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ANALYSIS
To Understand Consumer
Preferences using Indifference
Curve.
To understand Budget Constraints.
To Understand the Conditions which Enable
Consumer to Maximize his Satisfaction.
To Understand the Effect of Price and Income
Changes on Consumer Equilibrium.
To Understand Price Effect and the Methods by
which Price Effect can be Decomposed.
LECTURE OUTLINE
24
22 A(1, 22)
20
INDIFFERENCE 18
SCHEDULE 4 )
16 2, 1
(Table Showing B(
14 0 )
Different , 1
Combinations
Combinati Applesgiving
Orange 12 ( 3
C
8)
on Equal Satisfaction)
s 10
4,
7)
D(
A 1 22
5,
8
Oranges
E(
B 2 14 6
4
C 3 10
2 Apples
D 4 8
0
E 5 7 1 2 3 4 5 6
INDIFFERENCE CURVES
24
22 A(1, 22)
20
INDIFFERENCE 18
SCHEDULE 16 , 14)
Combinat Apples Orange
14 B(2 )
ion s 10
12 3,
A 1 22 C(
8)
B 2 14 10
4,
7)
D(
8
5,
C 3 10
E(
Oranges
6
D 4 8 IC1
4
E 5 7 2
Apples
0
1 2 3 4 5
MARGINAL RATE OF
SUBSTITUTION (MRS)
24 A
22
20
18
MRS =
16 -∆ O/∆ A = 8:1
14 MRS =
MRS is measured 12 B 4:1
by the slope of 10
MRS =
the indifference 8
C 2:1
Oranges
curve 6
D
IC1
E
4
2
0 Apples
1 2 3 4 5
ASSUMPTIONS OF IC
ANALYSIS
Rational Consumer
Ordinal Utility
Indifference
map
This is because the
combinations lying on More is preferred
higher indifference to Less
curve contain more of
either one or both
goods and more is
always preferred to
less.
PROPERTIES OF IC
X
12
6. Indifference curve 10 A(0, 10)
need not to be 8
parallel to each other Oranges
6
IC1
4
(because of Different
2 Apples
MRS on different 0
ICs) 1 2 3 4 5
BUDGET CONSTRAINTS
(What is Attainable)
in
tta
Com Apples Orange Total
na
bina (@ Rs. s budget U le
tion 6 @ Rs. 2 (Rs.)=6x ab
per Per unit A+2xO le
unit) ab
i n
t a
t
A
A 0 12 24
B 1 9 24
C 2 6 24
D 3 3 24 Budget line
E 4 0 24 corresponding to
budget of Rs. 24
BUDGET LINE
3 Pa
Slope = ∆ Oranges/∆Apples = (-) = (-)
1 Po
141 The slope is the negative of
A the ratio of the prices of the
2
10 two goods.The slope indicates
B
8 the rate at which the two
6 C goods can be substituted
Oranges
Condition-1:
Budget Line should be Tangent
16 to the Indifference Curve.
IC1
14
12
A
10
A Combination A can
8
not be attained
Oranges
6
4 due to budget
2 Budgetconstraints
0 B Line
1 2 3 4 Apples
5
CONDITIONS OF
CONSUMER EQUILIBRIUM
2 Budget
Line
0
1 2 3 4 Apples
5
CONDITIONS OF CONSUMER
EQUILIBRIUM
Equilibrium occurs (Point C)
when the consumer selects the
Combination which reaches the
(U highest attainable
na
12 A tIndifference
ta curve.
in At Equilibrium (Point
10 ab
le) C) we would have
Oranges
8
C slope of Indifference
6 IC
IC
Curve (MRSxy)
4
4 3
(Attainable) equal
IC to the slope of
2
2 IC
Budget Line (Px/Py)
1
B
0
1 2 3 4 5 6
Apples
CONDITIONS OF
CONSUMER EQUILIBRIUM
6 L3 various levels of
4 B
consumer income
2 A
given constant
0
productApples
price.
1 2 3 4 5 6
NEGATIVE INCOME EFFECT
8 showing decrease in
6 L3 the quantity
4 A demanded of a good
2 with the increase in
0
consumer income.
1 2 3 4 5 6
Apples
SUBSTITUTION EFFECT
N E
D F
P
I1 I2
B
I3
O M Q H C Apples
Substitution Effect
HICKS MEASURE
D F
P
I1 I2
B
O M Q H C Apples
Substitution Effect
EFFECT OF CHANGE IN
PRICE OF A GOOD
L2
6
(P = 4)
per unit, then for a
4 L1 a
budget of Rs. 24,
2 L3 (Pa=12) price line will shift
(Pa=6)
0
outward
Apples to L2
1 2 3 4 5 6
UNDERSTANDING
PRICE EFFECT
PRICE EFFECT: The price effect
may be defined as the change in the
consumption of goods when the price
of either of the two goods changes
while the price of the other good and
the income of the consumer remain
constant.
C
A B
DECOMPOSITION
OF PRICE EFFECT
Oranges
D E
F (NP)
I1 I2
B
O M N P H C Apples
Price Effect: Movement from D to E = MP
Substitution Effect: Movement from D to F = MN
Income Effect: Movement from F to E = NP
PRICE EFFECT AND
NATURE OF GOODS
Substitution
Nature of Income Effect
Price
Goods Effect Effect
Normal Goods
+ve +ve +ve
Inferior goods -ve (weak) +ve (strong)
+ve
Giffen's Goods -ve (strong) +ve (weak)
-ve
DERIVATION OF DEMAND
CURVE FROM PCC
SUMMING UP