Budget Line

How do people make choices? Income of consumer 
m/P2 OR
P1x1+P2x2=m Price of both the goods
Tastes (indifference map/utility function) falls say by 10%

Scarcity (income or budget constraint)

 The indifference map only reveals the ordering of
consumer preferences among bundles of goods. It
tells us what the consumer desires to buy. m/P1
 It does not tell us what the consumer is able to buy. The slope of the budget constraint What would
 The budget constraint determines what can be line (-P1/P2) equals the relative price happen if prices
Price of CD 
purchased with a given level of income and goods’ of the two goods. of goods and
prices. income of
The slope measures the rate at consumer
– People consume less than they desire because their doubles (in an
spending is constrained, or limited, by their income. which the two goods can be
inflationary
substituted without changing the economy)?
total amount of money spent.
 CHOICE Consumer Equilibrium
How is the most
Utility (satisfaction) is
preferred bundle in
x2 the choice set
maximized at the point (C)
where an indifference
found? The consumer curve is tangent to the
m/P2 It must be maximizes budget line.
More preferred affordable and satisfaction by
bundles purchasing the
it must provide combination of
higher level of goods that is on
utility than any the indifference
other affordable curve farthest
bundle. from the origin but
Affordable U = U(x1,x2)
attainable given
bundles P1x1+P2x2=m the consumer’s
budget.
m/P1 x
1

RATIONAL CONSTRAINED CHOICE RATIONAL CONSTRAINED CHOICE

(x1*,x2*) is the most preferred affordable bundle.
x2 At Equilibrium E, IC is tangent
m/P2 to the budget line:
MRS = Dx2/Dx1 (Slope of the
indifference curve: Individual’s
willingness to trade) = - P1/P2
(Slope of the budget constraint:
Society’s willingness to trade)
x2* E At E, MU1/P1 = MU2/P2 (since
MRS=-MU1/MU2)
U = U(x1,x2)
P1x1+P2x2=m
m/P1x1
x1*
Marginal utility per Rs. spent on good1 = Marginal utility per Rs. spent on good2
 The most preferred affordable bundle is called the
consumer’s ORDINARY DEMAND at the given
prices and income.
 Ordinary demands will be denoted by
x1*(p1,p2,m) and x2*(p1,p2,m).
 How can this information be used to locate
(x1*,x2*) for given p1, p2 and m?
 Two ways to do this:
1. Use Lagrange multiplier method.
2. Find MRS, equate it to the slope of
budget line, and then substitute the
relationship into the budget constraint.
 COMPUTING DEMAND COMPUTING DEMAND
Lagrange Multiplier Method Lagrange Multiplier Method
Differentiate
Let us take an example of Cobb-Douglas utility function
L
U ( x1 , x2 )  x1a x12 a  x1
 ax 1a  1 x 21  a    p 1  0 (1)

L
and a budget constraint given by  (1  a ) x1a x 2  a    p 2  0 (2)
x2
p1 x1  p2 x 2  m L
 m  p 1 x1  p 2 x 2  0 (3)

Aim
ax1a-1  x21  a  1  a x1a x 2 a
max x1a x 21  a  subject to p1 x1  p2 x2  m  λ
p1

p2
Set up the Lagrangian p1 ax2
L  x1a x 21  a    m  p1 x1  p2 x 2   
p2 1  a x1
 x1 , x 2 ,  

COMPUTING DEMAND COMPUTING DEMAND

Lagrange Multiplier Method Method 2
ap x U( x1 , x 2 )  x1axb2
Rearrange p1 x1  2 2
1  a  MU1 
U
 ax1a  1xb2
 x1
Remember p1 x1  p2 x 2  m U
MU2   bx1axb2  1
 x2
 x 2* 
1  a m x1* 
am
a 1 b
p2 p1  MRS  dx 2    U/ x1   ax1 x 2   ax 2 .
dx1  U/ x 2 bx1axb2  1 bx1
These are ordinary demand function for good 2 and 1.
Ordinary demand function is also called Marshallian At (x1*,x2*), MRS = -p1/p2, i.e., the slope of the budget
demand function or Walrasian demand function or constraint.
uncompensated demand function.
 COMPUTING DEMAND Rational Constrained Choice
Method 2 Example of Corner Solution: Perfect Substitutes

ax*2 p bp1 * Max U(x1,x2) = x1 + x2 s.t. p1x1+p2x2=m

   1  x*2  x1 . (1) x2
bx*1 p2 ap 2 MRS = -1
 What if x1* = 0 or x2* = 0?
(x1*,x2*) also exhausts the budget so,  If either x1* = 0 or x2* = 0
then the ordinary demand
p1x*1  p 2x*2  m. (2) (x1*,x2*) is at a corner
solution to the problem of
maximizing utility subject
By solving (1) and (2), we get to a budget constraint.

