HSC Upper Six Lesson 2

FORMAL DERIVATION OF DEMAND green indifference curve on the graph below

CURVE indicates a higher level of utility than the red or
the blue indifference curves. Economists
We all face a variety of potential goods and assume that people want to attain the highest
services to consume. The choice of how much level of utility possible (I3 is better than I2
and which goods/services to consume can be which is better than I1)
thought of as consisting of two parts:
There are an infinite number of indifference
 our preferences (what we like and curves in the indifference map, and each
dislike) and person’s indifference map is unique to that
 Our budget (constraints on our person.
preferences -- we can’t buy everything
we want).

Indifference curves represent an individual’s

preferences. For simplicity, assume that the
consumer has the choice of consuming just two
goods. An indifference curve shows all
combinations of the two goods that yield the
same level of utility. Utility is constant along
the indifference curve. All points along the
curve are equally satisfying. The consumer
does not prefer one combination of goods to
any other along the curve. Characteristics of Indifference Curves

The indifference curve below represents a  Downward sloping to the right: if a

consumer’s monthly preference for steak and consumer gives up a unit of one good,
pizza. The indifference curve shows that 8 he/she must have more of the other
steaks and 3 pizzas per month yield the same good to maintain the same level of
level of satisfaction as 2 steaks and 7 pizzas per utility
month.  Convex to the origin (bowed inward)
 Cannot intersect

As one moves along the indifference curve

(from left to right), each additional x-axis good
will replace fewer y-axis goods than the
previous one to maintain the same level of
utility. This is the diminishing marginal rate
of substitution (MRS). MRS is the rate at
which one good can be substituted for another
without changing the consumer’s total utility.
Goods substitute for one another at a
diminishing marginal rate because of
Indifference Map diminishing marginal utility for each.

Note that an indifference curve shows various To see the diminishing marginal rate of
combinations of goods that yield the same substitution, start with consuming 8 units of
utility, but different indifference curves show good Y and 3 units of good X. To increase
different levels of utility. For instance, the consumption of good X by one unit, this
HSC Upper Six Lesson 2

consumer is willing to trade-off (decrease) Example: Jane, a consumer has $100 to spend.
consumption of good Y by 3 units (8 – 5) in Good X costs $5 per unit. Good Y costs $10
order to maintain a constant level of utility. But per unit. If Jan spent all of her income on X,
notice what happens when more of good X is she could purchase 20 units (100 / 5) of X. If
consumed, say increasing consumption of good she spent all of her income on Y, she could
X from 6 to 7. Now this consumer is only purchase 10 units (100 / 10) of Y. She could
willing to sacrifice one unit of good Y to get also afford to buy different combinations of the
one more unit of good X (remaining at the two goods. For example, she could buy 6 units
same level of satisfaction). The rate at which of X and 7 units of Y, or 10 units of X and 5
people are willing to trade-off good Y for X units of Y, or 14 units of X and 3 units of Y.
diminishes as additional units of X is The budget line shows all combinations of the
consumed (The good Y is becoming more dear goods that Jan can afford. The slope of Jan’s
as we consumer more and more of good X). budget line is 0.5 ( Px / Py = 5/10 ).

Jane’s budget line is shown below:

Consumer Choice

MRS is the slope of the indifference curve, and Equilibrium is determined by combining the
can be measured as the ratio of marginal consumer’s preferences with the consumer’s
utilities of the two goods. budget line.To maximize utility, the consumer
tries to achieve the highest indifference curve
MRSx,y = MUx / MUy (highest utility), given the budget constraint.
Therefore, the consumer should maximize
The Budget Constraint utility subject to the budget constraint, or

Consumers have a limited amount of money Max U s.t. BC

(income, I) to spend on the two goods (X and
Y). Each good has a price (Px and Py). The Utility maximization occurs where the
budget line shows (if spending entire income marginal rate of substitution (the slope of the
only on some combination of the two goods, X indifference curve) equals the price ratio (the
and Y) all combinations of the goods that the slope of the budget line).
consumer could afford . The slope of the
budget line is the ratio of the prices. MUx / MUy = Px / Py

Slope = (I / Py) / (I / Px) = (Px / Py) At the point of utility maximization, the
marginal utility per dollar spent on each good
is equal.
HSC Upper Six Lesson 2

