Chapter 8; The theory of demand; the indifference curve approach PDF

Preview

Summary

The theory of demand explaining the indifference curve and gives clear understanding of the indifference curve ....

Description

CHAPTER 8 THE THEORY OF DEMAND: THE INDIFFERENCE CURVE APPROACH  Introduction



In the last chapter (7) we talked about the 2 approaches/theories to analysing consumer choices/behaviour.



These approaches/theories were the utility approach (in chapter 7 and the Indifference approach which we are going to look at in this chapter.



Indifference curve approach uses the notion of ordinal utility – which requires consumers to rank different bundle of goods in order of preference (i.e. from highest to lowest, best to worst, most satisfying to least satisfying etc.)



In this chapter we will look at: i.

Indifference curve, its assumptions and properties.

ii.

The budget line

iii.

Determining the consumer equilibrium.

iv.

Changes in consumer equilibrium.

 Indifference Curve



An indifference curve shows all the combinations of 2 goods/services that that will provide the consumer with the same level of satisfaction or utility.



Table 8.1 Pg 134 shows the different combination of meat and bread (combinations A, B, C and D) that gives Koos the same level of satisfaction.



Fig. 8.1 (pg 134) is an indifference curve from table 8,1. All the points along the indifference gives the same level of satisfaction.

 The three basic assumptions of the indifference curve.

i.

The assumption of completeness 1

ii.

The assumption of transitivity

iii.

The Assumption of non-satiation (non-satiety)

*Explain these assumptions.

 Properties of indifference curves.

i.

There are unique indifference curves for the different levels of satisfaction a consumer derives from a combination of products. Therefore, we can have a collection of indifference curves – referred to as Indifference Map. Look at table 8,2 and fig, 8.1. NOTE: Higher indifference curve gives higher level of satisfaction and therefore are more preferred by the consumer (assumption of non-satiation – the consumer prefer more to less).

ii.

Indifference curves never intersect or touch each other as shown on fig. 8.3. SEE WHY

*Also look at BOX 8-1 Pg. 136. The two extreme cases of indifference curves.

 The Budget Line.



The Budget Lined indicates all combinations of 2 products that the consumer can afford to purchase with the income at their disposal.



The budget line is also referred to as consumption possibilities curve, expenditure line or budget constraint.



Table 8.3 shows the maximum affordable combinations of bread and meat Koos can afford given his income of R24.



A budget line on fig,8.4 is drawn from table 8.4.



Note that all the points along the budget line are affordable.

2



The slope of the budget line is the ratio of the price of the 2 products = Py/Px (I,e, price of meat divide by price of bread (Pm/Pb = 6/4 = 1,5). This also is the opportunity cost of meat in terms of bread. Meaning that the consumer forgoes 1,5 portions of meat for a loaf of bread.

 Consumer Equilibrium using the indifference curve approach.



To determine the consumer equilibrium, we combine the indifference curve and the budget line as shown on fig. 8.5. and the graph below.



The consume will be in equilibrium when they obtain the maximum amount of satisfaction for the amount they spend.



Graphically, the consumer equilibrium is where the budget line is tangent or touches highest indifference curve – point B on fig 8.5, and the graph below, with 3 loaves of bread and 2 portions of meat is the consumer’s equilibrium. Y

Consumer Equilibrium

Qty of bread 6 5-

A

D

43-

B

210

C 1

2

3

4

X Qty of meat



Note, on the graph above, although point A and C are affordable, they represent a lower level of satisfaction (they are on a lower indifference curve). 3



And although point D may be more preferred because it is on a higher indifference curve, it is not affordable.



At equilibrium, the slope of the budget line is equal to the slope of the indifference curve.



The slope of the indifference curve is also referred to as the Marginal Rate of Substitution (MRS), which is equal to Change in Y divide by change in X.



MRS is the unit of Y the consumer is willing to forego to gain one unit of X. (calculate MRS given units of Y and X ) Slope of the BL = Px/Py

Marginal rate of substitution

Slope of the IC = MRS = change in Y = Mux Change in x

MUy

At equilibrium Mux = Px MUy Py This indicates that the slope of the indifference curve is equal to slope of the budget line.

 Changes in consumer equilibrium.



Changes in the consumer’s equilibrium occur due to the following.

i.

Changes in income of the consumer.

ii.

Changes in the price of the product.

 Changes in income 

When income changes and price remain constant, there will be a new consumption possibilities ( see table 8-3).



Increase in income - consumers can purchase more of both goods (in case of normal goods and less in case of inferior goods.

4



This would lead to the budget line shifting upwards to the right (rightward shift) and touches (tangent to) a higher indifference curve, a new equilibrium will be set as shown on fig 8-6 and vice versa in case of a decrease in income.



An INCOME CONSUMPTION CURVE is formed by joining the different equilibrium point (see fig. 8-6).

 Change in price



A fall in price of a product would lead to a rotation of the budget line as shown on fig. 8-7. While an increase in price would lead to an inward rotation of the budget line.



Consumer can purchase a higher maximum of the good whose price fell.



The higher budget line now tangent to a higher indifference curve and a new equilibrium (see fig. 8-7).



The different equilibrium points are joined to form a PRICE CONSUMPTION CURVE.

*You should be able to explain the behaviour of the budget line and the equilibrium in case of changes in price and income.

 Substitution and Income effects of price changes

*Study fig. 8-8 to distinguish between substitution and income effects of price changes.

PLEASE USE THESE NOTES WITH THE HELP OF DETAILS IN THE TESTBOOK.

THANK YOU AND STAY SAFE. 5...