x1

Example of Corner Solution: Example of Corner Solution:

Perfect Substitutes Perfect Substitutes

x2 x2
MRS = -1 MRS = -1

Slope = -p1/p2 with p1 > p2. Slope = -p1/p2 with p1 > p2.

x1 x1
 Example of Corner Solution:
Example of Corner Solution:
Perfect Substitutes
Perfect Substitutes

x2 x2
MRS = -1 MRS = -1
* m
x 
2
p2
First Case Second Case

Slope = -p1/p2 with p1 > p2. Slope = -p1/p2 with p1 < p2.

x*2  0

x*1  0 x1 x1* 
m x1
p1

Example of Corner Solution: CORNER SOLUTIONS

Perfect Substitutes
Every bundle on the budget constraint line will
x2 provide same level of utility when p1 = p2.
● Corner solution: situation in which the marginal rate of
substitution is not equal to the slope of the budget line (very
obvious for perfect substitutes)
When a corner solution

m MRS = -1 Third Case

p2 Slope = -p1/p2 with p1 = p2.
The budget constraint and the
indifference curve lie on each other.
m x1
p1
arises, the consumer
maximizes satisfaction by
consuming only one of
the two goods.
Given budget line AB, the
highest level of
satisfaction is achieved at
B on indifference curve
U1, where the MRS (of ice
cream for frozen yogurt)
is greater than the ratio of
the price of ice cream to
the price of frozen yogurt.
 Rational Constrained Choice Example of ‘Kinky’ Solution:
Example of ‘Kinky’ Solution: Perfect Complements Perfect Complements

X2 Max U(x1,x2) = min(ax1,x2) s.t. p1x1+p2x2=m x2 U(x1,x2) = min(ax1,x2)

MRS = - 
MRS is undefined
x2 = ax1 x2 = ax1
MRS = 0

X1 x1

Example of ‘Kinky’ Solution: Example of ‘Kinky’ Solution:

Perfect Complements Perfect Complements

x2 U(x1,x2) = min(ax1,x2) x2 U(x1,x2) = min(ax1,x2)

Which is the most preferred The most preferred

affordable bundle? affordable bundle (at the kinked
portion of the IC).

x2 = ax1 x2 = ax1

x1 x1
 Example of ‘Kinky’ Solution: How ordinary demands x1*(p1,p2,M) and
Perfect Complements x2*(p1,p2,M) change as prices p1, p2 and income
M change?

x2 U(x1,x2) = min(ax1,x2) x2 OWN-PRICE CHANGES

p1x1* + p2x2* = m (1) M/p2 (fixed p2 and M)
x2* = ax1* (2) p1 = 1
Solve (1) and (2) to get x1* and x2*.

x2 = ax1 p1x1 + p2x2 = M

x2* 
am p1= 3
p1  ap2 p1= 2

m
M/p1 x1
*
x 
1
x1
p1  ap2

Ordinary demand
p1 p1 curve for product 1
Own-Price Changes Own-Price Changes
Ordinary
The plot of the x1co-
(fixed p2 and M) demand curve (fixed p2 and M) ordinates of the price
x2 P1=3 for product 1 x2 P1=3 offer curve against p1 is
the ordinary demand
curve for product 1.
P1=2 P1=2

P1=1 P1=1
P1 price
offer curve
x1*(p1=3) x1*(p1=2) x1*(p1=1) x 1* x1*(p1=3) x1*(p1=2) x1*(p1=1) x 1*

x1*(p1=3) x1*(p1=2) x1*(p1=1) x1*(p1=3) x1*(p1=2) x1*(p1=1) x1

x1 The curve containing all the utility-maximizing bundles (in x1, x2 space)
as p1 changes, with p2 and M constant, is the price offer curve.
INCOME CHANGES: How does the value of x1* and x2* INCOME CHANGES Engel curve;
changes as income (M) changes, holding both p1 and p2 M
(fixed p1 and p2) good 2
constant?
M3
A plot of quantity M1 < M2 < M3
M2
M1 < M2 < M3 demanded against income M1
is called an Engel curve. Income
Income
M offer curve x21 x23 x2*
offer curve Engel curve;
good 1 x22
x23 M3 x23
x22 M2 x22
x21 M1 x21

