Chapter 3 Consumer Behaviour I --- The Indifference Curve Approach

1. Chapter 3Consumer Behaviour I ---The Indifference Curve Approach

2. Contents: Postulates of Consumer Behaviour Good, Bad and Neuter Utility Indifference Curve Properties of Indifference Curves of Two Goods Other Shapes of Indifference Curves Budget Line Consumer Equilibrium

3. Contents: Changes in Consumer Equilibrium in Response to Changes in Constraints Decomposition of Price Effect into Substitution Effect and Income Effect Advanced Material 3.1: Postulate of utility maximization Advanced Material 3.2: Corner solutions

4. Postulates of Consumer Behaviour

5. A theory has four components - definitions; postulates; test conditions; implications • Chapter one:basic definitions This chapter: postulates + test conditions + implications

6. What are the basic postulates of consumer behaviour? A. An economic agent behaves rationally. • Meaning:Behaviour of an economic agent has objectives and involves a prudent (審慎的) choice among alternative means. In other words, consumer behaviour is not random or arbitrary(隨意的). It has patterns and can be explained. Significance:Thus, economic investigation is possible and meaningful.

7. B. Postulate of constrained maximization / self-interest / selfishness Then how does an individual make his choice? • Meaning:An economic agent always chooses the option that _________ the achievement of his goals among the options allowed by existing constraints. maximizes • Significance:Without a postulate on economic choice, there is no economics. Without a confirmed postulate on economic choice, economics might not have survived. Note: This isthe most important & most useful postulate in economics.

8. C. Each individual has many wants. • Significance:Hence choice and exchange may arise. Competition Choice D. To each individual, some goods are scarce. • Significance:Hence competition and choice are inevitable. They constitute the main content of economics. Scarcity

9. E. Scarce goods are substitutable • Meaning:One is willingto forgo something to getmore of the scarce good — substitution,provided that the value got is larger than the cost paid. Significance:Exchange is possible.

10. Marginal rate of substitution (MRS): is the maximumamount of good Y that an individual is willing to forgo for an additional unit of good X. F. The law of diminishing MRS It is equal to marginal use value (MUV)of good X in terms of good Y. The law states that MRS or MUV of a good ____________ as more units of the good are obtained, ceteris paribus. declines Significance:(Both interior and corner solutions are possible.)

11. Good, Bad and Neuter

12. A good is something desired, i.e., _________ is preferred to _________. some none (Options: more / less / none / some)

13. Types of goods: Goods Free goods Scarce goods (economic goods)

14. Free good: Features • something desired • its amount available is ______ than its amount desired at zero price, i.e., ________ is preferred. more no more (Options: more / less / some / no more )

15. Scarce good(economic good): Features • something desired less • its amount available is _____ than its amount desired at zero price, i.e., ______ is preferred to _____. more less (Options: more / less / some / none )

16. Distinction between free goods and scarce goods: Depends on situations rather than kinds. Any examples?

17. Distinction between free goods and goods free-of-charge: • A free good must be a good free-of-charge. Why? its amount available is more than its amount desired. no one desires to have more of it no production nor exchange takes place  zero-priced. • A good free-of-charge may not be a free good. Why? a scarce good can also be free-of-charge if someone pays the cost for you. Any examples?

18. A bad is something undesired, i.e., _________ is preferred to _________. less more (Options: more / less / some / none) Is sickness a bad ?

19. A neuter (中性物品) is something neither desired nor undesired, i.e., the quantitydoes not matter. Any examples?

20. Q3.2: Which of the following are free goods? Explain. air pocket money sea water parental care Q3.3: Draw a demand and supply diagram to illustrate a free good and a scarce good respectively.

21. Utility

22. What is utility? Utility(效用) is a number • arbitrarily assigned to entities to rank them according to one’s preference. • the higher the utility, the more one prefers the entity. • a criterion of maximization to rank options for making choice.

