Microeconomics (PGP-I)

Session 3

Joysankar Bhattacharya
 Marginal Rate of Substitution
The marginal rate of substitution: is the maximum rate at which the
consumer would be willing to substitute a little more of good X for a
little less of good Y;

It is the increase in good X that the consumer would require in

exchange for a small decrease in good Y in order to leave the
consumer just indifferent between consuming the old basket or the
new basket;

It is the rate of exchange between goods X and Y that does not affect
the consumer’s utility;

It is the negative of the slope of the indifference curve:

MRSx,y =
(for a constant level of
preference)
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Marginal Rate of Substitution

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 Convex Indifference Curves

Quantity of Pepsi
At point A, the consumer
has little pizza and much
Pepsi, so he requires a lot of
14 extra Pepsi to induce him to
give up one of the pizzas:
MRS=6 The marginal rate of
substitution is 6 cans of
A Pepsi per pizza. At point B,
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1 the consumer has much
pizza and little Pepsi, so he
requires only a little extra
4 B Indifference
3 MRS=1 curve Pepsi to induce him to give
1 up one of the pizzas: The
marginal rate of substitution
0 2 3 6 7 Quantity of Pizza is 1 can of Pepsi per pizza.

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 Marginal Rate of Substitution

MUx(dX) + MUy(dY) = 0 …along an IC

= = MRSx,y

Positive marginal utility implies the indifference curve

has a negative slope (implies monotonicity)

Diminishing marginal rate of substitution implies the

indifference curves are convex to the origin (implies
averages preferred to extremes)

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 Marginal Rate of Substitution

Implications of this substitution:

• Indifference curves are negatively-sloped, bowed out

from the origin, preference direction is up and right
 
• Indifference curves do not intersect the axes

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Indifference Curves

Averages preferred to extremes =>

indifference curves are bowed toward
the origin (convex to the origin).

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 Indifference Curves
y
Example: Graphing Indifference
Curves

Preference direction

IC2

IC1
x 8
 Key Definitions

Budget Set:
• The set of baskets that are affordable

Budget Constraint:
• The set of baskets that the consumer may purchase
given the limits of the available income.

Budget Line:
• The set of baskets that one can purchase when
spending all available income.

PxX + PyY = I
Y = I/Py – (Px/Py)X

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 The Budget Constraint

Assume only two goods available: X and Y

• Price of X: Px ; Price of Y: Py
• Income: I
Total expenditure on basket (X,Y): PxX + PyY

The Basket is Affordable if total expenditure

does not exceed total Income:

PXX + PYY ≤ I

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 A Budget Constraint Example
Y

Budget line = BL1

I/PY
•
-PX/PY

•C
•
I/PX
X
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 A Budget Constraint Example
Y Shift of a budget line

If income rises, the budget line shifts parallel

to the right (shifts out)

If income falls, the budget line shifts parallel

to the left (shifts in)

BL2

BL1

X
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 A Budget Constraint Example

Y Rotation of a budget line

If the price of Y rises, the budget

line gets flatter and the vertical
intercept shifts in (BL2 )

If the price of Y falls, the budget

line gets steeper and the vertical
BL1 intercept shifts out (BL1 )

BL2

X 13
 Consumer Choice

Assume:

 Only non-negative quantities

 "Rational” choice: The consumer chooses
the basket that maximizes his satisfaction given
the constraint that his budget imposes.

Consumer’s Problem:

Max U(X,Y)

Subject to: PxX + PyY < I

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 Interior Consumer Optimum
(an optimum at which the consumer purchases both commodities
(X > 0 , Y > 0)
Y
B
• Preference Direction

Optimal Choice (interior solution)

•
IC
C
• BL
0 X
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 Interior Optimum

Interior Optimum: The optimal consumption basket is

at a point where the indifference curve is just tangent to
the budget line.

Tangency Equal Slope

MRSx,y = =

“The rate at which the consumer would be willing to

exchange X for Y is the same as the rate at which they
are exchanged in the marketplace.”
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 Equal Slope Condition

“At the optimal basket, each good gives

equal bang for the buck”
Now, we have two equations to solve for two unknowns
(quantities of X and Y in the optimal basket):

1. =

2. PxX + PyY = I
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•Consumer’s optimal basket.

•Thus, we can tell – for a given income and prices of

other goods – how much a consumer will demand of
X for a given price of X.

•We can find different amounts of X demanded by

changing the price of X(PX) and determining how
much of X the consumer will demand – prices of other
goods and income are held constant.

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