Sanjay K.

Singh

Indifference Curves
Consumer theory uses indifference curves (along with
budget constraints) to understand the consumer demand.
Theory of Consumer Behavior x2 x1 What is an indifference curve?
An indifference curve is a graph
- showing different combinations
Dr. Sanjay K. Singh of goods that yield the same
level of utility (satisfaction) for
Indian Institute of Management Lucknow x2 the consumer.

x3
I(x)
Consumer Behavior attempts to understand x1 x2 x3
the buyer decision making process, both
individually and in groups. x1

Indifference Curves Indifference Curves

All bundles in I1 are
p p I1 strictly preferred to all in I2.
x2 z x y x2 All bundles in I2 are strictly
x x preferred to all in I3.

z z Higher indifference curves

are preferred to lower ones.
I2 Consumers usually
prefer more of something
to less of it.
Higher indifference
y y curves represent larger
I3 quantities of goods than do
lower indifference curves.
x1 x1

WELL BEHAVED PREFERENCES

WELL BEHAVED PREFERENCES
A preference relation is well-behaved if it
is monotonic and convex. Convexity
Monotonicity: More of any product is always
preferred (i.e. every product is a good, no x2 x
satiation). z is strictly
x2+y2 x+y preferred to both
Convexity: Mixtures of bundles are (at least z=
weakly) preferred to the bundles themselves. 2 x and y
2
For example, the 50-50 mixture of the
bundles x and y is y
z = (0.5)x + (0.5)y. y2
z is at least as preferred as x or y. x1 x1+y1 y1
2

Managerial Economics 1
Sanjay K. Singh

WELL BEHAVED PREFERENCES WELL BEHAVED PREFERENCES

Convexity Convexity
Preferences are strictly convex
x x when all mixtures z
x2 x2
are strictly
z =(tx1+(1-t)y1, tx2+(1-t)y2) z
preferred to their
is preferred to x and y component
for all 0 < t < 1. bundles x and y.
y y
y2 y2
x1 y1 x1 y1

y Why INDIFFERENCE CURVES are

WELL BEHAVED PREFERENCES
negatively sloped?
Weak Convexity
A consumer is willing to give up one good only if he
x Preferences are or she gets more of the other good in order to remain
z weakly convex if at equally happy.
least one mixture z If the quantity of one good is reduced, the
quantity of the other good must increase.
is equally preferred For this reason, most indifference curves
x to a component slope downward.
z
y bundle, e.g. perfect
y substitutes.
A
I1
x

y Indifference curves never cross each Indifference curves are bowed inward
other. Why?
Points A and C should make the consumer
People are more willing to trade away goods that they
equally happy. have in abundance and less willing to trade away goods
Points C and B should make the consumer of which they have little.
equally happy.
This implies that A and B would make the These differences in a consumers marginal substitution
consumer equally happy. (remember,
rates cause his or her indifference curve to bow inward.
I2 preferences are also transitive)
I1 But B has more of both goods compared to
A.
B How come more of both goods doesnt
increase utility (satisfaction)?
A So, indifference curves will not intersect.
C

x

Managerial Economics 2
Sanjay K. Singh

Indifference curve when goods are Indifference curve when goods are
PERFECT SUBSITIUTES PERFECT COMPLEMENTS
Two goods with straight-line indifference Example: Each of (5,5), (5,9) and (9,5) is equally preferred
x2 curves are perfect substitutes. x2 If a consumer always
If a consumer always regards
45o consumes products
I2 units of products 1 and 2 as 1 and 2 in fixed
equivalent, then the products are proportion (e.g. one-
to-one), then the
perfect substitutes and only the products are perfect
total amount of the two products 9
complements and
matters. only the number of
I1 5 I1 pairs of units of the
Slopes are constant at - 1. two products
matters.
x1 5 9 x1
Two goods with right-angle indifference curves are perfect
complements.

Indifference curves when goods are

PERFECT COMPLEMENTS Indifference Curves: Shape

x2 The indifference curves are not likely to be

45o Each of (5,5), (5,9) vertical, horizontal, or upward sloping.
and (9,5) is less
A vertical or horizontal indifference curve (one of
preferred than the the goods doesnt provide any utility)
bundle (9,9). An upward-sloping indifference curve (consumer
9 I2 is indifferent between a combination of goods
that provides less of everything and another that
5 I1 provides more of everything)
Rational consumers usually prefer more to less.

5 9 x1

Shapes of Indifference Curves

Indifference Curve Shapes Perfect Substitutes Perfect Complements A good that gives zero
utility
No difference between
0 and 500 gms of meat;
it doesnt provide any
utility.

