Overview

1
Overview

• The budget constraint
• Indifference curves
• The consumers optimal choice
• Income and substitution effects on choice
• Deriving the demand curve

2
The Budget ConstraintWhat Consumers Can Afford

• The budget constraint depicts the consumption
  possibilities available to the individual.
• People consume less than they desire because
  their spending is constrained, or limited, by
  their income.

3
The Budget Constraint
Pepsi
Pepsi (2)
500
Pizza
Pizza (10)
100
4
The Budget Constraint
Pepsi (2)
Any point on the constraint line equals 1,000,
the income available to spend on the two products.
B
500
C
250
A
Pizza (10)
50
100
5
The Budget Constraint

• The slope of the budget constraint measures the
  rate at which the consumer can trade one good for
  the other.
• The slope equals the relative price of the two
  goods, i.e. the price of one good compared to the
  price of the other.

6
Indifference Curves
Pepsi
.
C
.
.
B
I2
I1
A
Pizza
7
Indifference Curves

• The consumer is indifferent among combinations A,
  B, and C, because they are all on the same curve.
• The slope at any point on an indifference curve
  equals the rate at which the consumer is willing
  to substitute one good for the other.

8
Indifference Curves
Pepsi
Slope between points A and B. Tradeoff between
the two bundles.
.
C
.
.
.
B
I2
D
I1
A
Pizza
9
The Marginal Rate of Substitution

• The slope is called the marginal rate of
  substitution.
• The rate at which consumers are willing to trade
  one good for another.
• The amount that the consumer must receive as
  compensation in order to give up something else
  that he/she desires.

10
Properties of Indifference Curves

• Higher indifference curves are preferred
  to lower ones.
• Indifference curves are downward sloping.
• Indifference curves do not cross.
• Indifference curves are bowed inward.

11
Optimization What the Consumer Chooses

• Consumers would like to obtain the combination of
  goods on the highest possible indifference curve.
  However, the budget constraint may restrict or
  limit the consumer to a lower indifference curve.
  
• Combining the indifference curve and budget
  constraint determines the optimum choice.

12
The Consumers Optimal Choice
Pepsi
Consumers indifference curves, based on
personal preferences.
I3
I2
I1
Pizza
13
The Consumers Optimal Choice
Pepsi
Consumers budget constraint.
I3
I2
I1
Pizza
14
The Consumers Optimal Choice

• The point at which the indifference curve and the
  budget constraint touch (i.e. its tangent) is
  called the optimum.
• The consumer chooses consumption of the two goods
  so that the marginal rate of substitution equals
  the relative price.

15
A Change in Income Affects Choices
Pepsi
An Increase in income shifts the
budget constraint.
.
QPepsi
I3
I2
I1
Pizza
QPizza
16
A Change in Income Affects Choices
Pepsi
A new optimum
.
QNew
QPepsi
I3
I2
I1
Pizza
QPizza
QNew
17
Changes in Prices Affect Consumers Choices

• A fall in the price of any good will shift the
  budget constraint outward and will change the
  slope of the budget constraint.

18
Deriving the Demand Curve

• A consumers demand curve is a summary of the
  optimal decisions that arise from his budget
  constraint and indifference curves.

19
Conclusion

• Indifference curve analysis describes how
  individuals make decisions. It has many relevant
  applications.
• If people behave AS IF they followed the model,
  then the model will yield accurate and useful
  predictions and results.