Transcript App 6
A Lecture Presentation in PowerPoint to accompany Exploring Economics Second Edition by Robert L. Sexton Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting EXPLORING ECONOMICS, Second Edition by Robert L. Sexton as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher. Printed in the United States of America ISBN 0030342333 Copyright © 2002 by Thomson Learning, Inc. A More Advanced Theory of Consumer Choice Copyright © 2002 by Thomson Learning, Inc. Indifference Curves What Is an Indifference Curve? A consumer’s indifference curve contains various combinations of two commodities and each combination of goods (like points A, B, and C) on the indifference curve will yield the same level of total utility to this consumer. The consumer is said to be indifferent between any combination of the two goods along an individual indifference curve, because the consumer receives the same level of satisfaction from each bundle. Copyright © 2002 by Thomson Learning, Inc. Quantity of Clothing Exhibit 1 An Indifference Curve A B C Indifference Curve 0 Quantity of Food Copyright © 2002 by Thomson Learning, Inc. The Properties of the Indifference Curve Four properties of indifference curves higher indifference curves represent greater satisfaction are negatively sloped cannot intersect are convex from the origin Copyright © 2002 by Thomson Learning, Inc. The Properties of the Indifference Curve Higher indifference curves represent greater satisfaction Although equally happy with any bundle of goods along the indifference curve, consumers prefer to be on the highest indifference curve possible. Copyright © 2002 by Thomson Learning, Inc. Quantity of Clothing Exhibit 2 Indifference Curves A D B C 0 Quantity of Food Copyright © 2002 by Thomson Learning, Inc. I0 I1 The Properties of the Indifference Curve Consumer would prefer I2 to I1. Bundle D gives the consumer more of both goods than bundle C, which is on a lower indifference curve. Bundle D is also preferred to bundle A because there is more than enough extra food to compensate the consumer for the loss of clothing; his total utility has risen. Copyright © 2002 by Thomson Learning, Inc. The Properties of the Indifference Curve Indifference curves are negatively sloped must slope downward from left to right If both goods are desirable and the quantity of one good is reduced, the quantity of the other good must be increased to maintain the same level of total satisfaction. Copyright © 2002 by Thomson Learning, Inc. The Properties of the Indifference Curve Indifference curves cannot intersect Each curve represents various combinations that yield a given level of satisfaction. If they did intersect, then it would violate the assumption that more of a good is preferred to less of a good. Copyright © 2002 by Thomson Learning, Inc. Indifference Curves Cannot Intersect Quantity of Clothing C B A 0 Copyright © 2002 by Thomson Learning, Inc. Quantity of Food I0 I1 The Properties of the Indifference Curve The consumer is indifferent between bundle A and bundle B (both on indifference curve I0) but is also indifferent between bundle A and bundle C (both on indifference curve I1). But how could this be correct if bundle C has more of both goods than bundle B? In other words, this violates the assumption that more is preferred to less, and therefore indifference curves cannot intersect. Copyright © 2002 by Thomson Learning, Inc. The Properties of the Indifference Curve Indifference curves are convex from the origin The slope of the indifference curve reflects the marginal rate of substitution. the rate at which a consumer is willing to trade one good to gain one more unit of another good Copyright © 2002 by Thomson Learning, Inc. The Properties of the Indifference Curve If the indifference curve is steep, the marginal rate of substitution is high. The consumer would be willing to give up a large amount of A for a small amount of B. Copyright © 2002 by Thomson Learning, Inc. Quantity of Clothing Indifference Curves Are Convex from the Origin A 20 5 MRS = 5 15 10 5 4 0 1 MRS = 5 B Indifference 1 Curve 1 2 3 4 5 6 7 8 9 10 Quantity of Food Copyright © 2002 by Thomson Learning, Inc. The Properties of the Indifference Curve If the indifference curve is flatter, the marginal rate of substitution is low. The consumer is only willing to give up a small amount of A in exchange for an additional unit of B to remain indifferent If you have lots of something, you will not value the prospect of getting even more of it more highly; this is just the law of