CB and I. Curve Analysis ( IMPT)

8/2/2019 CB and I. Curve Analysis ( IMPT)

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Consumer Behavior andUtility Analysis


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The Budget Line

The budget line depicts theconsumption bundles that a

consumer can afford. People consume less than they desire because

their spending is constrained, or limited, bytheir income.


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The Consumers Budget Line...

Quantityof Pizza

Quantityof Pepsi

0

250

50 100

500B

C

A

ConsumersBudget line


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The Consumers Budget Line

The slope of the budget line equalsthe relative price of the two goods,

that is, the price of one goodcompared to the price of the other.

It measures the rate at which the

consumer will trade one good for theother.


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Preferences:What the Consumer Wants

A consumers preferenceamong consumption bundles

may be illustrated withindifference curves.

An indifference curve shows

bundles of goods that make the

consumer equally happy.


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The Consumers Preferences...

Quantityof Pizza

Quantityof Pepsi

0

C

B

A Indifferencecurve, I1

D

I2


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The consumer is indifferent, or equally

happy, with the combinations shown atpoints A, B, and C because they are all onthe same curve.

The Consumers Preferences


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The Marginal Rate ofSubstitution

The slope at any point on an indifferencecurve is the marginal rate ofsubstitution. It is the rate at which a consumer is willing

to substitute one good for another.

It is the amount of one good that aconsumer requires as compensation to give

up one unit of the other good.


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The Consumers Preferences...

Quantityof Pizza

Quantityof Pepsi

0

C

B

A

D

Indifferencecurve, I1

I21MRS


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Properties of IndifferenceCurves

Higher indifference curves arepreferred to lower ones.

Indifference curves aredownward sloping.

Indifference curves do not cross.

Indifference curves are bowedinward.


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Property 1: Higher indifferencecurves are preferred to lower

ones.

Consumers usually prefer more of

something to less of it.Higher indifference curves represent

larger quantities of goods than dolower indifference curves.


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Property 2: Indifference curvesare downward sloping.

A consumer is willing to give up onegood only if he or she gets more of theother good in order to remain equallyhappy.

If the quantity of one good is reduced,the quantity of the other good must

increase. For this reason, most indifference

curves slope downward.


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Property 3: Indifference curves donot cross.

Quantity

of Pizza

Quantityof Pepsi

0

C

A

B


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1MRS= 1

8

3

Indifferencecurve

A

Property 4: Indifference curvesare bowed inward.

Quantity

of Pizza

Quantityof Pepsi

0

14

2

3

7

B

1

MRS= 6

4

6

People are more willing totrade away goods that theyhave in abundance and lesswilling to trade away goods of

which they have little.


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Perfect Substitutes

Dimes0

Nickels

21

4

2

I1I2

6

3

I3


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Perfect Complements

Right Shoes0

LeftShoes

75

7

5 I1

I2


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The Consumers Optimum...

Quantity

of Pizza

Quantityof Pepsi

0

I1

I2

I3

Budget constraint

AB

Optimum


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How Changes in Income Affect

the Consumers Choices

An increase in income shifts thebudget line outward. The consumer is able to choose a better

combination of goods on a higherindifference curve.


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An Increase in Income...

Quantityof Pizza

Quantityof Pepsi

0

I1

I2

2. raising pizza consumption

3. and Pepsiconsumption.

Initialoptimum

New budget line

1. An increase in income shifts

the budget line outward

Initialbudget line

New optimum


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How Changes in Prices Affect

Consumer Choices

A fall in the price of anygood rotates the budgetconstraint outward and

changes the slope of thebudget line.


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A Change in Price...

Quantity of Pizza100

Quantityof Pepsi

1,000

500

0

I1

New budget constraint

3. and

raising Pepsiconsumption.

Initial budgetconstraint

2. reducing pizza consumption

1. A fall in the price of Pepsirotates the budget constraintoutward

New optimum

I2

Income and Substitution


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Income and SubstitutionEffectsA price change has two effects on

consumption. Anincome effect

Asubstitution effect

Theincome effectis the change in consumption that

results when a price change moves the consumer to a

higher or lower indifference curve.

Thesubstitution effectis the change in consumptionthat results when a price change moves the consumer

along an indifference curve to a point with a different

marginal rate of substitution.


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X2

X1

Eb

I1

I2

xa xb

Ea

The new optimum isEb on I2.

The Total Price

Effect is xa to xb


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X2

X1

I1

I2

xa xb

EaEb

Draw a line parallel tothe new budget line andtangent to the oldindifference curve


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X2

X1

EcI1

I2

xa xc xb

EaEb

The new optimum on I1 isat Ec. The movement from

Ea to Ec (the increase inquantity demanded from

Xa to Xc) is solely inresponse to a change in

relative prices


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X2

X1

I1

I2

Substitution

Effect

EaEb

Ec

This is thesubstitution effect.

Xa Xc


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THE HICKSIAN METHODX2

X1

Ea

I1

xa

Optimal bundle is Ea, onindifference curve I1.


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X1

I1

xa

Ea

A fall in the price of X1

The budget line pivotsout from P

P

*


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X1

Eb

I1

I2

xa xb

Ea


The Total Price Effectis xa to xb


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THE HICKSIAN METHOD

To isolate the substitution effect we ask.

what would the consumers optimal

bundle be if s/he faced the new lowerprice for X1 but experienced no change inreal income?

This amounts to returning the consumer

to the original indifference curve (I1)


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X1

Eb

I1

I2

xa xb

Ea


The Total Price Effectis xa to xb


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X1

I1

I2

xa xb

EaEb

Draw a line parallel to thenew budget line andtangent to the oldindifference curve


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X1

Ec I1

I2

xa xc xb

EaEb

The new optimum on I1 is atEc. The movement from Ea

to Ec (the increase inquantity demanded from Xato Xc) is solely in response

to a change in relative prices


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X1

I1

I2

Substitution

Effect

EaEb

Ec

This is thesubstitution effect.

Xa Xc


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THE HICKSIAN METHOD

To isolate the income effect

Look at the remainder of the total

price effect This is due to a change in real

income.


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X1

I1

I2

Income Effect

EaEb

Ec

The remainder of the totaleffect is due to a change inreal income. The increase inreal income is evidenced bythe movement from I1 to I2

Xc

Xb


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X1

I1

I2

xa xc xb

Sub

Eff t

Income

Eff t

EaEb

Ec

CB and I. Curve Analysis ( IMPT)

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