Utility theory ,

Indifference Curve
Consumer behaviour
 Why does the Demand Curve
Slope Downward?
• Law of Demand
– Inverse relationship between price and quantity.
• Law of Diminishing Marginal Utility.
– Utility is the extra satisfaction that one receives
from consuming a product.
– Marginal means extra.
– Diminishing means decreasing.
 MARGINAL UTILITY
THEORY
• Total and marginal utility
– meaning of total utility

– marginal utility: TU/Q

• diminishing marginal utility

– total and marginal utility curves

 16

14 Shravan utility from consuming

coke (daily)
12

10

8 Bottles of TU
Coke in utils
6
Utility (utils)

4
0 0
1 7
2 2 11
0 3 13
0 1 2 3 4 5 6 4 14
-2
5 14
6 13

Bottles of coke consumed (per day)

 16

14 Shravan utility from consuming

TU
coke (daily)
12

10

8 Bottles of TU
Coke in utils
6
Utility (utils)

4
0 0
1 7
2 2 11
0 3 13
0 1 2 3 4 5 6 4 14
-2
5 14
6 13

Bottles of coke consumed (per day)

 16

14
Shravan utility from consuming
TU
Coke (daily)
12

10
Bottles of TU MU
8
Coke in utils in utils
6
-
Utility (utils)

0 0
4 1 7 7
2 2 11 4
3 13 2
0
4 14 1
0 1 2 3 4 5 6
-2 5 14 0
6 13 -1

Packets of crisps consumed (per day)

 16

14
Shrawan utility from consuming
TU
coke (daily)
12

10
Bottles of TU MU
8
Coke in utils in utils
6
Utility (utils)

0 0 -
4 1 7 7
2 2 11 4
3 13 2
0
4 14 1
0 1 2 3 4 5 6
-2 5 14 0
6 13 -1

MU
Bottles of coke consumed (per day)
 16

14
Shravan utility from consuming
TU
Coke (daily)
12

10
TU = 2
8

6
Q = 1
Utility (utils)

2
MU = TU / Q
0
0 1 2 3 4 5 6
-2

MU
Bottles of coke consumed (per day)
 16

14
Shrawan utility from consuming
TU
coke (daily)
12

10
TU = 2
8

6
Q = 1
Utility (utils)

2
MU = TU / Q = 2/1 = 2
0
0 1 2 3 4 5 6
-2

MU
Bottles of cokeconsumed (per day)
 Law of diminishing marginal
utility
All else equal as consumption increases
the marginal utility derived from each
additional unit declines
 Indifference
Curve Analysis
Combination Oranges Apples
A 1 10
B 2 6
C 3 3
D 4 1
Indifference curve
A curve showing all the combinations of
two goods (or classes of goods) that the
consumer is indifferent among.
Indifference Map
 An indifference map is a complete set of
indifference curves.
 It indicates the consumer’s preferences among
all combinations of goods and services.
 The farther from the origin the indifference
curve is, the more the combinations of goods
along that curve are preferred.

15 Copyright © Houghton Mifflin Company. All rights reserved.

 Marginal rate of substitution (MRS):
the rate at which the consumer is
willing to exchange the good
measured along the vertical axis for
the good measured along the
horizontal axis.
 Equal to the absolute value of the slope
of the indifference curve.
3-17
 The Marginal Rates of Substitution

Rate at which one good can be substituted for another

while holding utility constant
Slope of an indifference curve
3-18
dQY/dQX = -MUX/MUY
Diminishing Marginal Rate of
Substitution

3-19
Properties of IC’s
 The indifference curves are not likely to be
vertical, horizontal, or upward sloping.
 A vertical or horizontal indifference curve holds
the quantity of one of the goods constant,
implying that the consumer is indifferent to
getting more of one good without giving up any
of the other good.
 An upward-sloping curve would mean that the
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.
Indifference Curves:
No Crossing Allowed!
 Indifference curves cannot cross.
 If the curves crossed, it would mean that the
same bundle of goods would offer two different
levels of satisfaction at the same time.
 If we allow that the consumer is indifferent to all
points on both curves, then the consumer must
not prefer more to less.
 There is no way to sort this out. The consumer
could not do this and remain a rational consumer
Indifference curve bows towards origin
The slope or steepness of indifference curves is
determined by consumer preferences.
It reflects the amount of one good that a consumer
must give up to get an additional unit of the other
good while remaining equally satisfied.
This relationship changes according to diminishing
marginal utility—the more a consumer has of a good,
the less the consumer values an additional value of
that good. This is shown by an indifference curve that
bows in toward the origin.
Budget Constraint
 The indifference map only reveals the
ordering of consumer preferences among
bundles of goods. It tells us what the
consumer is willing to buy.
 It does not tell us what the consumer is able
to buy. It does not tell us anything about the
consumer’s buying power.
 The budget line shows all the combinations
of goods that can be purchased with a given
level of income
Budget Line
 The Effects of Changes in Income and Prices

FIGURE 3.11
EFFECTS OF A CHANGE IN
INCOME ON THE BUDGET
LINE
INCOME CHANGES
A change in income (with
prices unchanged) causes the
budget line to shift parallel to
the original line (L1).
When the income of $80 (on
L1) is increased to $160, the
budget line shifts outward to
L2.
If the income falls to $40, the
line shifts inward to L3.

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 FIGURE 3.12
EFFECTS OF A CHANGE IN
PRICE ON THE BUDGET
LINE
PRICE CHANGES
A change in the price of one
good (with income
unchanged) causes the
budget line to rotate about
one intercept.
When the price of food falls
from $1.00 to $0.50, the
budget line rotates outward
from L1 to L2.
However, when the price
increases from $1.00 to
$2.00, the line rotates inward
from L1 to L3.

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 Consumer Choice

Satisfaction is maximized (given the budget

constraint) at the point where

MRS = PX/Py

Budget line and indifference curve

are tangent

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Consumer Equilibrium
 MAXIMIZING CONSUMER
SATISFACTION
A consumer maximizes
satisfaction by choosing
market basket A. At this
point, the budget line
and indifference curve U2
are tangent.
No higher level of
satisfaction (e.g., market
basket D) can be attained.
At A, the point of
maximization, the MRS
between the two goods
equals the price ratio. At B,
however, because the
MRS [− (−10/10) = 1] is
greater than the price ratio
(1/2), satisfaction is not
maximized.

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Deriving the Demand Curve
Individual Demand: Effect of a Price Change
Clothing
(units per
month) Assume:
•I = $20
•PC = $2
10 •PF = $2, $1, $.50

A
6 U1 D
5 B Three separate
indifference curves
U3
4 are tangent to
each budget line.
U2

Food (units
per month)
4 12 20 Chapter 4
Slide 35
Individual Demand: Effect of a Price Change
Clothing The price-consumption
(units per curve traces out the
month) utility maximizing
market basket for the
various prices for food.

A
6 U1 Price-Consumption Curve
D
5 B
U3
4
U2

Food (units
4 12 20 per month)
Chapter 4
Slide 36
Individual Demand: Effect of Income
Changes
Clothing
Assume: Pf = $1
(units per
month) Pc = $2
I = $10, $20, $30

Income-Consumption
Curve
7 D
U3 An increase in income,
with the prices fixed,
5 U2 causes consumers to alter
their choice of
B
market basket.
3 A U1

Food (units
per month)
4 10 16 Chapter 4
Slide 37
 EXAMPLE 3.4 CONSUMER CHOICE OF HEALTH CARE

FIGURE 3.16
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).
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