MUx / Px = MUy / Py

Utility maximization occurs where the budget

line is tangent to the indifference curve.
Suppose the graph below represented Jane’s
budget line and preferences. According to the
information shown on the graph, Jane would
consume 5 units of good Y and 10 units of
good X. Given her budget constraint (purple
line), the highest level of utility she can
achieve is the red indifference curve (she
cannot afford any combination of goods X and
Y represented on the green (a higher The demand curve for a good can be derived
indifference curve). by determining how consumer choices change
when the price of that good changes, all else
held constant. Returning to the Jan example,
we now have two points on Jan’s demand curve
for good X. The price of good X was originally
$5 and Jan consumed 10 units of X. When the
price increased to $10, Jan's consumption fell
to 6 units of X (see graph below).

Effect of Price Changes

Assume Jane’s income remains the same

($100), but the price of good X increases from
$5 to $10 per unit. Note how the budget line
changes. The increase in price of good X
reduces Jane’s purchasing power, so she can no
longer achieve a utility level associated with
the red indifference curve. The highest level of
utility Jane can now achieve is associated with
the blue indifference curve. With the higher
price of good X, Jane now consumes only 6
units of good X and 4 units of good Y.
HSC Upper Six Lesson 2

Income & Substitution effects of a price

change.
A fall in the price of commodity has two
effects:

INCOME EFFECT: The consumer enjoys an

increase in real purchasing power, because they
can buy the same amount of the good for less
money and thus have money left for additional
expenditures (purchases).

SUBSTITUTION EFFECT: They will

consume more of the good that has become
cheaper and less of the goods that are now
relatively more expensive.

These two effects occur simultaneously but the

The consumer is initially at A on the budget
distinction can be drawn between them for
line RS, thereby obtaining level of utility
analytical analysis.
associated with the curve of indifference U1.
When the price of food falls the budget line
a). Substitution effect.
rotates outwards to line RT. The consumer now
chooses to consume market basket B on the
This effect measures the change in the purchase
indifference curve U2.and the consumption
of a good that results from the change in its
increases (consumption of food) by F1F2 (i.e.
relative price alone. In this case the utility
from 0F1 to 0F2) While the consumption of
(satisfaction) remains constant but the price
clothing declines as represented by line
changes.
segment C1C2 (i.e. from 0C1 to 0C2).
b). Income effect
The substitution effect
It is a change in the consumption of a good
This can be measured by drawing a budget line
resulting from the change in the purchasing
parallel to the new budget line RT (reflecting
power of money that occurs as a result of a
the lower relative price of food) but that is just
price change. In this case the price remains
tangent to the original indifference curve. Thus
constant but utility changes.
holding the level of utility constant. Given the
budget line, the consumer chooses market
basket C and consumes 0E units of goods.
Therefore line segment F1E represents the
substitution effect (move from A to C)

The income effect.

EF2 (associated with the move from C to B)

keeps relative prices constant but increases real
income (satisfaction) Þ Food is a normal good
because the income effect EF2 is positive.
Income and substitution.
HSC Upper Six Lesson 2

Income and substitution effects. budget line (DG) passing through shifts
outward to budget line RT. The consumer
Substitution and income effects for a normal chooses market basket B instead of market
goods work in the same direction (positive) basket Con indifference curve U2 [increase in
income] leading to a decline in food
For inferior goods the income and substitution consumption. (The move from OF2 to OE).
effects move in opposite direction
The income effect is represented by EF2 that is
The income and substitution effects move from B to C. In this case food is inferior
for Inferior good. Þ income effect is negative because when
income rises consumption falls.

However the substitution is larger than income

effect.

So, a decrease in price on food initially leads to

an increase in Quantity of food demanded.

Consumer is initially at equilibrium at market

basket A on budget line RS and he is
consuming 0F1 units of food thereby obtaining
the utility level associated with indifference
curve U1.

A decrease in the price of food shifts the

budget line to line RT, where the consumer
chooses market basket B on indifference curve
U2

The substitution effect could be measured by

drawing a new line parallel to budget line RT,
that is tangent to indifference curve U1. Given
that budget line the consumer chooses market
basket C and now is consuming 0F2 units of
Food therefore the substitution effect is
represented by line segment F1F2 (the move
from A to C) on indifference curve U1.

The income effect occurs when the dotted