I1
I1
I1
0 0 0
[i]. Packs of green pins [ii]. Right hand gloves [iii]. Meat

A good that confers a negative A good (X) that is

An absolute necessity utility after some level of not consumed
IC becomes vertical at consumption IC must cut the axis
I1
the minimum level of To be on same a measuring quantities
All other goods

absolute necessity. IC, more food of other goods. The

CDs dont provide any utility Gasoline provides no utility More is not good
(>f0) requires budget line must be
more of other steeper than the IC at
goods. the point of
intersection of the
axis.
I2
I1 0
w f0 b I1
0 0
[iv]. Water [v]. Food [vi]. Good X

Managerial Economics 3
Sanjay K. Singh

Shapes of Indifference Curves

Perfect Substitutes Perfect Complements A good (Meat) that
Indifference Map
gives zero utility

An indifference map is
I2 a complete set of
I2 indifference curves.
I2 I1
I1
I1 It indicates the
0 0 0 consumers
[i]. Packs of green pins [ii]. Right hand gloves [iii]. Meat
preferences among all
combinations of goods
A good (Food) that confers a A good (Good X) that
An absolute necessity negative utility after some level of is not consumed and services.
(Water) consumption
I2 I1
a The farther from the
All other goods

origin the indifference

curve is, the more the
combinations of goods
I2 along that curve are
I1 0 I2 preferred.
w f0 b I1
0 0
[iv]. Water [v]. Food [vi]. Good X

SLOPE OF AN INDIFFERENCE CURVE MRS

The slope of an indifference curve
x2 is referred to as the marginal rate- x2
of-substitution (MRS). MRS at x* is lim {x2/x1}
How can a MRS be calculated? as x1 0
= dx2/dx1 at x*
x* x2 x*
MRS at x* is the slope of
the indifference curve at x*.
x1

x1 x1

MRS MRS
MRS is the amount of Good 2 MRS decreases (in
x2 product 2 an individual is absolute terms) as
MRS = (-) 5 x1 increases and x2
willing to exchange for an
extra unit of product 1 decreases

dx2 x*
dx1

MRS = (-) 0.5 Good 1

x1

Managerial Economics 4
Sanjay K. Singh

Diminishing MRS UTILITY AND UTILITY FUNCTIONS

An indifference curve depicts different bundles that
In general, people tend to value more what yield the same level of utility (satisfaction).
they have less of: For a better description of the consumers
preferences, we require a large collection of
If you have 30 breads and 1 butter,
indifference curves (each curve representing a
youll be willing to give up breads for particular level of utility).
another butter. If you have 10 breads
The complete collection of indifference curves
and 3 butters, youll be less willing to completely represents the consumers preferences.
give up breads for butter.
The collection of all indifference curves for a given
Therefore MRSx1,x2 diminishes as x1 preference relation is an indifference map.
increases along the indifference curve. An indifference map is equivalent to a utility
function.

UTILITY FUNCTION UTILITY FUNCTION

Preferences can be represented by a utility 3. As X1 MRS (in absolute terms),
function if the functional form has certain i.e convex preferences
nice properties:
Example U(x1,x2)= x1.x2 =16
Example: Consider U(x1,x2)= x1.x2 X1 X2 MRS
1 16
1. u/x1>0 and u/x2>0
2. Along a particular indifference curve 2 8 (-) 8
x1.x2 = constant x2=c/x1 3 5.3 (-) 2.7
as x1 x2 4 4 (-) 1.3
i.e. downward sloping indifference curve
5 3.2 (-) 0.8

UTILITY FUNCTION Can Money buy Happiness?

Utility is an ordinal (i.e. ordering or ranking) An example of ordinal utility
concept.
An ordinal scale of happiness from 0 (completely
Ordinal utility theory states that while utility dissatisfied) to 10 (completely satisfied) can be used to find
cannot be measured using an objective scale, a out relationship between income and happiness (utility).
consumer is capable of ranking different
alternatives available.
Income and Happiness

For example, does individual A prefer 3 apples A cross-country

comparison shows that
and 2 oranges or 3 oranges and 2 apples? individuals living in
countries with higher
GDP per capita are on
Suppose, U(1) = 6 and U(2) = 3. Then, consumer average happier than
prefers bundle 1 over 2. However, 1 is not those living in countries
with lower per-capita
necessarily two times better than 2. GDP.

Managerial Economics 5
Sanjay K. Singh

UTILITY FUNCTIONS COBB DOUGLAS UTILITY FUNCTION

Cobb-Douglas Utility Function Any utility function of the form

U(x , x ) = x x (a > 0, b > 0)

1 2
a b
1 2 U(x1,x2) = x1a x2b

Perfect Substitutes Utility Function with a > 0 and b > 0 is called a Cobb-
U ( x1 , x 2 ) = ax 1 + bx 2 Douglas utility function.
Examples
Perfect Complements Utility Function U(x1,x2) = x11/2 x21/2 (a = b = 1/2)
U ( x1 , x2 ) = min( x1, x2 )
V(x1,x2) = x1 x23 (a = 1, b = 3)

COBB DOUBLAS INDIFFERENCE CURVES PERFECT SUBSITITUTES

Goods that are
perfect substitutes
x2 x2 can always be
substituted for
x1 + x2 = 5
All curves are hyperbolic, each other on a 1-
13 to-1 basis (or in
asymptoting to, but never x1 + x2 = 9 certain proportion)
touching any axis. 9
If a restaurant
doesnt carry
x1 + x2 = 13 Pepsi, you order a
Coke instead
5
U(x1,x2) = x1 + x2

x1 5 9 13 x1
All are linear and parallel.

