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PPA 723: Managerial Economics

PPA 723: Managerial Economics. Lecture 5: Indifference Curves. Managerial Economics, Lecture 5: Indifference Curves. Outline Properties of Consumer Preferences Indifference Curves. Managerial Economics, Lecture 5: Indifference Curves. Tastes.

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PPA 723: Managerial Economics

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  1. PPA 723: Managerial Economics Lecture 5: Indifference Curves

  2. Managerial Economics, Lecture 5: Indifference Curves Outline • Properties of Consumer Preferences • Indifference Curves

  3. Managerial Economics, Lecture 5: Indifference Curves Tastes • Individual tastes (preferences) determine the pleasure people derive from different goods and services • Our objective is to determine how a consumer’s tastes influence its decisions (positive analysis), not to judge tastes (normative).

  4. Managerial Economics, Lecture 5: Indifference Curves Standard Assumptions About Consumer Preferences 1. Completeness 2. Transitivity 3. More is better

  5. Managerial Economics, Lecture 5: Indifference Curves Assumption 1: Completeness • Consumer can rank any two bundles of goods • Only one of the following is true: The consumer • prefers Bundle x to Bundle y • prefers Bundle y to Bundle x • is indifferent between the two bundles

  6. Managerial Economics, Lecture 5: Indifference Curves Assumption 2: Transitivity (Rationality) • A consumer's preference over bundles is consistent: • If a consumer prefers Bundle z to Bundle y and Bundle y to Bundle x • Then that consumer prefers Bundle z to Bundle x

  7. Managerial Economics, Lecture 5: Indifference Curves Assumption 3: More is Better • More of a good is better than less of it. • Good: commodity for which more is preferred to less at least at some levels of consumption • Bad: something for which less is preferred to more, such as pollution • Consumers are not satiated.

  8. Managerial Economics, Lecture 5: Indifference Curves Figure 4.1a Bundles of Pizzas and Burritos Lisa Might Consume B , Burritos (a) Ranking Regions per semester c A 25 f 20 15 e a d 10 b B 0 15 25 30 Z , Pizzas per semester

  9. Managerial Economics, Lecture 5: Indifference Curves Figure 4.1b Bundles of Pizzas and Burritos Lisa Might Consume (b) Indifference Curve B , Burritos per semester c 25 f 20 e 15 a d I 10 b 0 15 25 30 Z , Pizzas per semester

  10. Managerial Economics, Lecture 5: Indifference Curves Figure 4.1c Bundles of Pizzas and Burritos Lisa Might Consume (c) Preference Map B , Burritos per semester c 25 f 20 2 I e 15 d 1 I 10 0 I 0 15 25 30 Z , Pizzas per semester

  11. Managerial Economics, Lecture 5: Indifference Curves Indifference Curve Properties • Bundles on indifference curves farther from the origin are preferred to those on indifference curves closer to the origin. • There is an indifference curve through every possible bundle. • Indifference curves cannot cross. • Indifference curves are “thin”. • Indifference curves slope down.

  12. Managerial Economics, Lecture 5: Indifference Curves Figure 4.2a Impossible Indifference Curves B , Burritos (a) Crossing per semester e b 1 I a 0 I Z , Pizzas per semester

  13. Managerial Economics, Lecture 5: Indifference Curves Figure 4.2b Impossible Indifference Curves (b) Upward Sloping B , Burritos per semester b a I Z , Pizzas per semester

  14. Managerial Economics, Lecture 5: Indifference Curves Willingness to Substitute • Downward-sloping indifference curve  consumer is willing to substitute one good for the other. • Marginal rate of substitution (MRS) of burritos (rise) for pizza (run), is slope of indifference curve:

  15. Managerial Economics, Lecture 5: Indifference Curves Marginal Rate of Substitution B , Burritos per semester MRS = B/Z B Z I Z , Pizzas per semester

  16. Managerial Economics, Lecture 5: Indifference Curves MRS Varies Along an Indifference Curve • Indifference curves bow away from the origin (called convex). • Indicates diminishing marginal rate of substitution (MRS).

  17. Managerial Economics, Lecture 5: Indifference Curves Figure 4.3a Marginal Rate of Substitution B , Burritos (a) Indifference Curve Convex to the Origin per semester a 8 – 3 b 5 1 – 2 c 3 1 d – 1 2 1 I 0 3 4 5 6 Z , Pizzas per semester

  18. Managerial Economics, Lecture 5: Indifference Curves Unlikely Outcome:Concave Indifference Curve • If indifference curve bows toward the origin (concave), • Then (implausibly) the consumer has an increasing MRS.

  19. Managerial Economics, Lecture 5: Indifference Curves Figure 4.3b Marginal Rate of Substitution B , Burritos (b) Implausible Indifference Curve that is Concave to the Origin per semester a 7 – 2 b 5 1 – 3 c 2 1 I 0 3 4 5 6 Z , Pizzas per semester

  20. Managerial Economics, Lecture 5: Indifference Curves Figure 4.4a Perfect Substitutes Coke, Cans per week 4 3 2 1 1 2 3 4 I I I I 0 1 2 3 4 Pepsi, Cans per week

  21. Managerial Economics, Lecture 5: Indifference Curves Figure 4.4b Perfect Complements Ice cream, Scoops per week e c 3 3 I b d 2 2 I a 1 1 I 0 1 2 3 Pie, Slices per week

  22. Managerial Economics, Lecture 5: Indifference Curves Figure 4.4c Imperfect Substitutes B , Burritos per semester I Z , Pizzas per semester

  23. Managerial Economics, Lecture 5: Indifference Curves Utility • Utility is a number that reflects the relative rankings of various bundles of goods • If Lisa prefers bundle A to B, then utility from A must be greater than utility from B • A utility function is a: • relationship between a utility measure and every possible bundle of good • succinct summary of information in an indifference curve map

  24. Managerial Economics, Lecture 5: Indifference Curves Utility and Marginal Utility • The marginal utility of Z is: • MUZ is the change in utility from a small increase in Z holding B fixed

  25. Managerial Economics, Lecture 5: Indifference Curves Utility U , Utils 350 ) Utility function, (10, Z U 250 = U 20 D 230 = 1 Z D 0 1 2 3 4 5 6 7 8 9 10 Z , Pizzas per semester

  26. Managerial Economics, Lecture 5: Indifference Curves Marginal Utility MU , Marginal Z utility of pizza 130 20 MU Z 0 1 2 3 4 5 6 7 8 9 10 Z , Pizzas per semester

  27. Managerial Economics, Lecture 5: Indifference Curves Totals, Margins, and Averages • Economic analysis often depends on the distinction betweena total, a average, and a margin. • In the case of utility • U = total utility • U/Z = average utility of Z • MUZ = U/Z = marginal utility of Z

  28. Managerial Economics, Lecture 5: Indifference Curves Utility and the Marginal Rate of Substitution • Let A = the good on the vertical axis and B = the good on the horizontal axis, • Then (note the inversion):

  29. Managerial Economics, Lecture 5: Indifference Curves Marginal Rate of Substitution Quantity of A MRS = A/B = - MUB/MUA Give up one unit of A A Gain MUA units of utility, which can “buy” MUA / MUB Units of B B I Quantity of B

  30. Managerial Economics, Lecture 5: Indifference Curves Deriving the Marginal Rate of Substitution

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