Indifference Curve Analysis

Question 1

What assumptions is the indifference curve based on?

Answer 1

• Completeness
  Consumers compare and rank the marker baskets in terms of their desirability or order of preference.
  -Monotonicity (more is better)
  Consumer always preferred more of any good to less, other things being equal
  -Transitivity
  Consumers has internally consistent preferences

Question 2

Define the following

• budget curve
• indifference curve
• indifference map

Answer 2

Budget Curve- The ability to consume

Indifference Curve- The desire to consume

Indifference Map- A graph showing a set of indifference curves with each indifference curve corresponding to a different level of total utility .

Question 3

Impact of an increase in income for a normal good (IC)

Answer 3

Budget Curve shifts right
Indifference Curve shifts right
This causes an increase in Y and X

For normal goods , goods are incremental. This means that if you have a lot of good Y, you’ll be willing to trade it for more of good X
This means that’s the marginal rate of substitution ( change in Y / change in X ) constantly changes

Question 4

Marginal Rate of Substitution

Answer 4

Change in Y / Change in X or MUx / MUy

MRS is the slope of the indifference curve and indicates the rate at which a consumer can substitute units of one good for units of another.

It is negative because in order to increase consumption of one good the consumer is willing to reduce consumption of the other good.

Question 5

Impact of an increase of the price of X (IC)

Answer 5

• Inwards swing of the budget curve as Y remains the same. Indifference Curve shifts left.
• Y and X both falls as consumer cuts down on both because purchasing power falls.

Question 6

Define the following

• Total Utility

- Marginal Utility

Answer 6

Total Utility- The total satisfaction a person gains from the consumption of a certain number of units if a good or service

Marginal Utility- The satisfaction gained from consuming an extra unit. MU= change in TU/ change in U

Question 7

Properties of indifference curves

Answer 7

• higher indifference curves are preferred to lower ones
• indifference curves never cross
  Because each market basket must correspond to a unique level of TU
• indifference curves slope downwards
• indifference curves are bowed inwards ( convex shape)

Question 8

Diminishing MRS

Answer 8

This happens towards the bottom of the indifference curve

As a person consumes more and more units of a good, additional units provide less additional satisfaction than previous units

Question 9

Define perfect substitutes and perfect compliments and explain their graph shapes.

Answer 9

• Perfect Substitutes
  Goods which a consumer is willing to exchange one for another at a constant MRS rare regardless of how much of each individual consumes. Straight indifference curve

-Perfect Compliments
Goods that are always consumed together in fixed proportions. “ L-shapes” indifference curve as MRS is undefined.