PERFECT COMPLEMENTS MARGINAL UTILITY

U(x1,x2) = min{x1,x2} Some goods are
x2 only useful in a set Marginal means incremental.
o ratio to each other; The marginal utility of product i is the rate of-
45 extra of one good is change of total utility as the quantity of
useless without
product i consumed changes by one unit; i.e.
extra of the other:
min{x1,x2} = 8 U
8 Shoes: 1 Left MU i =
min{x1,x2} = 5 shoe for every xi
5 Right shoe The general equation for an indifference curve
min{x1,x2} = 3 Cars: 4 full-size is: U(x1,x2) = k, a constant
3 tires for every Totally differentiating this gives
car
3 5 8 x1
All are right-angled with vertices/corners on a ray
from the origin.

Managerial Economics 6
Sanjay K. Singh

MARGINAL UTLITIES AND

MARGINAL RATE OF SUBISITUTION MUs and MRS: An example
U U
dx2 = dx1 x
x2 x1
x2 U(x1,x2) = x1x2; MRS = 2
d x2 U / x1 MU1
x1
So, MRS = = = This is the MRS.
d x1 U / x2 MU 2 8 MRS(1,8) = - 8/1 = -8
Example: COBB DOUBLAS Utility Function MRS(6,6) = - 6/6 = -1.
6
U(x1,x2) = x1x2, Then,

U = 36

U=8
1 6 x1

What would be MRS of Perfect Substitutes What would be MRS of Perfect Complements
Utility Function? Utility Function?
Perfect Substitutes: U = Ax1 + Bx2 Perfect Complements: U = min(x1,x2)
where: A and B are positive constants. where: is a positive constant.
MU1 = A MU1 = 0 or
MU2 = B MU2 = 0 or
MRS = -A/B MRS is 0 or minus infinite or undefined (corner)

So, if you want to increase consumption of good

1 by 1 unit, you have to reduce consumption of
good 2 by A/B units (constant MRS).

POSITIVE MONOTONIC TRANSFORMATIONS AND MRS POSITIVE MONOTONIC TRANSFORMATIONS AND MRS

These are simply increasing functions

Note: The negative-monotonic transformation will
E.g., for u(x1, x2) > 0, f(u) = u2; h(u) = ln(u) not represent the same preferences; f(u) would
If f(u) is a positive-monotonic transformation of u not be a utility but a disutility function.
then as u increases f(u) also increases.
Any positive monotonic transformation of a utility What will happen to the marginal rates-of-
function represent the same preference. substitution when a positive monotonic
transformation is applied on a utility function?
That is, if U is a utility function that represents a (Hopefully, nothing)
preference relation and f is a strictly increasing
function, then V = f(U) is also a utility function
representing the same preference relation.

Managerial Economics 7
Sanjay K. Singh

POSITIVE MONOTONIC TRANSFORMATIONS AND MRS POSITIVE MONOTONIC TRANSFORMATIONS AND MRS

For U(x1,x2) = x1x2, the MRS = (-) x2/x1 (recall

previous example) More generally, if V = f(U) where f is a strictly
increasing function, then
Create V = U2; i.e., V(x1,x2) = x12x22, What is
the MRS for V?
V / x1 2x x 2 x
MRS = = 1 2 = 2
V / x2 2 x12 x2 x1

which is the same as the MRS for U.

MRS is unchanged by a positive monotonic
transformation.

The Budget Line

How do people make choices?
m/P2
P1x1+P2x2=m
Tastes (indifference map/utility function)
Scarcity (income or budget constraint)
The indifference map only reveals the ordering of
consumer preferences among bundles of goods. It
tells us what the consumer desires to buy. m/P1
It does not tell us what the consumer is able to buy. The slope of the budget
The budget constraint determines what can be constraint line (-P1/P2)
purchased with a given level of income and goods
prices. equals the relative price of
People consume less than they desire because their the two goods.
spending is constrained, or limited, by their income. The slope measures the rate
at which the consumer can
trade one good for the other.

CHOICE Consumer Equilibrium

How is the most
Utility (satisfaction) is
preferred bundle in
x2 the choice set
maximized at the point (C)
where an indifference
found? The consumer curve is tangent to the
m/P2 It must be maximizes budget line.
More preferred affordable and satisfaction by
bundles purchasing the
it must provide combination of
higher level of goods that is on
utility than any the indifference
other affordable curve farthest
bundle. from the origin but
Affordable U = U(x1,x2)
attainable given
bundles P1x1+P2x2=m the consumers
budget.
m/P1 x
1

Managerial Economics 8
Sanjay K. Singh

RATIONAL CONSTRAINED CHOICE RATIONAL CONSTRAINED CHOICE

(x1*,x2*) is the most preferred affordable bundle.
The most preferred affordable bundle is called
x2 At Equilibrium E, IC is tangent the consumers ORDINARY DEMAND at the
m/P2 to the budget line:
MRS = x2/x1 (Slope of the given prices and income.
indifference curve: Individuals
willingness to trade) = - P1/P2 Ordinary demands are denoted by
(Slope of the budget constraint: x1*(p1,p2,m) and x2*(p1,p2,m).
Societys willingness to trade)
x2* E At E, MU1/P1 = MU2/P2 (since It is also called Marshallian demand function
MRS=-MU1/MU2)
or Walrasian demand function or
U = U(x1,x2) uncompensated demand function.
P1x1+P2x2=m
m/P1x1
x1*
Marginal utility per Rs. spent on good1 = Marginal utility per Rs. spent on good2

