Budget Lines and Indifference Curve Flashcards
budget line
shows the consumption contraints faced by a consumer
the combinations of 2 goods or services that a consumer can afford to buy
given their limited inccome
and the prices of the goods
indifference curve
a curve showing
the combinations of
two goods that give
equal total utility to a
consumer
MRS
the slope of an indifference curve
the amount
of one good that a
consumer must give up
in exchange for another
while keeping total
utility constant
. To induce the consumer to give up 1 pizza, she
has to be given 6 liters of Pepsi: The MRS is 6 liters per pizza.
consumer equilibrium (for indifference analysis)
the point at which a
consumer maximises
utility at the tangency
between an indifference
curve and the budget
line; this is the highest level of utility a consumer can reach given their budget constraint
it is a particular optimum combination on the highest attainable IC given available budget
substitution effect
following a change in relative prices, consumer substitues relatively cheaper good for relatively more expensive one
income effect
the way that a change in relative prices of goods affects purchasing power of given level of income, so consumer buys more or less of each good
giffen good
a good
for which the income
effect is so strong that
it more than offsets
the substitution effect,
so that the demand
curve becomes upward
sloping
assumptions of indifference analysis related to RATIONALITY
- consumers make rational decisions based on perfect information
- Consumer aims to maximise utility
- consumer** knows combos** b/w which there is indifference
- consumer can rank their level of satisfaction for multiple goods
- consumer **can compare two goods rationally **
- The rational consumer behavior remains constant over the IC curve
- consumers are assumed not to make choices under uncertainty
slope of budget line
represents relative prices of goods and hence the opportunity cost of increasing the consumption of one good by 1 unit
e.g. if slope is 5, it means to increase consumption of good X by 1, you must give up 5 of Y
calculating the boundaries of the budget line
budget/price of good A, budget/price of good B
4 properties of indifference curves
- Higher IC preferred to lower IC - consumer prefers more to less
- IC downward sloping - since all combos of goods on IC yield equal utility, decreasing consumption of one requires increasing consumption of the other to maintain same utility
- ICs don’t cross
- ICs are convex to origin due to diminishing MRS (DUE TO DMU) ; when they have more of A and less of B, prepared to sacrifice a lot of A for small increase in B
Reaching consumer equilibrium
**where BL is tangential to IC **is equilibrium since this is the highest level of utility given budget. The MRS is equal to relative price.
increase in income - budget line
parallel shift in or out
how does a change in price affect the shape and position of a budget line?
pivotal shift inward/outward
if both prices change, line will shift but gradient depends on relative price changes (if same ratio, parallel shift)
effect of income change on consumption - normal good
outward shift of BL allows consumer to reach higher IC
on the higher IC, will be consuming higher quantities of both goods than before
this is because increase in income = increase in purchasing power and rational consumer prefers more to less
effect of income change on consumption - one normal, one inferior good
parallel outward shift of BL allows consumer to reach higher IC
on the higher IC, will be consuming higher quantities of normal good and less of the inferior good
this is because increase in income increase demand for normal but decreases demand for inferior
(if income falls, inward shift, lower IC, higher quantities of inferior and lower of normal)
change in relative prices - normal goods
since A is now relatively cheaper, consumer gets more units of A for every unit of B given up, so decides to buy less B and more A - substitution effect
fall in the price of A means real income is higher, in effect shifting budget line outwards pivotally
this allows consumer to reach a point on higher IC - income effect
since I and S effects work in same direction for A, the new point on the IC will mean more A is consumed than before
however, since I and S work in opposite direction for B, the total effect on pizza consumption is ambiguous so the final consumption point will be in between the original and the point showing S effect
what is needed for a consumer to reach a higher indifference curve?
higher income, either nominal or real
explain the effect of advertising/non price/income factors on the indifference curve
- explain original equilibrium
- explain that advertising increases MRP - i.e. willing to give up more of the other for one unit of X
- explain that slope of IC increases and it becomes steeper at the original equilibrium point, thus pivots around the red curve
- after IC changed shape, consumer can actually reach a higher IC with more of X and less of Y
- therefore advertising changes consumer preferences and encourages purchasing more X
limitations of IC analysis
- Two-Goods Model Unrealistic
- assumes consumer rationality but many reasons why they don’t act rationally - e.g. social norms
- assumes they can rank their preference
- assumes more is ALWAYS preferred to less - ignores ideas of DMU which are more realistic