demand, which is based on the law of diminishing marginal utility. Copyright © 2002 by Thomson Learning, Inc. The Properties of the Indifference Curve Complements use of more units of one encourages the acquisition of additional units of the other. gasoline and automobiles baseballs and baseball bats snow skis and bindings bread and butter coffee and cream When complements, units of one good cannot be acquired without affecting the want-satisfying power of other goods. Copyright © 2002 by Thomson Learning, Inc. The Properties of the Indifference Curve Substitutes The more you have of one, the less your desire the other. coffee and tea sweaters and jackets home-cooked and restaurant meals Copyright © 2002 by Thomson Learning, Inc. The Properties of the Indifference Curve The degree of convexity of an indifference curve—that is, the extent to which the curve deviates from a straight line—depends on how easily the two goods can be substituted for each other. Perfect substitutes, the indifference curve is a straight line (in this case of slope –1). Copyright © 2002 by Thomson Learning, Inc. The Properties of the Indifference Curve Perfect complements, goods are never used separately but are consumed only together. left and right shoes. Since it is impossible to replace units of one with units of the other and maintain satisfaction, the marginal rate of substitution is undefined; thus, the indifference curve is a right angle Copyright © 2002 by Thomson Learning, Inc. Perfect Substitutes and Perfect Complements 6 Left Shoes $10 Bills 3 2 1 I0 0 2 I1 4 $5 Bills Copyright © 2002 by Thomson Learning, Inc. I2 6 5 B 4 C 3 A 2 1 0 1 2 3 4 5 6 Right Shoes I1 I0 The Properties of the Indifference Curve If two commodities can easily be substituted for one another, the nearer the indifference curves will approach a straight line The greater the complementarity between the two goods, the nearer the indifference curves will approach a right angle. Copyright © 2002 by Thomson Learning, Inc. The Budget Line A budget line represents the various combinations of two goods that a consumer can buy with a given income, holding the prices of the two goods constant. the horizontal axis measures the quantity of clothing the vertical axis measures the quantity of food. Copyright © 2002 by Thomson Learning, Inc. The Budget Line Moving along the budget line, we can see the various combinations of food and clothing the consumer can purchase with her income. Any combination of goods beyond the budget line is not feasible. Copyright © 2002 by Thomson Learning, Inc. The Budget Line Quantity of Clothing Y 10 A 8 6 4 Income = $50 PX (Food) = $10 PY (Clothing) = $5 B Not Affordable C D 2 E Affordable 0 Copyright © 2002 by Thomson Learning, Inc. Budget Line F 1 2 3 4 5 Quantity of Food X The Budget Line Finding the X- and Y-intercepts of the budget line The intercept can easily be found by dividing the total income available for expenditures by the price of the good in question. Copyright © 2002 by Thomson Learning, Inc. The Budget Line: Intercepts and Slopes Quantity of Clothing Y 10 8 (Income/PY = $50/$5 = 10) Income = $50 PX (Food) = $10 PY (Clothing) = $5 6 4 Budget Line 2 (Income/PX = $50/$10 = 5) X 0 1 2 3 4 5 Quantity of Food Copyright © 2002 by Thomson Learning, Inc. The Budget Line Finding the Slope of the Budget Line The slope of the budget line is equal to -PX/PY. The negative coefficient of the slope indicates that the budget line is negatively sloped (downward sloping), reflecting the fact that you must give up some of one good to get more of the other. Copyright © 2002 by Thomson Learning, Inc. Consumer Optimization Given the consumer’s indifference curves for two goods, together with the budget line showing the various quantities of the two that can be purchased with a given money income for expenditure, the optimal (or best) quantities of each good to be purchased can be determined. Copyright © 2002 by Thomson Learning, Inc. Consumer Optimization Income-consumption curve (ICC) a curve that connects the various optimum combinations of two goods as a consumer’s income changes Copyright © 2002 by Thomson Learning, Inc. Quantity of Clothing Point of Tangency—The Consumer’s Optimal 12 10 8 B A 6 C I2 4 Budget 2 Line 0 1 2 I1 I0 3 4 5 Quantity of Food Copyright © 2002 by Thomson Learning, Inc. 6 Consumer Optimization The optimum occurs where the budget line is tangent to indifference curve I1, at point A. To maximize satisfaction, the consumer must acquire the most preferred attainable bundle, that is, reach the