CORNER SOLUTIONS CONSUMER CHOICE OF HEALTH CARE

CONSUMER PREFERENCES FOR
Corner solution: situation in which the marginal rate of HEALTH CARE VERSUS OTHER GOODS
substitution for one good in a chosen market basket is not These indifference curves show the
equal to the slope of the budget line (very obvious for perfect trade-off between consumption of
substitutes) health care (H) versus other goods (O).
Curve U1 applies to a consumer with
When a corner solution
low income; given the consumers
arises, the consumer budget constraint, satisfaction is
maximizes satisfaction by maximized at point A.
consuming only one of
As income increases the budget line
the two goods. shifts to the right, and curve U2
Given budget line AB, the becomes feasible. The consumer moves
highest level of to point B, with greater consumption of
satisfaction is achieved at both health care and other goods.
B on indifference curve Curve U3 applies to a high-income
U1, where the MRS (of ice consumer, and implies less willingness
cream for frozen yogurt) to give up health care for other goods.
is greater than the ratio of Moving from point B to point C, the
the price of ice cream to consumers consumption of health care
the price of frozen yogurt. increases considerably (from H2 to H3),
while her consumption of other goods
increases only modestly (from O2 to O3).

Questions Questions (Answer)

what have you learned so far what have you learned so far
Radhika consumes two goods, X and Y. She has a utility function Y.5
given by the expression: PX MU X 2
X.5
MRS = MRS = =
U = 4X0.5Y0.5. PY X.5
MU Y 2
The current prices of X and Y are Rs. 25 and Rs. 50, respectively. Y.5
Radhika currently has an income of Rs. 750. Y P 25 1 X
MRS = X = = Y =
Calculate the optimal quantities of X and Y that Radhika should X PY 50 2 2
choose, given her budget constraint. X = 2Y
Suppose that the government rations purchases of good X such that So,750 = 25 X + 50Y = 100Y
Radhika is limited to 10 units of X. Assuming that Radhika chooses Y = 7.5 & X = 15.
to spend her entire income, how much Y will she consume?
Construct a diagram that shows the impact of the limited availability
of X. Is Radhika satisfying the usual conditions of consumer
equilibrium while the restriction is in effect?
Calculate the impact of the ration restriction on Radhika's utility.

Managerial Economics 9
Sanjay K. Singh

Questions (Answer) How ordinary demands x1*(p1,p2,M) and

x2*(p1,p2,M) change as prices p1, p2 and income
what have you learned so far M change?
Since 750 = 25X + 50Y
If X = 10, then Y = 10 x2 OWN-PRICE CHANGES
As indicated in the graph,
at Radhika's optimal bundle with
M/p2 (fixed p2 and M)
MU MU
the restriction, P
>
X P
X
.
Y
Y

p1 = 1
This implies Radhika should
consume more X to increase utility.
p1x1 + p2x2 = M

p1 = 3
p1 = 2
Radhika's utility without the restriction is:U ( x = 15, y = 7.5) = 4 (15) ( 7.5) = 42.43.
0.5 0.5

Radhika's utility with the restriction is: U ( x = 10, y = 10 ) = 4 (10 )0.5 (10 )0.5 = 40. M/p1 x1
The ration restriction results in a utility loss of 2.43 units for Radhika.

Ordinary demand
p1 p1 curve for product 1
Own-Price Changes Own-Price Changes
Ordinary
The plot of the x1co-
(fixed p2 and M) demand curve (fixed p2 and M) ordinates of the price
x2 P1=3 for product 1 x2 P1=3 offer curve against p1 is
the ordinary demand
curve for product 1.
P1=2 P1=2
P1=1 P1=1
P1 price
x1*(p1=3) x1*(p1=2) x1*(p1=1) offer curve x1*(p1=3) x1*(p1=2) x1*(p1=1)
x1* x1*

x1*(p1=3) x1*(p1=2) x1*(p1=1) x1*(p1=3) x1*(p1=2) x1*(p1=1) x1

x1 The curve containing all the utility-maximizing bundles (in x1, x2 space)
as p1 changes, with p2 and M constant, is the price offer curve.

