the trinidad and tobago economics association. the department of economics, uwi, st. augustine....

Trinidad and Tobago Economics Association and Department of Economics, UWI, St. Augustine.

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INDIFFERENCE CURVE AND THE BUDGET LINE

The Trinidad and Tobago Economics Association.

The Department of Economics, UWI, St. Augustine.

April 28th, 2012


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OBJECTIVES

Presentation hopes to:

1. Introduce and Explain concept of Marginal Utility.

2. Identify the basic tenants of Indifference Curve analysis.

3. Link the theory of Indifference Curves and the Budget Line as it relates

to the consumer.

4. Identify the Income and Substitution effects.

Overall the concepts should become clearer to the student in

relation to this module as identified in the syllabus.


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WHAT IS INDIFFERENCE CURVE?

The IC shows different combinations of

goods that yields the same level of utility

(satisfaction).


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0

A

CA DB

D

C

B

INDIFFERENCE CURVEFootbal

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IC


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SHAPE OF INDIFFERENCE CURVE

Convex to the origin (similar to demand

curve).

The indifference curve is drawn on the

principle known as the marginal rate of

substitution.


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MOVEMENTS ALONG

Any combination along the indifference curve will give the

consumer the same utility. They would derive the same

satisfaction from any combination of good x and good y.

The consumer will be indifferent to any point.

As the consumer gets less of y they would want more of x.

as such, the increased quantity of x is to compensate for

the number of y’s which were given up. The converse holds

true. (Marginal rate of substitution).


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SHIFT IN THE I.C

Either a leftward or rightward shift.

Shift of the IC to the right means that the consumer is

getting more utility. The converse to that is also true.


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BUDGET LINE

Indicates three (3) things:

•We can use all of our income to buy good y.

•We can use all of our income to buy good x.

•We can use all of our income to buy some combination of

good y and good x.


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SLOPE OF BUDGET LINE.

The relevant patterns of spending between the two goods

are illustrated by the slope of the budget line. Changes in

income have no impact on the slope of the budget line.

When the price of good x increases the budget line gets

steeper or moves inwards (closer to origin). The extent of

the movement inwards depends on the increase in the price

of good x. as price of x decreases the budget line gets

flatter.


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BUDGET LINE

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Is this possible?


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SHIFT OF THE BUDGET LINE.

An increase in income will cause the budget line to shift to

the right.

A simultaneous change in the price of both commodities

will also cause a shift in the budget line. If both prices

increase the budget line shifts to the left (need not be

proportionate) and an opposite shift should all prices

decrease.


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5. POINT OF TANGENCY

The combination of goods x and y that yields the highest

level of utility given the consumer’s income. It is

represented by the point where the IC is tangential to the

budget line.


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BUDGET LINE AND INDIFFERENCE CURVE

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1 2 3 4 50

IC


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6. INCOME CONSUMPTION CURVE

As a person’s total income rises, assuming prices do not change, we anticipate the quantity purchased of each good to also increase.


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SHIFT AND MOVEMENT OF BUDGET LINE

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1 2 3 4 50


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SPECIAL CASES

A normal good is a good that is bought in greater quantities as income increases. In the previous example both goods x and y were normal goods.

An inferior is one which is purchased in smaller quantities as income increases. Examples includes second hand books.


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Giffen good is one where as prices rise for a particular good, the consumer purchases more of it due to its impact on the disposable income (example potatoes).


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6. INCOME EFFECT

The reduction of the price of the good essentially increases the consumer’s purchasing power, thus leading to an increase in the quantity demanded of the commodity.


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6. SUBSTITUTION EFFECTS

Assuming a rational consumer and normal good, as the price of the good falls the consumer substitutes other goods (whose prices have not changed) with the commodity that had the price decrease.

There is an inverse relationship between price and quantity demanded, based on the above assumptions. Thus, as price falls the quantity demanded increases.


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WORKSHOP SESSIONS

The practical aspects of Indifference Curves and Budget Lines will now be explored.