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The Maxwell School, Syracuse University

Professor John Yinger

PPA 723: Managerial


Economics
Lecture 5:
Indifference Curves
Managerial Economics, Lecture 5: Indifference Curves

Outline

 Properties of Consumer Preferences

 Indifference Curves
Managerial Economics, Lecture 5: Indifference Curves

Tastes
 Individual tastes (preferences) determine
the pleasure people derive from different
goods and services

 Our objective is to determine how a


consumer’s tastes influence its decisions
(positive analysis), not to judge tastes
(normative).
Managerial Economics, Lecture 5: Indifference Curves

Standard Assumptions About


Consumer Preferences

1. Completeness

2. Transitivity

3. More is better
Managerial Economics, Lecture 5: Indifference Curves

Assumption 1: Completeness
 Consumer can rank any two bundles of
goods

 Only one of the following is true: The


consumer
prefers Bundle x to Bundle y
prefers Bundle y to Bundle x
is indifferent between the two bundles
Managerial Economics, Lecture 5: Indifference Curves

Assumption 2: Transitivity (Rationality)


 A consumer's preference over bundles
is consistent:

If a consumer prefers Bundle z to Bundle y


and Bundle y to Bundle x

Then that consumer prefers Bundle z to


Bundle x
Managerial Economics, Lecture 5: Indifference Curves

Assumption 3: More is Better


More of a good is better than less of it.
Good: commodity for which more is
preferred to less at least at some
levels of consumption
Bad: something for which less is
preferred to more, such as pollution

Consumers are not satiated.


Managerial Economics, Lecture 5: Indifference Curves

Figure 4.1a Bundles of Pizzas and Burritos Lisa Might Consume

(a) Ranking Regions B, Burritos


per semester
c A
25

20 f

15
e a
d
10 b

0 15 25 30
Z, Pizzas per semester
Managerial Economics, Lecture 5: Indifference Curves

Figure 4.1b Bundles of Pizzas and Burritos Lisa Might Consume


(b) Indifference Curve B, Burritos
per semester
c
25

20 f

e
15
a
d I
10 b

0 15 25 30
Z, Pizzas per semester
Managerial Economics, Lecture 5: Indifference Curves

Figure 4.1c Bundles of Pizzas and Burritos Lisa Might Consume


(c) Preference Map B, Burritos
per semester
c
25

20 f

I2
15 e

d
10 I1

I0

0 15 25 30
Z, Pizzas per semester
Managerial Economics, Lecture 5: Indifference Curves

Indifference Curve Properties


1. Bundles on indifference curves farther
from the origin are preferred to those on
indifference curves closer to the origin.
2. There is an indifference curve through
every possible bundle.
3. Indifference curves cannot cross.
4. Indifference curves are “thin”.
5. Indifference curves slope down.
Two Indifferent Managerial Economics, Lecture 5: Indifference
Curves

Figure 4.2a Impossible Indifference Curves


(a) Crossing B, Burritos
per semester

e
b

a I1
I0

Z, Pizzas per semester


Managerial Economics, Lecture 5: Indifference Curves

Figure 4.2b Impossible Indifference Curves


(b) Upward Sloping B, Burritos
per semester

Z , Pizzas per semester


Managerial Economics, Lecture 5: Indifference Curves

Willingness to Substitute
 Downward-sloping indifference curve ⇒
consumer is willing to substitute one
good for the other.
 Marginal rate of substitution (MRS) of
burritos (rise) for pizza (run), is slope of
indifference curve:
∆B
MRS =
∆Z
Managerial Economics, Lecture 5: Indifference Curves

Marginal Rate of Substitution


B, Burritos
per semester

∆ B MRS = ∆ B/∆ Z

∆ Z
I

Z, Pizzas per semester


Managerial Economics, Lecture 5: Indifference Curves

MRS Varies Along an Indifference


Curve

 Indifference curves bow away from the


origin (called convex).

 Indicates diminishing marginal rate of


substitution (MRS).
Managerial Economics, Lecture 5: Indifference Curves

Figure 4.3a Marginal Rate of Substitution


(a) Indifference Curve B , Burritos
Convex to the Origin per semester

a
8

–3

b
5
1
–2
c
3 1
–1 d
2
1
I

0 3 4 5 6
Z , Pizzas per semester
Managerial Economics, Lecture 5: Indifference Curves

Unlikely Outcome:
Concave Indifference Curve

 If indifference curve bows toward the origin


(concave),

 Then (implausibly) the consumer has an


increasing MRS.
Managerial Economics, Lecture 5: Indifference Curves

Figure 4.3b Marginal Rate of Substitution


B, Burritos (b) Implausible Indifference Curve
per semester that is Concave to the Origin

a
7
–2
b
5
1
–3
c
2
1
I

0 3 4 5 6
Z, Pizzas per semester
Managerial Economics, Lecture 5: Indifference Curves

Figure 4.4a Perfect Substitutes


Coke, Cans
per week
4

1
I1 I2 I3 I4

0 1 2 3 4
Pepsi, Cans per week
Managerial Economics, Lecture 5: Indifference Curves

Figure 4.4b Perfect Complements


Ice cream,
Scoops per week

e c
3 I3

d b
2 I2

a
1 I1

0 1 2 3
Pie, Slices per week
Managerial Economics, Lecture 5: Indifference Curves

Figure 4.4c Imperfect Substitutes


B, Burritos
per semester

Z, Pizzas per semester


Managerial Economics, Lecture 5: Indifference Curves

Utility
 Utility is a number that reflects the relative
rankings of various bundles of goods

 If Lisa prefers bundle A to B, then utility from


A must be greater than utility from B

 A utility function is a:
 relationship between a utility measure and every
possible bundle of good
 succinct summary of information in an indifference
curve map
Managerial Economics, Lecture 5: Indifference Curves

Utility and Marginal Utility


 The marginal utility of Z is:

∆U
MU Z =
∆Z

 MUZ is the change in utility from a small


increase in Z holding B fixed
Managerial Economics, Lecture 5: Indifference Curves

U , Utils
Utility
350 U (10,Z )
Utility function,

250
230 ∆ U = 20
∆ Z =1

0 1 2 3 4 5 6 7 8 9 10
Z , Pizzas per semester
Managerial Economics, Lecture 5: Indifference Curves

MU Z, Marginal Marginal Utility


utility of pizza
130

20
MUZ

0 1 2 3 4 5 6 7 8 9 10
Z, Pizzas per semester
Managerial Economics, Lecture 5: Indifference Curves

Totals, Margins, and Averages


 Economic analysis often depends on the
distinction between a total, a average, and a
margin.

 In the case of utility


 U = total utility
 U/Z = average utility of Z
 MUZ = marginal utility of Z
Managerial Economics, Lecture 5: Indifference Curves

Utility and the Marginal Rate of


Substitution
 Let A = the good on the vertical axis
and B = the good on the horizontal axis,
 Then (note the inversion):

∆A MU B
MRS = =−
∆B MU A
Marginal Rate of Substitution

Quantity of A

Give up
∆ A MRS = ∆ A/∆ B = - MUB/MUA
one unit
of A

Gain MUA units of utility, ∆ B


which can “buy” I
MUA / MUB Units of B

Quantity of B
Managerial Economics, Lecture 5: Indifference Curves

Deriving the Marginal Rate of


Substitution
∆U = 0 = ∆A( MU A ) + ∆B ( MU B )
= MU A + ∆B( MU B )

MU A
∆B = −
MU B

∆A −1 MU B
MRS = = =−
∆B MU A / MU B MU A