Marginal Rate of Substitution
Indifference curves with different shapes imply a different willingness to substitute Two polar cases are of interest
Consumers generally prefer a balanced market basket Along an indifference curve there is a diminishing marginal rate of substitution.
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A
B
D
U2 U1
Food
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Indifference Curves
Clothing 16
A
Observation: The amount of clothing given up for 1 unit of food decreases from 6 to 1
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1. Consumer Preferences
Consumer preferences can be represented graphically using indifference curves Indifference curves represent all combinations of market baskets that the person is indifferent to
More is better
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Indifference Curves: An Example
Clothin 50 g
B H A D E
40 30 20 10 10
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Chapter 3
Consumer Behavior
Topics to be Discussed
Consumer Preferences Budget Constraints Consumer Choice Revealed Preferences Marginal Utility and Consumer Choices
A person will be equally satisfied with either choice
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Indifference Curves: An Example
Market Basket A B D E G H Units of Food 20 10 40 30 10 10 Units of Clothing 30 50 20 40 20 40
It 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
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Consumer Behavior
Theory of consumer behavior
The explanation of how consumers allocate income to the purchase of different goods and services
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Marginal Rate of Substitution
Indifference curves are convex
As more of one good is consumed, a consumer would prefer to give up fewer units of a second good to get additional units of the first one
Three steps 1. Consumer Preferences
To describe how and why people prefer one good to another
2. Budget Constraints
People have limited incomes
3. Given preferences and limited incomes, What combination of goods will consumers buy to maximize their satisfaction?
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Indifference Map
Clothing
Market basket A is preferred to B. Market basket B is preferred to D.
D
B A
U3 U2 U1
Food
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Indifference Curves: An Example
Graph the points with one good on the xaxis and one good on the y-axis Plotting the points, we can make some immediate observations about preferences
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1. Consumer Preferences – Basic Assumptions
1. Preferences are complete
Consumers can rank market baskets
2. Preferences are transitive
Perfect substitutes Perfect complements
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Marginal Rate of Substitution
Perfect Substitutes
Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant Example: a person might consider apple juice and orange juice perfect substitutes
14 12 10 8 6
-6 1 -4 1 -2 1
2 1
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Food
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Indifference Curves
We measure how a person trades one good for another using the marginal rate of substitution (MRS)
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1. Consumer Preferences
How might a consumer compare different groups of items available for purchase? A market basket is a collection of one or more commodities Individuals can choose between market baskets containing different goods
Violates
assumption that more is better
Why? What if we assume they can cross?
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Indifference Maps
Clothing
U
2
U1
•B is preferred to D •A is indifferent to B & D •B must be indifferent to D but that can’t be if B is preferred to D
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Indifference Maps
Indifference maps give more information about shapes of indifference curves
Indifference curves cannot cross
The consumer prefers A to all combinations in the yellow box, while all those in the pink box are preferred to A.