x11 x13 x11 x13 x1* x11 x13

x12 x12 x12

 Normal versus Inferior Goods

EFFECT OF INCOME
CHANGES (normal goods)
An increase in income, with the AN INFERIOR GOOD
prices of all goods fixed, causes An increase in a
consumers to alter their choice of person’s income can
market baskets. lead to less
In part (a), the baskets that consumption of one of
maximize consumer satisfaction the two goods being
for various incomes (point A, $10; purchased.
B, $20; D, $30) trace out the Here, hamburger,
income-consumption curve. though a normal good
The shift to the right of the between A and B,
demand curve in response to the becomes an inferior
increases in income is shown in good when the
part (b). (Points E, G, and H income-consumption
correspond to points A, B, and D, curve bends backward
respectively.) between B and C.
 CONSUMER EXPENDITURES IN THE UNITED STATES

We can derive Engel curves for groups

of consumers. This information is
particularly useful if we want to see how
ENGLE CURVES
consumer spending varies among
Engel curves relate the
quantity of a good
different income groups.
consumed to income.
In (a), food is a normal ANNUAL U.S. HOUSEHOLD CONSUMER EXPENDITURES
good and the Engel curve
is upward sloping. INCOME GROUP (2009 $)
In (b), however, hamburger EXPENDITURES LESS 10,000– 20,000– 30,000– 40,000– 50,000– 70,000
is a normal good for ($) ON: THAN 19,999 29,999 39,999 49,999 69,999 AND
$10,000 ABOVE
income less than $20 per
month 4,733
Entertainment 1,041 1,025 1,504 1,970 2,008 2,611
and an inferior good for
Owned Dwelling 1,880 2,083 3,117 4,038 4,847 6,473 12,306
income greater than $20
per month. Rented Dwelling 3,172 3,359 3,228 3,296 3,295 2,977 2,098

Health Care 1,222 1,917 2,536 2,684 2,937 3,454 4,393

Food 3,429 3,529 4,415 4,737 5,384 6,420 9,761

Clothing 799 927 1,080 1,225 1,336 1,608 2,850

CONSUMER EXPENDITURES IN THE UNITED STATES CONSUMER CHOICE OF HEALTH CARE

ENGEL CURVES FOR U.S.
CONSUMERS
Average per-household
expenditures on rented
dwellings, health care, and
entertainment are plotted as
functions of annual income.
Health care and
entertainment are normal
goods, as expenditures
increase with income.
Rental housing, however, is
an inferior good for
incomes above $30,000.
CONSUMER PREFERENCES FOR
HEALTH CARE VERSUS OTHER GOODS
These indifference curves show the
trade-off between consumption of
health care (H) versus other goods (O).
Curve U1 applies to a consumer with
low income; given the consumer’s
budget constraint, satisfaction is
maximized at point A.
As income increases the budget line
shifts to the right, and curve U2
becomes feasible. The consumer moves
to point B, with greater consumption of
both health care and other goods.
Curve U3 applies to a high-income
consumer, and implies less willingness
to give up health care for other goods.
Moving from point B to point C, the
consumer’s consumption of health care
increases considerably (from H2 to H3),
while her consumption of other goods
increases only modestly (from O2 to O3).
 Rationing
When a good is rationed
(e.g., water rationing in few
Indian cities; gasoline
rationing in the US during
WWII), less is available than
what consumers would like
to buy. Consumers may be
worse off.
Without gasoline rationing,
up to 20,000 gallons of
gasoline are available for
consumption (at point B).
The consumer chooses
point C on indifference
curve U2, consuming 5000
gallons of gasoline.
However, with a limit of
2000 gallons of gasoline
under rationing, the
consumer moves to D on
the lower indifference curve
U1.
Questions (Answer)
what have you learned so far
Y.5
P MU X 2 X.5
MRS  X  MRS  
PY MU Y 2 X.5
Y.5
Y P 25 1 X the restriction,
 MRS   X   Y 
X PY 50 2 2 This implies Radhika should
 X  2Y
So,750  25 X  50Y  100Y
 Y  7.5 & X  15.
Questions
INEFFICIENCY OF RATIONING what have you learned so far
 Radhika consumes two goods, X and Y. She has a utility function
given by the expression:
 U = 4X0.5Y0.5.
 The current prices of X and Y are Rs. 25 and Rs. 50, respectively.
Radhika currently has an income of Rs. 750.
 Calculate the optimal quantities of X and Y that Radhika should
choose, given her budget constraint.
 Suppose that the government rations purchases of good X such that
Radhika is limited to 10 units of X. Assuming that Radhika chooses
to spend her entire income, how much Y will she consume?
Construct a diagram that shows the impact of the limited availability
of X. Is Radhika satisfying the usual conditions of consumer
Then, why is rationing necessary some time? In equilibrium while the restriction is in effect?
absence of rationing, economically worse off people  Calculate the impact of the ration restriction on Radhika's utility.
may not be able to consume the good…prices may be
too high…
Questions (Answer)
what have you learned so far
Since 750 = 25X + 50Y
If X = 10, then Y = 10
As indicated in the graph,
at Radhika's optimal bundle with
MU MU
P

