Imp.

1. Microeconomics (PGP-I)
Session 3
Joysankar Bhattacharya

2. 2
Example: Graphing Indifference
Curves
IC1
IC2
x
y
Preference direction
Indifference Curves

3. 3
PxX + PyY = I
Y = I/Py – (Px/Py)X
Budget Set:
• The set of baskets that are affordable
Budget Constraint:
• The set of baskets that the consumer may purchase
given the limits of the available income.
Budget Line:
• The set of baskets that one can purchase when
spending all available income.
Key Definitions

4. 4
• Price of X: Px ; Price of Y: Py
• Income: I
Total expenditure on basket (X,Y): PxX + PyY
Assume only two goods available: X and Y
The Basket is Affordable if total expenditure
does not exceed total Income:
PXX + PYY ≤ I
The Budget Constraint

5. 5
I/PX
Y
X
•
•C
•
I/PY
Budget line = BL1
-PX/PY
A Budget Constraint Example

6. 6
Y
X
BL1
BL2
If income rises, the budget line shifts parallel
to the right (shifts out)
If income falls, the budget line shifts parallel
to the left (shifts in)
Shift of a budget line
A Budget Constraint Example

7. 7
Y
X
BL1
BL2
If the price of Y rises, the budget
line gets flatter and the vertical
intercept shifts in (BL2 )
If the price of Y falls, the budget
line gets steeper and the vertical
intercept shifts out (BL1 )
Rotation of a budget line
A Budget Constraint Example

8. 8
Consumer’s Problem:
Max U(X,Y)
Subject to: PxX + PyY < I
Consumer Choice
Assume:
 Only non-negative quantities
 "Rational” choice: The consumer chooses
the basket that maximizes his satisfaction given
the constraint that his budget imposes.

9. 9
Y
X
•Optimal Choice (interior solution)
IC
BL
0
C•
•B
Preference Direction
Interior Consumer Optimum
(an optimum at which the consumer purchases both commodities
(X > 0 , Y > 0)

10. 10
Interior Optimum: The optimal consumption basket is
at a point where the indifference curve is just tangent to
the budget line.
Tangency Equal Slope
“The rate at which the consumer would be willing to
exchange X for Y is the same as the rate at which they
are exchanged in the marketplace.”
Interior Optimum
MRSx,y =
MUx
MUy
=
Px
Py

11. 11
“At the optimal basket, each good gives
equal bang for the buck”
1.
MUx
Px
=
MUy
Py
2. PxX + PyY = I
Now, we have two equations to solve for two unknowns
(quantities of X and Y in the optimal basket):
Equal Slope Condition
MUx
Px
=
MUy
Py

12. 12
•Consumer’s optimal basket.
•Thus, we can tell – for a given income and prices of
other goods – how much a consumer will demand of
X for a given price of X.
•We can find different amounts of X demanded by
changing the price of X(PX) and determining how
much of X the consumer will demand – prices of other
goods and income are held constant.

13. 13
Y (units)
X (units)
0
PX = 4 PX = 2
PX = 1
XA=2 XB=10 XC=16
•
• •
10
PY = 4
I = 40
Price Consumption Curve
20
The price consumption curve for
good x can be written as the
quantity consumed of good x for
any price of x.
Price Consumption Curves

14. 14
Is the set of optimal baskets for
every possible price of good x,
holding all other prices and
income constant.
The Price Consumption Curve of Good X:
Price Consumption Curves

15. 15
X
PX
XA XB XC
Individual
Demand Curve
For X
PX = 4
PX = 2
PX = 1
•
•
•
U increasing
Individual Demand Curve

16. 16
Change in Income & Demand
The income consumption curve of
good X is the set of optimal baskets
for every possible level of income.

17. 17
Income Consumption Curve

18. 18
The income consumption curve for
good X also can be written as the
quantity consumed of good X for any
income level. This is the individual’s
Engel Curve for good X. When the
income consumption curve is
positively sloped, the slope of the
Engel Curve is also positive.
Engel Curves

19. 19
X
0
92
68
40
10 18 24
Engel Curve
I
“X is a normal good”
Engel Curves

20. 20
• If the income consumption curve shows that the consumer
purchases more of good X as her income rises, good X is a
normal good.
• Equivalently, if the slope of the Engel curve is positive, the
good is a normal good.
• If the income consumption curve shows that the consumer
purchases less of good X as her income rises, good X is an
inferior good.
• Equivalently, if the slope of the Engel curve is negative, the
good is an inferior good.
Definitions of Goods

21. 21
Impact of Change in the Price of a Good
•If price of a good falls – consumer substitutes
into the other good to achieve the same level of
utility
•When price falls – purchasing power increases
the consumer can buy the same amount and still
have money left

22. 22
Impact of Change in the Price of a Good
Pizza-Pepsi Story
• Reduction in price of Pepsi
• Now that the price of Pepsi has fallen, I get more Pepsi for
every Pizza that I give up. Because Pizza is now relatively more
expensive, I should buy less Pizza and more Pepsi (Substitution
Effect, change in consumption on the same IC with a different
MRS )
• Now that Pepsi is cheaper, my income has greater purchasing
power. I am, in effect, richer than I was. Because I am richer, I
can buy both more Pizza and more Pepsi (Income Effect,
change in consumption that results from the movement to a
higher IC)

23. 23
Impact of Change in the Price of a Good
• Substitution Effect: Change in relative
price affects the amount of good that is
bought as consumer tries to achieve the same
level of utility
• Income Effect: Consumer’s purchasing
power changes and affects the consumer in a
way similar to effect of a change in income

24. 24
• As the price of X falls, all else constant, good X
becomes cheaper relative to good Y
•This change in relative prices alone causes the
consumer to adjust his/ her consumption basket.
• This effect is called the substitution effect.
• The substitution effect always is negative(in
direction).
The Substitution Effect

25. 25
Impact of Change in the Price of a Good
Definition: As the price of X falls, all else
constant, purchasing power rises. As the price
of X rises, all else constant, purchasing power
falls.
This is called the income effect of a change in
price.
The income effect may be positive (normal
good) or negative (inferior good).

26. Y
Clothing
X
Food
A C
B
XA XC
XB
BL1 BL2
BLd
U1
U2
• Initial Basket
• Final Basket
• Decomposition
Basket
The Substitution and Income Effects

27. 27
The Substitution and Income Effects

28. 28
The Substitution and Income Effects

29. 29
Giffen Goods – Income and Substitution Effects

30. 30
Giffen Goods
If a good is so inferior that the net effect of a price
decrease of good X, all else constant, is a decrease in
consumption of good X, good X is a Giffen good.
For Giffen goods, demand does not slope down.
When might an income effect be large enough to offset
the substitution effect?
The good would have to represent a very large
proportion of the budget.
A Giffen good has to be an inferior one, but the
converse is not necessarily true.