Consumers face trade-offs in their purchase decisions, since their income is limited and choices are numerous. In order to make choices, consumers must combine budget constraints (what they can afford), and preferences (what they would like to consume).
A budget contraint, means what a consumer can purchase is constrained by income. The slope of the budget constraint measures the rate at which one consumer can trade off one good for another, and the relative prices of the two goods. Budget constraints are determined by both the income of the consumers, and the relative prices.
If a consumer equally prefers two product bundles, then the consumer is indifferent between the two bundles. The consumer will get the same level of satisfaction (utility) from either bundles. Graphically speaking, this is known as the indifference curve. This curve shows that all bundles are equally preferred, or have the same utility or same level of satisfaction. The slope of indifference curve is the rate at which a consumer is willing to trade one good for another, which is also known as the marginal rate of substitution (MRS).
Properties of Indifference Curves
1. Higher indifference curves are preferred to lower ones, since more is preferred to less (non-satiation).
2. Indifference curves are downward sloping. If the quantity of one goods is reduced, then you must have more of the other good to compensate for the loss.
3. Indifference curves do not cross (intersect), since this would imply a contradiction.
4. Indifference curves are bowed inward (in most cases). The slope of indifference curves represent the MRS (rate at which consumers are willing to substitute one good for the other). People are usually willing to trade away more of one good when they have a lot of it, and less willingto trade away goods which are in scarce supply. This implies that MRS must increase as we get less of a good.
Nota bene that two extreme examples exist. Perfect substitutes have straight-line indifference curves. As we get more of the good, we trade off with the substitute at a constant rate because we are indifferent between them (i.e. Coke and Pepsi). Perfect complements have right-angled indifference curves. If goods can only be used together, there is no satisfaction in having more of A without additional amounts of B (i.e. left and right shoe). In general, the better substitutes goods are, the straighter the indifference curve.
Consumers' Optimal Choice
We must combine what a consumer can obtain (budget constraint) and the preferences (indifference curve). The optimum is the highest point on the indifference curve that is still within the budget constraint. This will usually occur where the indifference curve is tangent to budget constraint. At the optimum point, MRS = relative prices of goods since MRS = slope of indifference curve, and relative price = slope of budget constraint. The marginal rate of substitution is the rate at which consumers are willing to trade-off, and is equal to rate at which they can trade.
Changes in income will undoubtedly affect the optimal choice. The budget constraint will shift parallel to the original - upwards for an increase in income, and downwards for a decrease in income. The new equilibrium for a higher income will be on a higher indifference curve, and since income is higher, more of both products could be consumed. For normal goods, as income increases, more of the good will be preferred. For inferior goods, as income increases, less of the good will be chosen.
Changes in Prices
A change in price will change the slope of the curve. A fall in price will rotate the budget constraint outwards, and an increase in price will rotate the budget constraint inwards. Thus a change in price will change both the relative prices of the two products and also the amount that can be bought, ceteris paribus (income). Changes in price has two effects:
1. Substitution Effect
o arises from the tendency to buy less of goods which are more expensive
o can be measured by keeping satisfaction constant (stay on same indifference curve and finding where MRS = new relative prices
2. Income Effect
o arises from change in price effect on total amount that can be purchased
o change in consumption when we shift to a new indifference curve as a result of the price change
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