P
.
X Y
X Y
consume more X to increase utility.
Radhika's utility without the restriction is:U  x  15, y  7.5  4 15  7.5  42.43.
0.5 0.5
Radhika's utility with the restriction is: U  x  10, y  10   4 10 0.5 10 0.5  40.
The ration restriction results in a utility loss of 2.43 units for Radhika.
 COST-OF-LIVING INDEXES COST-OF-LIVING INDEXES
● You know that DA (dearness allowance) to Government IDEAL COST-OF-LIVING INDEX
2000 (SARAH) 2010 (RACHEL)
employees and pensioners increases @ increase in CPI… Price of books $20/book $100/bk
• Is it an ideal cost-of-living index? Number of books 15 6
• An ideal cost-of-living index represents the cost of attaining a Price of food $2.00/lb. $2.20/lb.
given level of utility at current prices relative to the cost of Pounds of food 100 300
attaining the same utility at base prices. Expenditure $500 $1260
• Let us see a simple example.
The initial budget constraint
• Two sisters having identical preferences received discretionary facing Sarah in 2000 is given
budget from parents in a manner so that they’ll have same level by line l1; her utility-
maximizing combination of
of utility during their college days. food and books is at point A
IDEAL COST-OF-LIVING INDEX on indifference curve U1.
15×100+100×2.2=$1720
2000 2010 Rachel requires a budget
(Sarah) (Rachel)
was demanded by Rachel; sufficient to purchase the
Price of books $20/book $100/book
parents refused saying that food-book consumption
bundle given by point B on
Number of books 15 6 $1260 will give you same line l2 (and tangent to
Price of food $2.00/lb. $2.20/lb. level of utility as Sarah got indifference curve U1).
Pounds of food 100 300 in $500 in 2000. Do you
Expenditure $500 $1260 agree?

COST-OF-LIVING INDEXES  Laspeyres Index (based on cost of buying a base-year bundle)

IDEAL COST-OF-LIVING INDEX
2000 (SARAH) 2010 (RACHEL)
• Estimating ideal cost-of-living index is very difficult practically
Price of books $20/book $100/bk (since large amount of information on prices, expenditure and
Number of books 15 6 preferences are required).
Price of food $2.00/lb. $2.20/lb. • Actual price indexes are therefore based on consumer
Pounds of food 100 300
purchases, not preferences.
Expenditure $500 $1260
• Laspeyres price index is one such indexes: amount of money at
A price index, which current year prices that an individual requires to purchase a
represents the cost of
17.2
buying bundle A at current
bundle of goods and services chosen in a base year divided by
prices relative to the cost of the cost of purchasing the same bundle at base-year prices.
bundle A at base-year
prices, overstates the ideal
cost-of-living index.

In our example, Laspeyres index is ($1720/$500)*100 = 344 (using

100 as the base in 2000).
So, in this case, ideal cost-of-living index is $1260/$500 = 2.52 The Laspeyres index overcompensates the consumer (Rachel) for
which means that base year (2000) index is 100 and value of the higher cost of living, and the Laspeyres cost-of-living index is,
index in 2010 is 252. therefore, greater than the ideal cost-of-living index.
This result holds generally. Why?
Because Laspeyres price index assumes that consumers do not
alter their consumption patterns as prices change.
But, consumers actually substitute expensive goods by cheaper
ones …Let us now see another commonly used index.
 Paasche Index (based on cost of buying the current year’s bundle
● Paasche index answers the following question: What is the
amount of money at current-year prices that an individual requires
to purchase a current bundle of goods and services divided by
the cost of purchasing the same bundle in a base year?
• Both indexes are fixed-weight indexes: quantities of goods
and services remain unchanged.
• Historically, CPI, WPI and PPI are measured as Laspeyres
price indexes.
• Stanford University Prof. Michael Boskin found that the CPI
overstated inflation by approximately 1.1 percentage points in
the US (0.4 due to fixed weight and goods, 0.1 due to growth of
discount stores, and 0.6 due to improvement in quality of the
product and introduction of new products).
• That’s why, weights and goods need to be changed frequently.
Chain-weighted price index: cost-of-living index that accounts
for changes in quantities of goods and services.