INCOME CHANGES: How does the value of x1* and x2* INCOME CHANGES Engel curve;
changes as income (M) changes, holding both p1 and p2 M
(fixed p1 and p2) good 2
constant?
M3
A plot of quantity M1 < M2 < M3
M2
M1 < M2 < M3 demanded against income M1
is called an Engel curve. Income
Income x21 x23
offer curve M Engel curve; offer curve x2*
good 1 x22
x23 M3 x23
x22 M2 x22
x21 M1 x21

x11 x13 x11 x13 x1* x11 x13

x12 x12 x12

Managerial Economics 10
Sanjay K. Singh

Normal versus Inferior Goods

EFFECT OF INCOME
CHANGES (normal goods)
An increase in income, with the AN INFERIOR GOOD
prices of all goods fixed, causes An increase in a
consumers to alter their choice of persons income can
market baskets. lead to less
In part (a), the baskets that consumption of one of
maximize consumer satisfaction the two goods being
for various incomes (point A, $10; purchased.
B, $20; D, $30) trace out the Here, hamburger,
income-consumption curve. though a normal good
The shift to the right of the between A and B,
demand curve in response to the becomes an inferior
increases in income is shown in good when the
part (b). (Points E, G, and H income-consumption
correspond to points A, B, and D, curve bends backward
respectively.) between B and C.

CONSUMER EXPENDITURES IN THE UNITED STATES

We can derive Engel curves for groups

of consumers. This information is
particularly useful if we want to see how
ENGLE CURVES
consumer spending varies among
Engel curves relate the
quantity of a good different income groups.
consumed to income.
In (a), food is a normal ANNUAL U.S. HOUSEHOLD CONSUMER EXPENDITURES
good and the Engel curve
is upward sloping. INCOME GROUP (2009 $)
In (b), however, hamburger EXPENDITURES LESS 10,000 20,000 30,000 40,000 50,000 70,000
is a normal good for ($) ON: THAN 19,999 29,999 39,999 49,999 69,999 AND
$10,000 ABOVE
income less than $20 per
month 4,733
Entertainment 1,041 1,025 1,504 1,970 2,008 2,611
and an inferior good for
Owned Dwelling 1,880 2,083 3,117 4,038 4,847 6,473 12,306
income greater than $20
per month. Rented Dwelling 3,172 3,359 3,228 3,296 3,295 2,977 2,098

Health Care 1,222 1,917 2,536 2,684 2,937 3,454 4,393

Food 3,429 3,529 4,415 4,737 5,384 6,420 9,761

Clothing 799 927 1,080 1,225 1,336 1,608 2,850

CONSUMER EXPENDITURES IN THE UNITED STATES

Price Change: Income and

ENGEL CURVES FOR U.S.
CONSUMERS
Average per-household
Substitution Effects
expenditures on rented
dwellings, health care, and
entertainment are plotted as
functions of annual income.
Health care and
entertainment are normal
goods, as expenditures
increase with income.
Rental housing, however, is
an inferior good for
incomes above $30,000.

Managerial Economics 11
Sanjay K. Singh

THE IMPACT OF A PRICE CHANGE Pure Substitution Effect

Economists often separate the impact of a price
change into two components: Slutsky (Russian mathematician Evgeny
the substitution effect; and Slutsky, 1880-1948) isolated the change in
the income effect.
demand due only to the change in relative
prices by asking
The substitution effect involves the substitution
of good x1 for good x2 or vice-versa due to a What is the change in demand when
change in relative prices of the two goods. the consumers income is adjusted so
The income effect results from an increase or that, at the new prices, she can only just
decrease in the consumers real income or
purchasing power as a result of the price change. buy the original bundle?
The sum of these two effects is called the price
effect.

Pure Substitution Effect Only Pure Substitution Effect Only

x2 x2

Assume, price of good 1 has

reduced.
x2 x2

x1 x1 x1 x1

Pure Substitution Effect Only Pure Substitution Effect Only

x2 x2
So, at new prices, youll have to take
back some money/income from
consumer. Reduce the income so that
x2 she can only just buy the original x2
bundle.
x2

x1 x1 x1 x1 x1

Managerial Economics 12
Sanjay K. Singh

Pure Substitution Effect Only Pure Substitution Effect Only

x2 x2 Lower p1 makes good 1 relatively
cheaper and causes a substitution
from good 2 to good 1.
x2 x2

x2 x2

x1 x1 x1 x1 x1 x1

Pure Substitution Effect Only And Now The Income Effect

x2 Lower p1 makes good 1 relatively x2
cheaper and causes a substitution
from good 2 to good 1.
(x1,x2) (x1,x2) is the
x2 x2 (x1,x2)
pure substitution effect.
x2 x2

x1 x1 x1 x1 x1 x1

And Now The Income Effect The Overall Change in Demand

x2 The income effect is x2 The change to demand due to
(x1,x2) (x1,x2). lower p1 is the sum of the
income and substitution effects,
(x1,x2) (x1,x2).
x2 (x1,x2) x2 (x1,x2)

x2 x2

x1 x1 x1 x1 x1 x1

Managerial Economics 13
Sanjay K. Singh

Slutskys Effects for Normal Goods Slutskys Effects for Normal Goods
x2 Good 1 is normal because
Most goods are normal (i.e. demand higher income increases
increases with income). demand

The substitution and income effects x2 (x1,x2)

reinforce each other when a normal
x2
goods own price changes.

x1 x1 x1

Slutskys Effects for Normal Goods Slutskys Effects for Normal Goods
x2 Good 1 is normal because
higher income increases Since both the substitution and
demand, so the income income effects increase demand
and substitution
x2 (x1,x2) when own-price falls, a normal
effects reinforce
each other. goods ordinary demand curve
x2 slopes down.
The Law of Downward-Sloping
Demand therefore always applies to
x1 x1 x1 normal goods.