23. What is utility? Utility reflects preference  happiness / satisfaction  social welfare Why?

24. Ordinal utility only reflects an order but the difference between the numbers assigned is meaningless Cardinal utility can also reflect an order and the difference between the numbers assigned is meaningful Measurement of utility

25. Measurement of utility Which measurement of utility is used in the indifference curve approach? Ordinal measure of utility

26. Indifference Curve

27. What is an indifference curve? Good Y 0 Good X • An indifference curve (IC, 等優曲線) is a line joining all the points (representing different baskets of goods) giving the same utility to an individual. U=10

28. What is an indifference map? Good Y U=30 U=20 U=10 0 Good X • An indifference map (等優曲線圖) is a set of ICs showing the _________ of an individual. preference

29. Properties of Indifference Curves of Two Goods

30. 1. ICs of two goods are negatively sloped Good Y +X -Y U=10 0 Good X • Keeping utility constant, along an IC, a basket with more units of good X must have _____ units of good Y. fewer Slope of an IC of two goods (= ΔY/ Δ X) must be ________. negative (Options: more / fewer / positive / negative)

31. 2. Indifference curves are continuous • If quantities of good X and good Y can be increased or decreased by infinitesimal amounts, the ICs are continuous. Why? Good Y U=10 Good X 0

32. 3. Indifference curves can never intersect B  A  C  • Along U1: point A = point B = U1 • Along U2: point A = point C = U2 What is the utility of point A, = U1 or U2? U of the intersection pointlogical contradiction

33. 4. Full coverage Good Y U3 U2 U1 0 Good X If a consumer knows hispreference on every basket of commodities, the commodity plane will be fully covered by ICs. Why? • The higher the IC , the higher the utility (U3 > U2 > U1). Why?

34. 5. Indifference curves of two goods are convex to the origin • The numerical value of the slope of an IC (+1X -?Y) is equal to the MRS. Why? Good Y +1X -Y U1 0 Good X • As the consumption of good X rises, MRS (the slope)falls. Why? • As the IC becomes flatter & flatter, its shape is _______ to the origin. convex

35. Other Shapes of Indifference Curves

36. 1. X is a neuter and Y is a good Y (A good) U3 U2 ICs are ___________. U1 0 X(A neuter) Why? • Any increase or decrease in the quantity of X makes no difference to the consumer. U3>U2>U1 horizontal

37. What will be the shape of the ICs if (a) X is a good and Y is a neuter?(b) both X and Y are neuters?

38. Y (A good) • To keep U constant, in a bad (+X) requires in a good (+Y) as a compensation. U3 U2 U1 ICs are _________sloping with a/an _________slope. +Y +X 0 X (A bad) 2. X is a bad and Y is a good Why? U3>U2>U1 upward increasing

39. What will be the shape of the ICs if (a) X is a good and Y is a bad?(b) both X and Y are bads?

40. Good Y U3 U2 U1 0 X X is a good X becomes a bad 3. X is a commodity with a satiation threshold (beyond which X turns from a good to a bad) • ICs are __________. U-shaped U3>U2>U1 Why?

41. What will be the shape of the ICs if both X and Y are goods with a satiation threshold?

42. U1 U2 U3 4. X and Y are perfect substitutes downward • ICs are _________ sloping _______ lines. Good Y (pack of 8 kg rice) straight Why? U3>U2>U1 0 Good X (pack of 5 kg rice)

43. U3 U2 U1 45o 5. X and Y are perfect complements Good Y (left shoes) • ICs are __________. right-angled Why? U3>U2>U1 0 Good X (right shoes)

44. Y Y U3 U1 U2 U3 U2 U1 X X Q3.7: Study the indifference maps below and determine if X and Y are goods, bads or neuters. (b) U1 > U2 > U3 (a) U1 < U2 < U3

45. Budget Line

46. What is a budget line? Budget line (BL) or consumption possibility curve isa boundary showing the largest possible combinations of goods that a consumer can buyin a market, givenhis money income and market prices of the goods. It is also called the budget constraint.

47. Y +1X -0.8Y 0 X Derivation of a BL: Given I = $100, PX = $20 & PY = $25 The maxi. amount of X one can buy = ___________ The BL is a downward sloping straight line. $100/$20 = 5 4 The maxi. amount of Y one can buy = ___________ The slope of BL = cost of consuming an additional unit of good X in terms of good Y. $100/$25 = 4 To buy 1 more unit of X, one forgoes =____________ unit of Y. $20/$25 = 0.8 5

48. Features: Y 0 X < Point A: Expenditure ____ Income = Point B: Expenditure ____ Income > Point C:Expenditure ____ Income  C (Options: > = < )  B  A

49. Expenditure on good X • Expenditure on good Y • Money income of the consumer Equation of budget line X  PX + Y  PY = I

50. Y in income in income 0 X Changes in budget constraints 1. Changes in income • When one’s income increases, the budget line will shift ______ in a parallel manner, and vice versa. outward Why?