Just as the Laspeyres index will overstate the ideal cost of living, • An index in which the base weights are updated every few
the Paasche will understate it (In our example, Paasche index is years.
((100×6+2.2×300)×100/(20×6+2×300)) = 1260×100/720 = 175
(using 100 as the base in 2000)).

For example, suppose you buy two goods which are close
substitutes – bananas (30p) and apples (30p)
At this price, you may buy 2 bananas and 2 apples.
Let us assume the price of bananas increased 50% to 45p, but
apples stayed the same price 30p.
This would suggest a jump in the inflation rate (25% = 50%/2 +
0%/2). Price Change: Income and
However, if the price of bananas increased, you might just shift
to buying apples. Therefore, the price of goods that you actually Substitution Effects
buy has not changed.
A chain weighted inflation measure would take into account the
fact that you no longer buy bananas. The prices you actually pay
for apples have stayed the same. Therefore, it would give an
inflation rate of 0% – very different to the actual CPI rate of 25%.
What if you don’t like apples? You were consuming 4 bananas
earlier; now, you have to pay 50% more. For some, chain
weighted CPI may under estimate the living cost.
THE IMPACT OF A PRICE CHANGE Pure Substitution Effect
 Economists often separate the impact of a price
change into two components:  Slutsky (Russian mathematician Evgeny
– the substitution effect; and
Slutsky, 1880-1948) isolated the change in
– the income effect.
demand due only to the change in relative
prices by asking
 The substitution effect involves the substitution
of good x1 for good x2 or vice-versa due to a – “What is the change in demand when
change in relative prices of the two goods. the consumer’s income is adjusted so
 The income effect results from an increase or that, at the new prices, she can only just
decrease in the consumer’s real income or
purchasing power as a result of the price change. buy the original bundle?”
 The sum of these two effects is called the price
effect.

Pure Substitution Effect Only Pure Substitution Effect Only

x2 x2

Assume, price of good 1 has

reduced.
x 2’ x 2’

x 1’ x1 x 1’ x1
 Pure Substitution Effect Only Pure Substitution Effect Only
x2 x2
So, at new prices, you’ll have to take
back some money/income from
consumer. Reduce the income so that
x 2’ she can only just buy the original x 2’
bundle.

x2’’

x 1’ x1 x 1’ x1’’ x1

Pure Substitution Effect Only Pure Substitution Effect Only

x2 x2 Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
x 2’ x 2’

x2’’ x2’’

x 1’ x1’’ x1 x 1’ x1’’ x1
 Pure Substitution Effect Only And Now The Income Effect
x2 Lower p1 makes good 1 relatively x2
cheaper and causes a substitution
from good 2 to good 1.
(x1’,x2’)  (x1’’,x2’’) is the
x 2’ x 2’ (x1’’’,x2’’’)
pure substitution effect.
x2’’ x2’’

x 1’ x1’’ x1 x 1’ x1’’ x1

And Now The Income Effect The Overall Change in Demand

x2 The income effect is x2 The change to demand due to
(x1’’,x2’’)  (x1’’’,x2’’’). lower p1 is the sum of the
income and substitution effects,
(x1’,x2’)  (x1’’’,x2’’’).
x 2’ (x1’’’,x2’’’) x 2’ (x1’’’,x2’’’)

x2’’ x2’’

x 1’ x1’’ x1 x 1’ x1’’ x1
Slutsky’s Effects for Normal Goods Slutsky’s Effects for Normal Goods
x2 Good 1 is normal because
 Most goods are normal (i.e. demand higher income increases
increases with income). demand

 The substitution and income effects x 2’ (x1’’’,x2’’’)

reinforce each other when a normal
x2’’
good’s own price changes.