Slutskys Effects for Income-Inferior Slutskys Effects for Income-Inferior

Goods Goods
x2
Some goods are income-inferior (i.e.
demand is reduced by higher
income). x2
The substitution and income effects
oppose each other when an income-
inferior goods own price changes.

x1 x1

Managerial Economics 14
Sanjay K. Singh

Slutskys Effects for Income-Inferior Slutskys Effects for Income-Inferior

Goods Goods
x2 x2
Assume, price of good 1 falls.

x2 x2

x1 x1 x1 x1

Slutskys Effects for Income-Inferior Slutskys Effects for Income-Inferior

Goods Goods
x2 x2
The pure substitution effect is as for
a normal good. But, .

x2 x2

x2 x2

x1 x1 x1 x1 x1 x1

Slutskys Effects for Income-Inferior Slutskys Effects for Income-Inferior

Goods Goods
x2 The pure substitution effect is as for a x2 The pure substitution effect is as for a
normal good. But, the income effect is normal good. But, the income effect is
in the opposite direction. in the opposite direction. Good 1 is
(x1,x2) (x1,x2) income-inferior
x2 x2 because an
increase to income
x2 x2 causes demand to
fall.

x1 x1 x1 x1 x1 x1

Managerial Economics 15
Sanjay K. Singh

Slutskys Effects for Income-Inferior

Goods Giffen Goods
x2 In rare cases of extreme income-inferiority, the
The overall changes to demand are
income effect may be larger in size than the
the sums of the substitution and substitution effect,
(x ,x ) income effects. causing quantity demanded to fall/increase as
1 2
x2 own-price falls/increases.
Such goods are Giffen goods. Example?
x2 Rice for a very poor family. Why?
What happens when rice becomes costly?
Real income goes down; family will reduce
consumption of vegetables, cereals, and replace
x1 x1 x1 them by rice (still the cheapest food).
Rice consumption increases

Slutskys Effects for Giffen Goods Slutskys Effects for Giffen Goods
x2 A decrease in p1 causes x2 A decrease in p1 causes
quantity demanded of quantity demanded of
good 1 to fall. good 1 to fall.
x2

x2 x2

x1 x1 x1 x1 x1

Slutskys Effects for Giffen Goods Slutskys Effects for Giffen

x2
Goods
A decrease in p1 causes
quantity demanded of Slutskys decomposition of the effect
good 1 to fall. of a price change into a pure
x2
substitution effect and an income
effect thus explains why the Law of
x2
Downward-Sloping Demand is
violated for extremely income-
x2 inferior goods.
x1 x1 x1 x1
Substitution effect
Income effect

Managerial Economics 16
Sanjay K. Singh

Income and substitution effects Income and Substitution Effects for Perfect
So, there could be two kinds of inferior goods: Giffen good Complements and Perfect Substitutes
(upward-sloping demand curve) and Non-Giffen good
(downward sloping demand curve) Perfect Complements: Since perfect
Non-Giffen good: income effect is not as dominant as complements have right angled indifference
substitution effect. So, quantity demanded will increase as a curves, there is no substitution effect, only an
result of fall in price, though not as much as for a normal income effect.
good. Demand curve will be downward sloping.
Giffen good: income effect is superior to the substitution
effect and thus leads to a positively sloped demand curve.
Perfect Substitutes: There is both an income
In reality it is highly unlikely that a Giffen good exists.
and substitution effect. Often the substitution
A familys cereals consumption is 20Kg (10 Kg of Bajra (inferior
effect is very large.
good) and 10 Kg of Wheat (normal good)); PB=Rs.15/Kg,
PW =Rs.25/Kg, I=Rs.400; Suppose, Now PB=Rs.20/Kg, Can family
afford the same bundle? No, since E=450. Then? Family has to
consume 20 Kg of cereals.
20X+25(20-X)=400; X=20; i.e., B=20Kg, W=0; B when PB

APPLICATION of Income and Substitution Effects

LABOUR and LEISURE
How do wages affect labor supply? Framework
24 hours a day
There is only two things you can do with
your time
Work (paid labour market)
Leisure
Ignores housework (extension possible)
You divide all of your time between these
two activities.
When you work in the paid labour market,
you are paid a market wage.

LABOUR and LEISURE LABOUR and LEISURE

w(24-Leisure) = p.Consumption What happens if the wage rate increases?
24.w = w.Leisure + p.Consumption
C Consumption (C) = 24w/p (w/p)Leisure
Where 24.w is the value of initial endowment,
w.Leisure is the amount of the endowment
spent on leisure and p.Consumption is the Slope = -w/p
amount of endowment spent on consumption
24w/p
Rearranging:
Consumption (C) = 24w/p (w/p)Leisure

24 Leisure

Managerial Economics 17
Sanjay K. Singh

LABOUR and LEISURE LABOUR and LEISURE

More labour or more leisure.?
What happens if the wage rate increases?
Use income and substitution effects

C 24w2/p W2 > W1 C Is leisure a normal or

an inferior good?
w w
The budget
line pivots out
24w1/p from here 24w1/p

24 Leisure 24h Leisure

LABOUR and LEISURE LABOUR and LEISURE

More labour or more leisure.? More labour or more leisure.?

