A Level Economics - Indifference Curves and Budget Lines

A Level – unit 7 The price system and the macroeconomy 7.2 Indifference curves and budget lines 7.2.1 meaning of an indifference curve and a budget line 7.2.2 causes of a shift in the budget line 7.2.3 income, substitution and price effects for normal, inferior and Giffen goods 7.2.4 limitation...

A Level – unit 7 The price system and the macroeconomy 7.2 Indifference curves and budget lines 7.2.1 meaning of an indifference curve and a budget line 7.2.2 causes of a shift in the budget line 7.2.3 income, substitution and price effects for normal, inferior and Giffen goods 7.2.4 limitations of the model of 1. Define an indifference curve An indifference curve shows all of the combinations of two goods that give the consumer equal satisfaction or utility 2. Explain the characteristics of an indifference curve  The consumer in indifference curve I1 is indifferent with respect to combinations x, y or z since each are on the same indifference curve.  The indifference curve slopes downwards to indicate that a fall in the quantity consumed of one good is accompanied by an increase in the consumption of the other good, given the same level of satisfaction  Higher indifference curves represent higher levels of satisfaction;  An indifference curve is normally drawn as convex to the origin.  A rational consumer will always opt for the highest indifference curve  Indifference curves cannot cross each other as this would be where a consumer was being irrational in the choices being made.  The slope of the indifference curve it represents the extent to which the consumer is willing to substitute one good for another. The rate at which the consumer is willing to substitute one good for another. This is known as the marginal rate of substitution 3. Why are indifference curves convex to the origin?  The slope of the indifference curve indicates the marginal rate of substitution ( the quantity of one good that an individual is prepared to give up in order to obtain an additional unit of another while leaving the individual at the same level of utility), in this case apples for bananas.  The indifference curve becomes shallower as we move down the curve from left to right, reflecting the individuals diminishing marginal rate of substitution of one good for another. As an individual obtains more and more of one good, bananas , they will be prepared to sacrifice fewer and fewer units of the other, apples, in order to obtain another banana.  4. Define a budget line A budget line shows numerically all the possible combinations of two goods that a consumer can purchase with a given income and given prices of the two goods. Suppose a person has $200 to spend on two goods, X and Y. Assume the price of Y is $20 and the price of X is $10. The Table below shows the possible combinations that can be purchased. Each of the combinations costs $200 in total 5.What is the Optimal choice of goods for consumer  Given a budget line of B1, the consumer will maximise utility where the highest indifference curve is tangential to the budget line (20 apples, 10 bananas)  Given current income – IC2 is unobtainable.  IC3 is obtainable but gives less utility than the higher IC1  The optimal choice of goods can also be shown with the Equi -marginal principle 6.Causes of a shift in the budget line  Substitution effect can be defined as a situation where, following a price change, a consumer will substitute the cheaper product for the one that is now relatively more expensive.  Income effect can be defined as a situation where, following a price change, a consumer has higher real income (purchasing power), and will purchase more of this product.  7. Show the income and substitution effects of a price change I. The income and substitution effects of a increase in price of bananas , when banana is a normal good  A rise in price changes the budget line. You can now buy less of good Bananas. The budget curve shifts to B2  Consumption falls from point A to point C (fall in Quantity of bananas from Q3 to Q1 To find different substitution and income effects.  We draw a new budget line parallel to B2 but tangential to the first indifference curve.  Being tangential to first indifference curve it enables the consumer to obtain the same utility as before (as if there was no change in income.)  By focusing on B-3, we are examining the effect of price change – ignoring any income effect.  The change from A to B (Q3 to Q2) is purely due to the substitution effect and relative price change. Income effect  However, income has fallen causing the consumer to choose from a lower indifference curve I2. The change due to income is, therefore, b to C (Q2 to Q1.)  In this case of a normal good, the income and substitution effect reinforce each other – both leading to lower demand. 11. The income and substitution effects of a increase in the price of bananas , if bananas are an inferior good  The substitution effect (using a parallel budget line of B-3) causes a big fall from a to b.  However, the income effect leads to an increase in demand (Q1 to Q2)  Overall demand falls, but the substitution effect is partly offset by the income effect.  This is because when income falls, the decline in income causes us to buy more inferior goods because we can’t afford normal / luxury goods anymore. 111. The income and substitution effects of a increase in the price of rice , when rice is a Giffen good A Giffen good occurs when the income effect outweighs the substitution effect. This is quite rare, but it is theoretically possible for poor peasants who have a choice between expensive meat and cheap rice. We start at Q2, the rise in the price of rice, reduces the budget line for rice to B2. But, the fall in income causes a large income effect that outweighs the substitution effect. Demand for rice rises to Q3 with a big fall in demand for meat. Price Type of good Substitution and income effect Change in demand change Fall Normal Substitution and income effects both Rise act in the same direction Fall Inferior Substitution effect increasing Rise demand is greater than the income effect reducing demand Fall Giffen Income effect reducing demand is Fall greater than the substitution effect increasing demand Rise Normal Substitution and income effects both Fall act in the same direction Rise Inferior Substitution effect reducing demand Fall is greater than the income effect increasing demand Rise Giffen Income effect increasing demand is Rise greater than the substitution effect reducing demand 9.The limitations of indifference curve analysis 1. It is doubtful if individuals can easily be able to identify imaginary combination of two goods which will give equal amounts of satisfaction 2. Indifference curves are drawn on the basis of an individual’s perception of the amount of utility that will be obtained from commodities, which might differ significantly from the satisfaction that is obtained when they are actually consumed. 3. It fails to explain the purchase of durable goods which are purchased infrequently with no consistent trade off against another product 4. Consumers may not act rationally when planning their expenditure 10. MCQ