highest indifference curve that can be reached with a given level of income. The highest curve that can be reached is the one to which the budget line is tangent, at point A. Copyright © 2002 by Thomson Learning, Inc. Changes in the Budget Line The position of the budget line if income rises An increase in income, holding relative prices constant, will cause the curve to shift out parallel to the old curve. a richer person can afford more of both goods than a poorer person because of the higher budget line. The change in income, holding relative prices constant, is called the income effect and it causes this parallel shift in the budget line. Copyright © 2002 by Thomson Learning, Inc. Quantity of Clothing A Change In Income Richer An Increase in Income Poorer L0 Quantity of Food Copyright © 2002 by Thomson Learning, Inc. L1 Changes in the Budget Line With a given pattern of indifference curves, larger amounts available for spending will result in an income consumption curve (ICC) connecting the best consumption points (tangencies) at each income level. Copyright © 2002 by Thomson Learning, Inc. Changes in the Budget Line The rise in income shifts the budget line outward. If both goods are normal goods in this range, then the consumer will buy more of both goods If income rises and the consumer buys less of one good, we say that good is an inferior good. Copyright © 2002 by Thomson Learning, Inc. B A I1 L0 0 Income Consumption Curve I0 B Income Consumption Curve I1 A I0 L0 L1 Quantity of Food Copyright © 2002 by Thomson Learning, Inc. Quantity of Clothing Quantity of Clothing Change in Income 0 L1 Quantity of Low-Quality Meat Changes in the Budget Line Budget line reflects price changes Purchases depend on relative prices as well as income level. When the price of one good changes, holding income and the price of the other good constant, it causes a relative price effect. Relative prices affect the way the consumers allocates their income among different goods. Copyright © 2002 by Thomson Learning, Inc. Changes in the Budget Line A price change of the good on either the Yor X-axis causes the budget line to rotate inward or outward from the intercept on the other axis. This fall in price expands consumers’ buying opportunities—rotating the budget line outward Copyright © 2002 by Thomson Learning, Inc. Quantity of Clothing Change in the Relative Price of Food 10 A Income = $50 Price of Food Rises from $10 to $25 Price of Food Rises from $10 to $5 L2 0 L0 L1 1 2 3 4 5 6 7 8 9 10 Quantity of Hamburger Copyright © 2002 by Thomson Learning, Inc. Changes in the Budget Line The tangency relationship between the budget line and the indifference curve indicates the optimal amounts of each of the two goods the consumer will purchase, given the prices of both goods and the consumer’s total available income for expenditures. Copyright © 2002 by Thomson Learning, Inc. Changes in the Budget Line At different possible prices for one of the goods, given the price of the other and given total income, a consumer would optimally purchase different quantities of the two goods. A change in the price of one of the goods will alter the slope of the budget line because a different amount of the good can be purchased with a given level of income. Copyright © 2002 by Thomson Learning, Inc. 10 9 8 7 6 5 4 3 2 1 L0 Budget Line, Price of $5 for clothing. $10 for food. L1 Budget Line, Price of $5 for clothing. $5 for food. Income = $5 for food. A B I2 I1 I0 L0 Copyright © 2002 by Thomson Learning, Inc. A $10 B 5 Demand for Food L1 0 1 2 3 4 5 6 7 8 9 10 Quantity of Food Price of Food Quantity of Clothing The Price Consumption Curve 0 2 5 Quantity of Food Changes in the Budget Line The point of tangency moves from A to B as a result of the decline in price of food from $10 to $5; the equilibrium quantity of food purchased increases from two to five units. Copyright © 2002 by Thomson Learning, Inc. Changes in the Budget Line Price-consumption curve (PCC): a curve consisting of the various optimum combinations of two goods as the relative price of one good changes The price-consumption curve (PCC) may be drawn through these points of tangency, indicating the optimum quantities at various possible prices of food (given the price of clothing). Copyright © 2002 by Thomson Learning, Inc. Changes in the Budget Line From this price-consumption curve can be derived the usual demand curve for the good. Essentially, the demand curve is made up of various price and quantity optimum points. Copyright © 2002 by Thomson Learning, Inc.