Total Effect ?
C C
Depends (to some
w extent) on whether
Leisure is assumed to
be normal or inferior
24w1/p 24w1/p

A 24h Leisure A 24h Leisure

LABOUR and LEISURE LABOUR and LEISURE

More labour or more leisure.? More labour or more leisure.?
SE: Increase in price of
leisure (opportunity cost of SE: A to B (youll work more and
leisure) reduces the demand reduce the consumption of
C for the same since consumer C leisure)
will substitute leisure by
consumption. IE: Depends on whether Leisure
w IE: Real income goes up; w is assumed to be normal
Demand of leisure goes up if (consume more when income
it is normal good; goes up) or inferior (consume
24w1/p 24w1/p less when income goes up)
Demand of leisure goes down
if it is inferior good

A 24h Leisure B A 24h Leisure

Managerial Economics 18
Sanjay K. Singh

LABOUR and LEISURE LABOUR and LEISURE

More labour or more leisure.? More labour or more leisure.?

Overall we could end SE: A to B

up here if leisure is
C very normal
C
IE: B to C
w w TE: A to C
IE dominates SE
24w1/p 24w1/p
(leisure is very
normal)

B A C 24h Leisure B A C 24h Leisure

LABOUR and LEISURE ANOTHER APPLICATION

Increase in wage rate AN INCREASE in INCOME v. A SUBSIDY
on ONE PRODUCT ONLY
Substitution effect: w price of leisure
leisure and labour supply
Income effect: w income (value of Involves equal cost to the government
the initial endowment) Example: food subsidy for BPL card
leisure and labour supply holders; free electricity for farmers in
(when leisure is normal good)
certain states;
IF LEISURE IS A NORMAL GOOD
Overall effect: Leisure?? Labour Supply??
IF LEISURE IS AN INFERIOR GOOD
Overall effect: Leisure IF Wage rate

AN INCREASE in INCOME v. A SUBSIDY AN INCREASE in INCOME v A SUBSIDY

on ONE PRODUCT ONLY on ONE PRODUCT ONLY
Budget constraint is given by But which makes the consumer better off ?

p1 x1A + p2 x 2A = M X2

The government can

(1) give a subsidy on food (x1)
( p1 t )x1B + p2 x2B = M
Note: Equal A
(2) give a increase in income cost to the
government
p1 x1C + p2 x 2C = M + tx1B U0
X1

Managerial Economics 19
Sanjay K. Singh

AN INCREASE in INCOME v A SUBSIDY AN INCREASE in INCOME v A SUBSIDY

on ONE PRODUCT ONLY on ONE PRODUCT ONLY
But which makes the consumer better off ? But which makes the consumer better off ?
X2 The subsidy on food X2 The subsidy on food
leaves the consumer at leaves the consumer at
B (better off than at A) p1 x1A + p2 x2A = M B (better off than at A)

B B
A A
U1 U1
( p1 t )x1B + p2 x2B = M
U0 U0
X1 X1

AN INCREASE in INCOME v A SUBSIDY AN INCREASE in INCOME v A SUBSIDY

on ONE PRODUCT ONLY on ONE PRODUCT ONLY
But which makes the consumer better off ?
To illustrate the equal cost nature of the
X2 U2 The increase in
the subsidy v. the income increase, you
draw a line parallel to the original budget income leaves
C
constraint which passes through the the consumer
point B (as B must be affordable after the at C (better off
income increase). than at B)
B
A
U1

U0
X1

AN INCREASE in INCOME v A SUBSIDY Quiz 1

on ONE PRODUCT ONLY what have you learned so far
Suppose the market for frozen orange juice is in equilibrium at
But which makes the consumer better off ? a price of $1.00 per can and a quantity of 4200 cans per month.
Now suppose that at a price of $1.50 per can, quantity
X2 U2 The increase in demanded falls to 3000 cans per month and quantity supplied
increases to 4500 cans per month.
income leaves
C the consumer A. Draw the appropriate diagram for this market
at C (better off B. Calculate the price elasticity of demand for frozen orange
than at B) juice between the prices of $1.00 and $1.50. Is the demand
B elasticity elastic or inelastic?
A
U1 C. Calculate the elasticity of supply for frozen orange juice
between prices of $1.00 and $1.50. Is the supply elasticity
U0 p1 x1C + p2 x2C =M + tx1B elastic or inelastic?
X1

Managerial Economics 20
Sanjay K. Singh

Answer Question
what have you learned so far what have you learned so far
Each of the events listed below has an impact on the market for
bicycles. For each event, which curve is affected (supply or
demand for bicycles), what direction is it shifted, and what is
the resulting impact on equilibrium price and quantity of
bicycles?
A. The price of steel used to make bicycle frames increases.
B. An environmental movement shifts tastes toward bicycling.
C. Consumers expect the price of bicycles to fall in the future.
D. A technological advance in the manufacture of bicycles
occurs.
E. Consumers' incomes decrease, if bicycles are an inferior
good

