Module 12: Indifference Curves and Budget

Constraints
Objectives:

 Define an indifference curve and understand the significance of

the slope of an indifference curve.

 Define a budget constraint, understand how to graph a budget line,

and understand the significance of the slope of the budget line.

 Understand how to identify the utility-maximizing bundle

and illustrate this graphically.

 Understand how the rule of equal marginal utility per dollar holds
at the consumer’s equilibrium bundle.

 Understand how to derive a demand curve using indifference

curves and budget lines.
 Objective 1

Define an indifference curve……

 Indifference curves are a mechanism for illustrating consumers’

tastes and preferences.

 Two key assumptions in indifference curve analysis:

1. Consumers are able to rank different bundles of goods
2. Preferences are transitive.

 In our analysis, we will consider a simple two-good model and only

the consumption of goods that are desirable to the consumer as
opposed to “undesirables”. Desirable goods are products that give
the consumer satisfaction.
 A consumer’s indifference curve shows the various
combinations of two goods that give the consumer the
same level of utility or satisfaction.

Erin’s indifference curve: Erin

is indifferent between bundles
a, b and c.
Three properties of indifference curves:

 Higher indifference curves represent higher levels of

satisfaction.
 Indifference curves are negatively sloped and they are
bowed toward the origin.
 Indifference curves cannot cross.

4
 Objective 1: ..……and understand the significance of the
slope of an indifference curve.

 An indifference curve is
negatively sloped and it is
bowed toward the origin
A convex
(convex). Indifference
curve

 The slope of an indifference

curve tells us the rate at
which Erin is willing to
trade coffee for an
additional bagel with no
loss in satisfaction.
 The slope of the indifference curve is referred to as
the marginal rate of substitution (MRS).

 The marginal rate of substitution is the rate at

which a consumer is willing to give up good Y for
an additional unit of good X with no loss in
satisfaction

 The marginal rate of substitution falls as we move

down a given indifference curve.
 Objective 2

Define a budget constraint ……

 The budget constraint indicates the amount of income a

consumer allocates to goods and services.

 Suppose Erin has $I to spend on bagels and coffee.

Let Pb = price of bagels and Pc = price of coffee.

 We can write an equation for Erin’s budget constraint:

Pb Bagels + PcCoffee = I
Where Pb Bagels = Price of bagels × Quantity of bagels = expenditure on bagels

PcCoffee = Price of coffee × Quantity of coffee = expenditure on coffee and

I = income
 Equation of a budget constraint ……

 Suppose Erin has $18 to spend on coffee and bagels.

The price of coffee is $3 and the price of bagels is $2.

 Let’s plug this information into the equation of her budget

constraint:

Pb Bagels + PcCoffee = I

$2 × Bagels + $3 × Coffee = $18

Objective 2 …understand how to graph a budget constraint
 First find the intercept values: divide the total income by the price of the
good in question.

 Example: Erin has $18 a week and the price of bagels is $2. If she spends all her
income ($18) on bagels, she can buy (income ÷ price of bagels) $18÷$2 = 9
bagels. This is the X-intercept.

 The Y-intercept value is (income ÷ price of coffee) $18÷$3 = 6 cups of coffee.

Objective 2 …and understand the significance of slope of the budget
line

PX
 The slope of the budget line is the negative of the price ratios: −
PY
 The negative sign indicates that the consumer has to give up some of one
good to get more of the other.

Y= coffee and X= bagels

Slope = rise ÷ run

 Pbagels 2
 For example, the slope = −  , which means Erin has
Pcoffee 3
to give up 2/3 units of coffee to buy 1 additional bagel or 2 units of

coffee for 3 additional bagels.

 Objective 3

Understand how to identify the utility-maximizing combination

of goods and illustrate graphically.

 The equilibrium bundle gives the consumer the highest satisfaction,

given her budget constraint. This means that Erin wants to reach the
highest indifference curve possible that lie on her budget line.

Erin’s optimal bundle is “b”

which contains 4 cups of coffee
and 3 bagels. Her expenditure
on this bundle exhausts her
income.
Objective 3…. illustrate the utility-maximizing bundle
graphically.

 At the point of optimal consumption, the indifference curve is

tangent to the budget line.
 …….the significance of slope of the budget line

Key Points:

 The slope of the budget line equals the negative of the price

ratio, −
PX
PY

 The slope indicates how many units of good Y you have to

forego to obtain an additional unit of good X.

 The ratio of prices is also called the relative prices.

 The price ratio is the opportunity cost or the rate of exchange

dictated by the market.
 Objective 4
Understand how the rule of equal marginal utility per dollar
holds in equilibrium.

 Recall, the optimal consumption bundle (1) exhausts income, and

(2) satisfies the rule of equal marginal utility per dollar holds.

 Since bundle “b” lies on the budget line, the budget is exhausted.

 Recall the rule of equal marginal utility per dollar:

MU bagels MUcoffee
=
Pbagels Pcoffee

For the last unit, a dollar spent on

bagels yields the same utility as a
dollar spent on coffee.
 Objective 4 ……the rule of equal marginal utility per dollar
holds in equilibrium.

 Does bundle “b” satisfy the rule of equal marginal utility per dollar?

MU bagels MUcoffee
=
Pbagels Pcoffee

 Rearrange the equation above

MU bagels Pbagels
=
MU coffee Pcoffee
ratio of
marginal utilities ratio of prices
 YES! The rule of equal marginal utility per dollar holds at the
point of tangency between the indifference curve and the
budget line.

MU bagels Pbagels
=
MU coffee Pcoffee

The ratio of marginal The price ratio or

utilities is the slope of the relative prices is the
indifference curve or the slope of the budget line
marginal rate of substitution
 Objective 6
Understand how to derive a demand curve using indifference
curves and budget lines.

 The demand curve shows the quantities of a good that the consumer is
willing to purchase at alternative prices.

 At a price of $2, Erin’s utility-maximizing choice is 3 bagels.

 Objective 6….. deriving a demand curve

 To derive the demand for bagels curve we must change the price
of bagels and observe what happens the quantity demanded, holding
all else constant.

 Suppose the price of bagels falls to $1.50. What happens?

 First, the budget line changes. The new intercept value is 12 bagels
(income ÷ new price of bagels). The coffee intercept does not change.
 What happens to her optimal bundle?

 Now, her optimal bundle is bundle “h” containing 4 cups of coffee

and 4 bagels. Note “h” lies on her new budget line.

 Thus, when the price of bagels falls from $2.00 to $1.50, Erin
increases her quantity demanded from 3 to 4 bagels.
 With these two price-quantity combinations, we can derive Erin’s
demand for bagels curve

 Our result is consistent with the law of demand.