Overview • Illustrated using example of choices on movies and concerts • Assumptions of preference • ______________________ • ______________________ • ______________________ • Indifference curve • Consumer choice • maximize utility with constraint of budget
Assumption 3: More is better No. of movies per month D? B? A C? E? No. of concerts per month
Assumption 3: Nonsatiation -- More is better No. of movies per month more preferred ? B A C B preferred to A A preferred to C less preferred ? No. of concerts per month
Assumption 1: Can rank any two bundles No. of movies per month ‘More is better’ means that as we go northeast from C to B, utility increases B A C No. of concerts per month
Indifference Curve:All Combinations of two Goods that yield the same level of utility (Make the consumers equally well off.) No. of movies per Month After giving you an additional concert, how many movies could we take away from you and leave you no better or worse off than D? B D A E C U0 No. of concerts per month
Two things about the Indifference curve • First, it slopes _____. This follows the assumption about preferences _________. • Second, notice the curvature about the indifference curve. As we move downward and rightward along it, the curve becomes _________. Why?
Diminishing Marginal Utility:As No. of concert increases, takes away decreasing amounts of movies to leave utility unchanged No. of movies per month Along an indifference curve, As No. of movies decreases and No. of concerts increases, Marginal utility from an additional movie ____ andMarginal utility from an additional concert _______. ΔM1 ΔM2 ΔM3 U0 No. of concerts per month ΔC ΔC ΔC
Marginal Rate of Substitution– the absolute value of the slope of the indifference curve. What does the slope (without the minus sign) of indifference Curve mean? The maximum amount of movie Max would willingly trade for one more concert. No. of movies per month ΔM1 ΔM2 ΔM3 U0 No. of concerts per month ΔC ΔC ΔC
Marginal Rate of Substitution Along the indifference curve, the slope _______in absolute value; the MRS _______ when No. of movies decreases and No. of concert increases. No. of movies per month ΔM1 ΔM2 ΔM3 U0 No. of concerts per month ΔC ΔC ΔC
Indifference Map -Ranking Indifference Curves Any point on a higher indifference curve is preferred to any point on a lower one. No. of movies per month B A U1 C U0 U-1 No. of concerts per month
Budget Set: All combinations of goods that lie on or inside the budget line No. of movies per month 15 Not affordable affordable 5 No. of concerts per month
Combine budget line with indifference curve No. of movies per month The optimal combination of Goods for a consumer is the Point on the budget line where an indifference curve is tangent to the budget line. 15 C B U2 U1 A U0 5 No. of concerts per month
Combine budget line with indifference curve No. of movies per month The absolute value of the slope of the budget line=__________ The absolute value of the slope of the indifference curve =______ The optimal decision-making rule is _________________ 15 C B U2 U1 A U0 5 No. of concerts per month
Changes in income 30 No. of movies per month A rise in income, with no change in prices, leads to a new quantity demanded for each good. Whether a particular good is normal (quantity demanded increases) or inferior (quantity demanded decreases) depends on the individual’s __________, as represented by his ____________. 15 C B U2 U1 A U0 5 10 No. of concerts per month
Changes in Price No. of movies per month The drop in the price of concert rotates Max’s budget line ______. Based on his difference curves, he will choose ___. What if we dropped the price of concert again? How can we derive Max’s individual demand curve for concert? 15 B C U2 U1 A U0 10 5 No. of concerts per month
Income and Substitution Effects • Demand curve actually summarizes impact of two separate effects of price change on quantity demanded • Substitution effects • As the price of concert falls, its relative price ( relative to movies) _____. • Max substitutes concerts in place of movies whose prices have not changed. • It always moves quantity demanded in the opposite direction to the price change • When price decreases (increases), substitution effect works to _______ (_______) quantity demanded.
The Income Effect • When the price of concert drops, Max’s budget line rotates rightward. The price decline of concert ____ his total purchasing power over both goods. • Income effect can work to either increase or decrease the quantity of a good demanded, depending on whether the good is normal or inferior. If concert is a normal good, the income effect of a price cut will lead Max to consume _____ of them. If concert is an inferior good, the income effect of a price cut will lead Max to consume _______ of them.
Ultimate Effect (Almost Always) Figure 7: Combining Income and Substitution Effects Price Decrease: Substitution Effect P QD Þ QD QD if normal Purchasing Power QD if inferior Price Increase: Substitution Effect P QD Þ QD QD if normal Purchasing Power QD if inferior