Answer Questions
what have you learned so far what have you learned so far
A. supply, shifts left, equilibrium price rises, equilibrium Ankits utility function is u (x1, x2) = min {x1, x2}. Ankit has
quantity falls Rs. 150/- and price of x1 and the price of x2 are both 1.
B. demand, shifts right, equilibrium price and quantity rise Ankits boss is thinking of sending him to another town
where the price of x1 is 1 and the price of x2 is 2. The boss
C. demand, shifts left, equilibrium price and quantity fall
offers no raise in pay. Ankit complains bitterly. He says that
D. supply, shifts right, equilibrium price falls, equilibrium although he does not mind moving for its own sake and the
quantity rises new town is just as pleasant as the old, having to move is as
E. demand, shifts right, equilibrium price and quantity rise bad as a cut in pay of Rs. A. He also says he would not mind
moving if when he moved he got a raise of Rs B. What are
A and B equal to?

Questions (Answer) Questions

what have you learned so far what have you learned so far
Ankits demand functions are 150 A 150 There are 100 consumers in an isolated village. All of them
150 Now, =
x1 = x2 = since, x1 = x2 and P1 x1 + P2 x2 = m = 150 1+ 1 1+ 2 consumes only two goods, bread (good 1) and butter (good 2).
P1 + P2 A A
where P1 = price of good 1 and 75 = 50 = 25 A = 50 Price per unit of bread is Rs. 10 and price per unit of butter is
2 2
P2 = price of good 2. 150 150 + B B
Rs. 20. All consumers have monthly income of Rs 1000/-. All
Indirect utility of Ankit is: and = 75 = 50 + B = 75 of them have utility function represented by U(x1, x2) = lnx1 +
1+ 1 1+ 2 3
m 150
v( P1 , P2 , m) = = Hence, A = Rs 50/- and lnx2. Village Panchayat wants to raise Rs 10000/- per month. It
P1 + P2 P1 + P2 B = Rs 75/-.
150
can impose a quantity tax on good 1 or lump sum income tax
v(1,1,150) = = 75 on consumers. What would be quantity tax rate? If Panchayat
1+1
v(1,2,150) =
150
= 50 wants to maximize combined utility of consumers what tax
1+ 2 option it should choose, lump-sum tax or quantity tax and
why? (Remember P1 = 10, P2 = 20).

Managerial Economics 21
Sanjay K. Singh

Questions (Answer) Questions (Answer)

what have you learned so far what have you learned so far
so, when quantity tax on goods 1 is t, then each consumer will consume:
500 Indirect utility (in case of no tax):
x1 * = units of bread per month
Now, max U ( x1 , x2 ) = ln x1 + ln x2 10 + t U ( x1 , x2 ) = ln (50 X25)
max U ( x1 , x 2 ) = ln x1 + ln x2 x1 x2 10 + t 500
x1 x2 x2 * = = 25 units of butter per month = ln (1250)
s.t. 10 x1 +20 x2 =1000 s.t. (10 + t) x1 +20 x2 =1000 20 10 + t

FOC: L = ln x1 + ln x2 (10 x1 +20 x2 -1000) L = ln x1 + ln x2 ((10 + t) x1 +20 x2 1000) Now, govt. wants to generate Rs 100 per person per month.
Lump-sum tax of Rs100/-
FOC: So, m 1000 100 = 900
1 So, t x1 * = 100 (in case of quantity tax).
= 10 Hence, max ln x1 + ln x2
1 x 10 + t 500
= (10 + t ) 2 =
x1 x2
x1 x 1 x t = 100
2 = x2 = 1 x1 x1 20 10 + t s.t. 10 x1 +20 x2 = 900
1 x1 2 2
= 20 5t = 10 + t 4t = 10 L = ln x1 + ln x2 (10 x1 +20 x2 900)
1 10 + t
x2 = 20 x2 = x1 t = 2.5. So, impose a tax of Rs 2.5 per unit of bread.
1
10 x1 +20 x2 =1000 x2 20 = 10
500 500 5000 x1 x 1 x
10 x1 +10 x1 =1000 (10 + t) x1 + 20 x2 = 1000 So, x1 * = = = = 40 2 = x2 = 1
10 + 2.5 12.5 125 1 x1 2 2
So, each consumer will consume: 10 + t = 20
(10 + t) x1 + 20 x1 = 1000 x2 * = 25 x2
x1 = 50 units of bread per month 20
10 x1 +10 x1 = 900 x1 * = 45, x2 * = 45/2
x2 =25 units of butter per month 2 (10 + t) x1 = 1000 Indirect utility (in case of quantity tax):
U ( x1 , x2 ) = ln x1 + ln x2 Hence, indirect utility, U ( x1 , x2 ) = ln (452/2) = ln (1012.5)
= ln x1 x2 which is more than ln(1000). Hence, lump-sum tax will increase
= ln (40 X 25) the combined utility of the consumers.
= ln (1000)

THANKS

Managerial Economics 22