Chapter 5.1 : indifference curves

• Consumer Demand Function: The relationship between the quantity of a good bought and its price.
• Consumption bundle: A combination of different quantities of goods a consumer might like to consume.
• Utility: Satisfaction derived from consuming goods.
• Marginal Rate of Substitution (MRS): How much of one good the consumer is willing to give up to consume more of another good without changing their utility.
• Indifference Curves:

  • Show all combinations of two goods that provide the same utility.
• Downward-sloping curves that become flatter to represent diminishing marginal rates of substitution
• Budget Constraint: The maximum combinations of goods a consumer can afford given their income and the prices of the goods.
• The cost of forgoing one good to obtain more of another.

  • Representation: Slope of the budget line shows trade-offs between two goods
• The theory of consumer choice : 

  Purpose:

  • To explain how a consumer chooses how much to consume of different goods given their resources (income) and the market conditions (prices of goods)
  • This relates to the demand function 
• ingredients for the theory of consumer choice

  • The consumer’s tastes & utility 
  • The behavioral assumption that consumers are rational so they choose maximum utility
  • Consumers income (representing the resources available) 
  • The prices at which goods can be bought 
• Consumption bundle : 

  This represents what a consumer would like to consume. 

  A consumption bundle contains different quantities of various goods
• Assumptions about tastes:

  • Consumption bundles: contain different quantities of only two goods 
  • Completeness: 
  • We can always rank bundles according to utility 
  • Geometrically: indifference curves go through any bundle (function is continuous) 
  • Transitivity : the ranking of possible bundles is internally consistent 
  • If a is preferred to b and b is preferred to c then a is preferred to c 
  • Geometrically: indifference curves don’t cross 
• Assumptions about tastes:

  • Consumers prefer consuming more to less : 
  • We have to redefine it for bad goods like pollution 
  • Geometrically: consumers prefer higher indifference curves as they do not cross 
  • Diminishing marginal rate of substitution : 
  • When a consumer has a lot of one good he would have to sacrifice a lot of it to get another scarce good
  • Geometrically: convex to the origin 
• Utility:

  The amount of satisfaction a consumer would gain from consuming goods and services or a particular consumption bundle. 
• A consumer prefers one consumption bundle to another if the utility they get from one bundle is greater than the other 
• Indifference curve 

  Shows all the consumption bundles yielding a particular level of utility
• Downward slope : MRS
• Map of indifference curves:

  Shows different consumers’ tastes
• Ordinal utility:

  Non-measurable utility 
• Cardinal Utility:

  Measurable utility
• Marginal rates of substitution : 

  The quantity of a good a consumer must sacrifice to increase the quantity of another good by one unit without changing utility
• Diminishing marginal rates of substitution:

  For every additional unit of good 1 the consumer is willing to give up less and less amount of good 2
• • An indifference curve is a downward sloping curve connecting all the bundles that our consumer considers as equally desirable in terms of the utility they provide
  • Every point on one indifference curve yields the same utility
• • The consumer can face multiple different bundles, so we can have many different indifference curves on the same graph to represent the tastes of our consumer. 
• • Diminishing marginal rates of substitution imply that each curve becomes flatter as we move along it to the right
• • Because a consumer prefers more to less indifference curves must slope downwards 
• There is an indifference curve passing through every possible bundle faced by our consumer
• • Indifference curves further away from the origin are associated with higher levels of utility because the consumer prefers more to less 
• • Indifference curves cannot cross 
  • As it would violate our assumption that consumers prefer more to less 
• along each curve consumer utility is constant
• The budget constraint: 

  The different bundles a consumer can afford 
• the budget constraint:

  • Shows the maximum affordable quantity of one good given the quantity of another good being purchased 
  • A straight line, sometimes called the budget line 
  • Shows the maximum combinations of goods that the consumer can afford given income and the prevailing prices 
• • The end points show the position of the budget line 
  • The first point is the most of the Y axis variable that the budget will buy 
  • The end point is the most of the X axis variable that the budget will buy 
  • The end points show how much of each good the budget buys if the other good is not bought at all 
• • Any point above the budget line is unaffordable 
• • The slope of the budget line shows how many of x must be sacrificed to get another unit of Y 
  • Representing the opportunity cost of Y in terms of X 
  • Opportunity cost is constant along the the budget line 
  • The slope of the budget line depends only on the ratio of prices of the two goods 
• • Calculating the slope of the budget line = - (change in y) / (change in x)
  • Slope of the budget line = -PH/PV 
  • PH : price of the good on the horizontal axis 
  • PV: price of the goods on the vertical axis 
• • Budget Constraint: The combination of two goods (X and Y) a consumer can afford, given their income (M) and prices of the goods (Px and Py).
  • Budget Line: Depicted as a straight line that shows all combinations of goods a consumer can buy with their income.
• Slope of the Budget Line:

  • represents the trade-off (opportunity cost) between the two goods.
• • Qy = M/Py - Px/Py Qx 
  • The equation for the budget line 
  • M/Py = the first point of the budget line / the vertical intercept of the budget line 
  • -Px/Py = slope of the budget line 
• • M/Py : indicates how much of good y can be bought when a consumer spends all their income on good y