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Transcript of Engineerin Economics IC CURVES
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Consumer
Behavior
Ordinal Approach
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Topics to be Discussed
Consumer Preferences
Budget Constraints
Consumer Choice
Revealed Preferences
Cost-of-Living Indexes
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Consumer Behavior
In Chacterizing consumer Behavior, there are two important but distinct factors to consider:
Consumer opportunities (Possible Goods and services consumer canafford to consume)
Consumer preferences (which of these goods will be consumed). In today’s global economy millions of goods are offered for
sale, however to focus on essential aspects of individual behavior and to keep things manageable, we assumes thatonly two goods exist in the economy. X and Y be any twogoods i.e. chicken and beef.
Assume a consumer is able to order his preferences for alternatives bundles or combinations of goods from best toworst i.e. Bundle A > B (A is preferred to B), A ~ B(indifferent means equally satisfying)
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PREFERENCES: WHAT THE
CONSUMER WANTS
A consumer’s preference amongconsumption bundles may be
illustrated with indifference curves.
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Representing Preferences withIndifference Curves
An indifference curve is acurve that showsconsumption bundles thatgive the consumer the
same level of satisfaction.
Marginal rate of substitution: The rate atwhich a consumer is
willing to substitute onegood for another goodand still maintain thesame level of satisfaction.
Y
U1
1 2 3 4
3
6
4
5
2
1
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Consumer Preferences
Three Basic Assumptions
1. Preferences are complete.
2. Consumers always prefer more of any good to less.
3. Diminishing MRS
4. Preferences are transitive.
Market Baskets
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The consumer prefersA to all combinationsin the blue box, whileall those in the pink
box are preferred to A.
Consumer Preferences
Food
10
20
30
40
10 20 30 40
Clothing
50
G
A
EH
B
D
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U1
Combination B,A, & D yield the same satisfaction•E is preferred to U1
•U1 is preferred to H & G
Consumer Preferences
Food
10
20
30
40
10 20 30 40
Clothing
50
G
D
A
EH
B
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Properties of Indifference Curves
Higher indifference curves are preferred tolower ones.
Indifference curves are downward sloping.
Indifference curves do not cross.
Indifference curves are bowed inward.
IC cannot touch the Horizontal or VerticalAxis
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Properties of Indifference Curves
Property 1: Higher indifference curves 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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Quantity
of Pizza
Quantity
of Pepsi
0
Indifference
curve, I 1
I 2
C
B
A
D
The Consumer’s Preferences
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Properties of Indifference Curves
Property 2: Indifference curves are downward
sloping.
A consumer is willing to give up one good only
if he or she gets more of the other good in order to remain equally happy.
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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Quantity
of Pizza
Quantity
of Pepsi
0
Indifference
curve,I 1
The Consumer’s Preferences
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Properties of Indifference Curves
Property 3: Indifference curves do not cross.
Points A and B should make the consumer equally
happy.
Points B and C should make the consumer equallyhappy.
This implies that A and C would make the consumer
equally happy.
But C has more of both goods compared to A.
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The Impossibility of Intersecting Indifference Curves
Quantity
of Pizza
Quantity
of Pepsi
0
C A
B
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Properties of Indifference Curves
Property 4: Indifference are convex to the origin.
People are more willing to trade away goods that
they have in abundance and less willing to trade
away goods of which they have little.
These differences in a consumer’s marginal
substitution rates cause his or her indifference
curve to bow inward.
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Bowed Indifference Curves
Quantity
of Pizza
Quantity of Pepsi
0
Indifference
curve
8
3
A
3
7
B
1
MRS = 6
1
MRS = 1 4
6
14
2
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Marginal Rate of Substitution
The marginal rate of substitution ( MRS ) quantifies the
amount of one good a consumer will give up to obtain
more of another good.
It is measured by the slope of the indifference curve.
Along an indifference curve there is a diminishing
marginal rate of substitution.
Indifference curves are convex.
Consumers prefer a balanced market basket
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Consumer Preferences
Food
Clothing
2 3 4 51
2
4
6
8
10
12
14
16A
B
D
E G
-6
1
1
1
1
-4
-2-1
MRS = 6
MRS = 2
F C MRS
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Consumer Preferences
Perfect Substitutes
Two goods are perfect substitutes when themarginal rate of substitution of one good for
the other is constant.
Perfect Complements
Two goods are perfect complements when the
indifference curves for the goods are shaped asright angles.
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Consumer Preferences
Orange Juice(glasses)
AppleJuice
(glasses)
2 3 41
1
2
3
4
0
PerfectSubstitutes
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Consumer Preferences
Right Shoes
LeftShoes
2 3 41
1
2
3
4
0
PerfectComplements
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THE BUDGET CONSTRAINT: WHAT THECONSUMER CAN AFFORD
The budget constraint depicts the limit on the
consumption “bundles” that a consumer can afford.
People consume less than they desire because their
spending is constrained, or limited, by their income. The budget constraint shows the various
combinations of goods the consumer can afford given
his or her income and the prices of the two goods.
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The Consumer’s Budget
Constraint
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THE BUDGET CONSTRAINT: WHAT THE
CONSUMER CAN AFFORD
The Consumer’s Budget Constraint
Any point on the budget constraint line
indicates the consumer’s combination or tradeoff between two goods.
