Chapter 31: Indifference Curves & Budget Lines¶

Preferences & Indifference Curves¶

Indifference — a consumer receives the same satisfaction from two alternatives and therefore has no preference between them.
Indifference curve (IC) — a curve showing all combinations of two goods that give a consumer the same level of satisfaction.
Indifference map — a diagram containing several indifference curves, with each curve representing a different level of utility. A higher curve represents greater satisfaction.
Marginal rate of substitution (MRS) — the rate at which a consumer is willing to give up one good to obtain an additional unit of another good while remaining equally satisfied. It is the absolute slope of the indifference curve.

MRSxy = MUx / MUy

Diminishing marginal rate of substitution — as a consumer obtains more of good X, they are willing to give up fewer units of good Y for an additional unit of X. This gives a standard indifference curve its convex shape.
Perfect substitutes — two goods that a consumer is willing to substitute for each other at a constant rate. Their indifference curves are straight lines.
Perfect complements — two goods that are consumed together in fixed proportions. Their indifference curves are L-shaped.

Budget line — all combinations of two goods that a consumer can purchase with given income and given prices.

PxQx + PyQy = income

Budget-line pivot — a change in the price of one good, with income and the other price unchanged, causing the budget line to rotate around the unchanged intercept.
Parallel budget-line shift — a change in income, with prices unchanged, causing the consumer’s budget line to shift outward or inward without changing its slope.
Consumer equilibrium in indifference-curve analysis — the point where the budget line is tangent to the highest attainable indifference curve. At this point, the consumer maximizes utility and:

MRS = Px / Py

Substitution effect — the change in quantity demanded caused by a change in relative prices, as the consumer substitutes the relatively cheaper good for the relatively more expensive good.
Income effect — the change in quantity demanded caused by the change in real purchasing power that follows a price change.
Price effect — the total change in quantity demanded resulting from a price change; it is the combined substitution effect and income effect.

Price effect = substitution effect + income effect

Normal good — a good for which demand increases when consumer income increases. Its income effect reinforces the substitution effect when its price falls.
Inferior good — a good for which demand decreases when consumer income increases. Its income effect opposes the substitution effect.
Giffen good — an inferior good for which quantity demanded increases when price increases and decreases when price falls because the negative income effect is greater than the substitution effect. It has a positive price elasticity of demand.

Transitivity — if a consumer is indifferent between A and B, and indifferent between B and C, the consumer is indifferent between A and C.
Bounded rationality — consumers have limited time, information, memory, or ability to calculate, so they cannot always compare every possible combination of goods.
Perfect information — consumers know the relevant prices and the utility or quality associated with the choices available to them. It is an assumption of the model.
Experience good — a good whose quality or utility can be judged only after it has been consumed.
Credence good — a good whose quality or utility consumers may be unable to judge reliably even after consumption.

Income effect vs substitution effect: the income effect works through real purchasing power; the substitution effect works through relative prices.
Inferior vs Giffen: every Giffen good is inferior, but not every inferior good is Giffen. A Giffen good requires the income effect to outweigh the substitution effect.
Budget line vs indifference curve: the budget line shows what is affordable; the indifference curve shows what gives equal satisfaction.
IC properties: standard ICs are downward sloping, convex because of diminishing MRS, and cannot intersect.