x 1’ x1’’ x1

Slutsky’s Effects for Normal Goods Slutsky’s Effects for Normal Goods
x2 Good 1 is normal because
higher income increases  Since both the substitution and
demand, so the income income effects increase demand
and substitution
x 2’ (x1’’’,x2’’’) when own-price falls, a normal
effects reinforce
each other. good’s ordinary demand curve
x2’’ slopes down.
 The Law of Downward-Sloping
Demand therefore always applies to
x 1’ x1’’ x1 normal goods.
Slutsky’s Effects for Income-Inferior Slutsky’s Effects for Income-Inferior
Goods Goods
x2
 Some goods are income-inferior (i.e.
demand is reduced by higher
income). x 2’
 The substitution and income effects
oppose each other when an income-
inferior good’s own price changes.

x 1’ x1

Slutsky’s Effects for Income-Inferior Slutsky’s Effects for Income-Inferior

Goods Goods
x2 x2
Assume, price of good 1 falls.

x 2’ x 2’

x 1’ x1 x 1’ x1
Slutsky’s Effects for Income-Inferior Slutsky’s Effects for Income-Inferior
Goods Goods
x2 x2
The pure substitution effect is as for
a normal good. But, ….

x 2’ x 2’

x2’’ x2’’

x 1’ x1’’ x1 x 1’ x1’’ x1

Slutsky’s Effects for Income-Inferior Slutsky’s Effects for Income-Inferior

Goods Goods
x2 The pure substitution effect is as for a x2 The pure substitution effect is as for a
normal good. But, the income effect is normal good. But, the income effect is
in the opposite direction. in the opposite direction. Good 1 is
(x1’’’,x2’’’) (x1’’’,x2’’’) income-inferior
x 2’ x 2’ because an
increase to income
x2’’ x2’’ causes demand to
fall.

x 1’ x1’’ x1 x 1’ x1’’ x1
Slutsky’s Effects for Income-Inferior
Goods Giffen Goods
x2 In rare cases of extreme income-inferiority, the
The overall changes to demand are 
income effect may be larger in size than the
the sums of the substitution and substitution effect,
(x ’’’,x ’’’) income effects. – causing quantity demanded to fall/increase as
1 2
x 2’ own-price falls/increases.
 Such goods are Giffen goods. Example?
x2’’  Rice for a very poor family. Why?
 What happens when rice becomes costly?
 Real income goes down; family will reduce
consumption of vegetables, cereals, … and replace
x 1’ x1’’ x1 them by rice (still the cheapest food).
 Rice consumption increases …

Slutsky’s Effects for Giffen Goods Slutsky’s Effects for Giffen Goods
x2 A decrease in p1 causes x2 A decrease in p1 causes
quantity demanded of quantity demanded of
good 1 to fall. good 1 to fall.
x2’’’

x 2’ x 2’

x 1’ x1 x1’’’ x1’ x1
Slutsky’s Effects for Giffen Goods Slutsky’s Effects for Giffen
x2
Goods
A decrease in p1 causes
quantity demanded of  Slutsky’s decomposition of the effect
good 1 to fall. of a price change into a pure
x2’’’
substitution effect and an income
effect thus explains why the Law of
Downward-Sloping Demand is
x 2’
violated for extremely income-
x2’’ inferior goods.
x1’’’ x1’ x1’’ x1
Substitution effect
Income effect

Income and substitution effects … Income and Substitution Effects for Perfect
•So, there could be two kinds of inferior goods: Giffen good Complements and Perfect Substitutes
(upward-sloping demand curve) and Non-Giffen good
(downward sloping demand curve)  Perfect Complements: Since perfect
•Non-Giffen good: income effect is not as dominant as complements have right angled indifference
substitution effect. So, quantity demanded will increase as a curves, there is no substitution effect, only an
result of fall in price, though not as much as for a normal income effect.
good. Demand curve will be downward sloping.
•Giffen good: income effect is superior to the substitution
 Perfect Substitutes: There is both an income
effect and thus leads to a positively sloped demand curve.
•In reality it is highly unlikely that a Giffen good exists.
and substitution effect. Often the substitution
•A family’s cereals consumption is 20Kg (10 Kg of Bajra (inferior
effect is very large.
good) and 10 Kg of Wheat (normal good)); PB=Rs.15/Kg,
PW=Rs.25/Kg, I=Rs.400; Suppose, Now PB=Rs.20/Kg, Can family
afford the same bundle? No, since E=450. Then? Family has to
consume 20 Kg of cereals.
•20X+25(20-X)=400; X=20; i.e., B=20Kg, W=0; B  when PB
Compensating Variation and Equivalent Compensating Variation
Variation (measures of consumer welfare) p1=p1’ p2 is fixed.
x2
m1  p'1x'1  p 2x'2
Compensating Variation
 p1 rises. x'2
 Q: What is the least extra income u1
that, at the new prices, just restores
the consumer’s original utility level?
x'1 x1
 A: The Compensating Variation.