For example, if the consumer buys no
pizzas, he can afford 500 pints of Pepsi(point B). If he buys no Pepsi, he can
afford 100 pizzas (point A).
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The Consumer’s Budget Constraint
Quantity
Quantity of Pepsi
0
Consumer’s budget constraint
500 B
100
A
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THE BUDGET CONSTRAINT: WHAT THECONSUMER CAN AFFORD
The slope of the budget constraint line
equals the relative price of the two
goods, that is, the price of one good compared to the price of the other .
It measures the rate at which the
consumer can trade one good for theother.
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Budget Constraints
The Budget Line
The slope of the line measures therelative cost of food and clothing.
The slope is the negative of the ratioof the prices of the two goods.
The slope indicates the rate at which
the two goods can be substitutedwithout changing the amount of money spent.
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OPTIMIZATION: WHAT THE CONSUMERCHOOSES
Consumers want to get thecombination of goods on the highestpossible indifference curve.
However, the consumer must also endup on or below his budget constraint.
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The Consumer’s Optimal Choices
Combining the indifference curve andthe budget constraint determines theconsumer’s optimal choice.
Consumer optimum occurs at thepoint where the highest indifferencecurve and the budget constraint are
tangent.
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The Consumer’s Optimal Choice
The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative
price.
At the consumer’s optimum, theconsumer’s valuation of the two goods
equals the market’s valuation.
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The Consumer’s Optimum
Quantity
of Pizza
Quantity
of Pepsi
0
Budget constraint
I 1
I 2
I 3
Optimum
A B
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How Changes in Income Affect theConsumer’s Choices
An increase in income shifts thebudget constraint outward.
The consumer is able to choose abetter combination of goods on ahigher indifference curve.
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Budget Constraints: Income Changes
Food
Clothing
80 120 16040
20
40
60
80
0
A increase inincome shifts
the budget lineoutward
(I = $160)
L2
(I = $80)
L1
L3
(I =$40)
A decrease inincome shifts
the budget line
inward
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An Increase in Income ( normal goods)
Quantity
of Pizza
Quantity of Pepsi
0
New budget constraint
I 1
I 2
2. . . . raising pizza consumption . . .
3. . . . and
Pepsi
consumption.
Initial
budget
constraint
1. An increase in income shifts the
budget constraint outward . . .
Initial
optimum
New optimum
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How Changes in Income Affect the
Consumer’s Choices
Normal versus Inferior Goods If a consumer buys more of a good
when his or her income rises, the good
is called a normal good .
If a consumer buys less of a good whenhis or her income rises, the good iscalled an inferior good .
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An Inferior Good (pepsi as inferior good)
Quantity
of Pizza
Quantity
of Pepsi
0
Initial
budget
constraint
New budget constraint
I 1 I 2
1. When an increase in income shifts the
budget constraint outward . . . 3. . . . butPepsi
consumption
falls, making
Pepsi an
inferior good.
2. . . . pizza consumption rises, making pizza a normal good . . .
Initial
optimum
New optimum
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Budget Constraints: Prices Change
If the two goods increase (decrease)in price, but the ratio of the twoprices is unchanged, the slope will
not change.
However, the budget line will shiftinward (outward) to a point parallel
to the original budget line.
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How Changes in Prices Affect Consumer’s
Choices
A fall in the price of any goodrotates the budget constraintoutward and changes the slope of
the budget constraint.
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Budget Constraints: Price Changes
Food(units per week)
Clothing(units
per week)
80 120 16040
40
(PF = 1)
L1
An increase in theprice of food to$2.00 changesthe slope of thebudget line and
rotates it inward.
L3
(PF = 2)(PF = 1/2)
L2
A decrease in theprice of food to$.50 changes
the slope of thebudget line and
rotates it outward.
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A Change in Price of pepsi.
Quantity
of Pizza
Quantity of Pepsi
0
1,000 D
500 B
100
A
I 1 I 2
Initial optimum
New budget constraint
Initial
budget
constraint
1. A fall in the price of Pepsi rotates
the budget constraint outward . . .
3. . . . and
raising Pepsi
consumption.
2. . . . reducing pizza consumption . . .
New optimum
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Summary
A consumer’s budget constraint showsthe possible combinations of differentgoods he can buy given his income
and the prices of the goods. The slope of the budget constraint
equals the relative price of the goods.
The consumer’s indifference curvesrepresent his preferences.
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Summary
Points on higher indifference curvesare preferred to points on lowerindifference curves.
The slope of an indifference curve atany point is the consumer’s marginalrate of substitution.
The consumer optimizes by choosingthe point on his budget constraint thatlies on the highest indifference curve.
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Summary
When the price of a good falls, theimpact on the consumer’s choices can bebroken down into an income effect and a
substitution effect. The income effect is the change in
consumption that arises because a lowerprice makes the consumer better off.
The income effect is reflected by themovement from a lower to a higherindifference curve.
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Summary
The substitution effect is the change inconsumption that arises because aprice change encourages greater
consumption of the good that hasbecome relatively cheaper.
The substitution effect is reflected by a
movement along an indifference curveto a point with a different slope.