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Outcomes

Define, explain and illustrate how the budget constraint


(and the slope) can change.
Discuss the characteristics of consumer preferences
Define, illustrate and discuss the different charateristics
of indifference curves.
Calculate, illustrate and explain the slope and change in
the budget line.
Use a graph to illustrate the consumers equilibrium.
Explain and illustrate the difference between the income
and substitutuion effect by using indifference curves.
Derive the demand curve by using the indifference
approach.
Apply the rational choice model.

Properties of Preference
Orderings
Completeness: the consumer is able to rank
all possible combinations of goods and
services.
More-Is-Better: other things equal, more of a
good is preferred to less.
Transitivity: for any three bundles A, B, and
C, if one prefers A to B and prefers B to C,
then one always prefers A to C.
Covexity: mixtures of goods are preferable to
extremes.

Figure 3.1: Generating Equally


Preferred Bundles

Indifference Curves
Indifference curve: a set of bundles
among which the consumer is indifferent.
Indifference map: a representative
sample of the set of a consumers
indifference curves, used as a graphical
summary of her preference ordering.

Properties of Indifference
Curves
Indifference curves
1. Are Ubiquitous.
Any bundle has an indifference curve passing through it.

2. Are Downward-sloping.
This comes from the more-is-better assumption.

3. Cannot cross.
4. Become less steep as we move downward and to the
right along them.
This property is implied by the convexity property of
preferences.

Trade-offs Between Goods


Marginal rate of substitution (MRS): the
rate at which the consumer is willing to
exchange the good measured along the
vertical axis for the good measured along
the horizontal axis.
Equal to the absolute value of the slope of the
indifference curve.

Figure 3.2: An Indifference Curve

Fig. 3.7: People have different tastes

Figure 3.10: Part of an Indifference


Map

Figure 3.13: Why Two Indifference


Curves Do Not Cross

Figure 3.14: The Marginal Rate


of Substitution

Figure 3.15: Diminishing Marginal


Rate of Substitution

Budget constraint
Definition:
All the combinations
(bundles) of 2 goods a
person can purchase given
a certain money income
and prices for the two
goods.
Any point on budget
constrain (and below)
represents possible
combinations.

Slope = relative prices of


two goods, X and Y
(Px/Py).

Changes in budget
constraint:
Relative prices changes:
budget constraint revolves
(rotates) away or towards
origin
Number of bundles
available increases or
decreases

Individuals income
changes: budget constraint
moves parallel towards or
away from origin.

Figure 3.8: The Budget Line,


or Budget Constraint

Budget shifts due to price or income


changes
If the price of ONLY one good changes
The slope of the budget constraint changes.

If the price of both goods change by the same


proportion
The budget constraint shifts parallel to the original
one.

If income changes .
The budget constraint shifts parallel to the original
one.

Figure 3.10: The Effect of a Rise


in the Price of Shelter

Figure 3.11: The Effect of Cutting


Income by Half

The Best Feasible Bundle


Consumers Goal: to choose the best
affordable bundle.
The same as reaching the highest indifference
curve she can, given her budget constraint.
For convex indifference curves.
the best bundle will always lie at the point of
tangency between the budget line and the
indifference curve.

Figure 3.17: The Best Affordable Bundle

Calculation of optimal bundle


Example: pg 92 -95
Optimal bumdle where U =XY, Px = 4, Py
= 2 and M = 40

Figure 3.25: The Optimal Bundle when


U = XY, Px = 4, Py = 2, and M = 40