Compensating Variation Compensating Variation

p1=p1’ p2 is fixed. p1=p1’ p2 is fixed.
x2 p1=p1” x2 p1=p1”
m1  p'1x'1  p 2x'2 m1  p'1x'1  p 2x'2
x'"
2
 p"1x"1  p 2x"2  p"1x"1  p 2x"2
x"2 x"2
x'2 x'2
m2  p1"x1'"  p2 x '"
2
u1 u1
u2 u2
x"1 x'1 x1 x"1 x'"
1 x'1 x1
 Compensating Variation Equivalent Variation
p1=p1’ p2 is fixed.
x2 p1=p1”  p1 rises.
m1  p'1x'1  p 2x'2
x'"
2  Q: What is the least extra income
 p"1x"1  p 2x"2
x"2 that, at the original prices, just
x'2
m2  p1"x1'"  p2 x '"
2 restores the consumer’s original
u1 utility level?
u2 CV = m2 - m1.  A: The Equivalent Variation.

x"1 x'"
1 x'1 x1

Equivalent Variation Equivalent Variation

p1=p1’ p2 is fixed. p1=p1’ p2 is fixed.
x2 x2 p1=p1”
m1  p'1x'1  p 2x'2 m1  p'1x'1  p 2x'2
 p"1x"1  p 2x"2
x"2
x'2 x'2
u1 u1
u2
x'1 x1 x"1 x'1 x1
 Equivalent Variation Equivalent Variation
p1=p1’ p2 is fixed. p1=p1’ p2 is fixed.
x2 p1=p1” x2 p1=p1”
m1  p'1x'1  p 2x'2 m1  p'1x'1  p 2x'2
 p"1x"1  p 2x"2  p"1x"1  p 2x"2
x"2 x"2
m2  p'1x'"
1  p 2x 2
'"
m2  p'1x'" '"
1  p 2x 2
x'2 x'2
u1 u1
x'"
2 x'"
2
u2 u2 EV = m1 - m2.
' '
x"1 x'"
1 x1 x1 x"1 x'"
1 x1 x1

Questions Questions (Answer)

what have you learned so far what have you learned so far
Ankit’s utility function is u (x1, x2) = min {x1, x2}. Ankit has Ankit’s demand functions are
Now,
150  A 150

150
Rs. 150/- and price of x1 and the price of x2 are both 1. x1  x 2 
P1  P2
since, x1 = x2 and P1 x1  P2 x2  m  150 11 1 2
A A
Ankit’s boss is thinking of sending him to another town where P1 = price of good 1 and  75   50   25  A  50
2 2
where the price of x1 is 1 and the price of x2 is 2. The boss P2 = price of good 2.
and
150 150  B

B
 75  50   B  75
Indirect utility of Ankit is: 11 1 2 3
offers no raise in pay. Ankit complains bitterly. He says that m 150 Hence, A = Rs 50/- and
v( P1 , P2 , m)  
although he does not mind moving for its own sake and the P1  P2 P1  P2 B = Rs 75/-.
150
new town is just as pleasant as the old, having to move is as v(1,1,150) 
11
 75
bad as a cut in pay of Rs. A. He also says he would not mind v(1,2,150) 
150
 50
moving if when he moved he got a raise of Rs B. What are 1 2

A and B equal to?

 AN INCREASE in INCOME v. A SUBSIDY
AN APPLICATION on ONE PRODUCT ONLY
AN INCREASE in INCOME v. A SUBSIDY
on ONE PRODUCT ONLY Budget constraint is given by

p1 x1A  p2 x 2A  M
 Involves equal cost to the government
The government can
 Example: food subsidy for BPL card
holders; free electricity for farmers in (1) give a subsidy on food (x1)
certain states; …  p1  t x1B  p2 x2B  M
Note: Equal
(2) give a increase in income cost to the
government
p1 x1C  p2 x 2C  M  tx1B

AN INCREASE in INCOME v A SUBSIDY AN INCREASE in INCOME v A SUBSIDY

on ONE PRODUCT ONLY on ONE PRODUCT ONLY
But which makes the consumer better off ? But which makes the consumer better off ?
X2 X2 The subsidy on food
leaves the consumer at
B (better off than at A)

B
A A
U1

U0 U0
X1 X1
 AN INCREASE in INCOME v A SUBSIDY AN INCREASE in INCOME v A SUBSIDY
on ONE PRODUCT ONLY on ONE PRODUCT ONLY
But which makes the consumer better off ?
To illustrate the equal cost nature of the
X2 The subsidy on food the subsidy v. the income increase, you
leaves the consumer at draw a line parallel to the original budget
p1 x1A  p2 x2A  M B (better off than at A) constraint which passes through the
point B (as B must be affordable after the
B income increase).
A
U1
 p1  t x1B  p2 x2B  M
U0
X1

AN INCREASE in INCOME v A SUBSIDY AN INCREASE in INCOME v A SUBSIDY

on ONE PRODUCT ONLY on ONE PRODUCT ONLY
But which makes the consumer better off ? But which makes the consumer better off ?
X2 U2 The increase in X2 U2 The increase in
income leaves income leaves
C
the consumer C the consumer
at C (better off at C (better off
than at B) than at B)
B B
A A
U1 U1

U0 U0 p1 x1C  p2 x2C  M  tx1B

X1 X1
 Question Questions (Answer)
what have you learned so far what have you learned so far
There are 100 consumers in an isolated village. All of them
consumes only two goods, bread (good 1) and butter (good 2). max U ( x1 , x 2 )  ln x1  ln x 2 Now, max U ( x1 , x 2 )  ln x1  ln x 2
x1 x2

Price per unit of bread is Rs. 10 and price per unit of butter is
x1 x2

s.t. 10 x1 +20 x2 =1000 s.t. (10 + t) x1 +20 x2 =1000

Rs. 20. All consumers have monthly income of Rs 1000/-. All FOC: L = ln x1 + ln x2 –  (10 x1 +20 x2 -1000) L = ln x1 + ln x2 –  ((10 + t) x1 +20 x2 – 1000)
FOC:
of them have utility function represented by U(x1, x2) = lnx1 + 1
 10 1 x 10  t
x1
lnx2. Village Panchayat wants to raise Rs 10000/- per month. It 1
x 1
 2   x2  1
x
x1
 (10  t )  2 
x1 20
x1 2 2
can impose a quantity tax on good 1 or lump sum income tax x2
 20 1
 20  x2 
10  t
x1
on consumers. What would be quantity tax rate? If Panchayat 10 x1 +20 x2 =1000 x2 20
wants to maximize combined utility of consumers what tax  10 x1 +10 x1 =1000 (10 + t) x1 + 20 x2 = 1000
10  t
So, each consumer will consume:
option it should choose, lump-sum tax or quantity tax and  x1 = 50 units of bread per month
(10 + t) x1 + 20
20
x1 = 1000

why? (Remember P1 = 10, P2 = 20). x2 =25 units of butter per month  2 (10 + t) x1 = 1000

Questions (Answer)
what have you learned so far
so, when quantity tax on goods 1 is t, then each consumer will consume:
500 Indirect utility (in case of no tax):
 x1 * = units of bread per month

THANKS
10  t U ( x1 , x2 ) = ln (50 X25)
10  t 500 = ln (1250)
x2 * =   25 units of butter per month
20 10  t
Lump-sum tax of Rs100/-
Now, govt. wants to generate Rs 100 per person per month.
So, m  1000 – 100 = 900
So, t x1 * = 100 (in case of quantity tax).
Hence, max ln x1  ln x2
 500  x1 x2
 t  = 100
 10  t  s.t. 10 x1 +20 x2 = 900
 5t = 10 + t  4t = 10 L = ln x1 + ln x2 –  (10 x1 +20 x2 – 900)
 t = 2.5. So, impose a tax of Rs 2.5 per unit of bread.
1
 10
500 500 5000 x1 x 1 x
So, x1 * =    40  2   x2  1
10  2.5 12.5 125 1 x1 2 2
 20
x2 * = 25 x2
10 x1 +10 x1 = 900  x1 * = 45, x2 * = 45/2
Indirect utility (in case of quantity tax):
U ( x1 , x2 ) = ln x1 + ln x2 Hence, indirect utility, U ( x1 , x2 ) = ln (452/2) = ln (1012.5)
= ln x1 x2 which is more than ln(1000). Hence, lump-sum tax will increase
= ln (40 X 25) the combined utility of the consumers.
= ln (1000)