EQ: What is an Indifference Curve? EQ: What is Indifference?

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1 EQ: What is Indifference? Remember that a budget constraint is a limit on the money resources a consumer has to purchase products. A budget constraint is shown graphically as a budget line showing the different combinations of goods a consumer can afford to buy. Remember that utility is the amount of satisfaction that a consumer receives from consuming products and that it changes. We will now combine these two concepts. EQ: What is Indifference? Have you ever been asked to choose where to eat and you said, It doesn t matter I don t really care? Or maybe you heard it from a friend. When a person has to choose between two things and they don t prefer one over the other, that is called indifference. Indifference means having no preference of one thing over another or making no distinction between two things. In terms of utility, indifference is a situation in which two things/situations provide equal utility. EQ: What is Indifference? EQ: What is an Indifference Curve? In microeconomics, indifference is an important concept. Economics is fundamentally concerned with making decisions where one thing is chosen instead of another thing. Usually, the thing that is chosen is preferred over the other thing that is not chosen (probably because it provides greater utility or higher profit). In the case of indifference, there is no reason to choose one thing over another because both provide equal utility. But when we combine this concept with the idea of budget constraints, indifference becomes very useful because one of those things might have a lower price than the other. An indifference curve is a graph of ALL combinations of the amounts of two goods such that an individual does not prefer any one combination of the two goods over any other combination of the two goods on the same curve. For example, let s say that you are eating chicken nuggets and waffle fries. Would you rather have nuggets and waffle fries or 5 nuggets and 1 waffle fries? What s that? You don t care? Oh, then you are indifferent. They are the same to you. Would you rather have nuggets and waffle fries or nuggets and waffle fries? Oh, either one is the same to you? Then you are indifferent. nuggets and 1 waffle fries? All the same to you?

2 EQ: What is an Indifference Curve? EQ: What is an Indifference Curve? Waffle Fries utils Each point along this curve provides an equal amount of utility as every other point on the curve. That means that no combination of quantities of the two goods on the curve provides more utility than any other combination of quantities on the curve Nuggets For example, let s say that nuggets & fries, nuggets & fries, 5 nuggets & 1 fries, and nuggets & 1 fries all provide 5 utils of satisfaction. Each of these combinations of nuggets and fries provides an equal amount of utility. Why is an indifference curve bowed inward? Pretty much for the same reason that the PPF is bowed outward The Law of Diminishing Returns. Remember that the more you consume of something, the less of a positive effect it has on you (i.e., it provides less and less utility per unit consumed). Since it is not critical for you to understand this in a principles class, I will not bore you with the details. An indifference map is a coordinate plane (Cartesian Plane) with many indifference curves, each curve representing successively higher levels of utility provided by combinations of the same two products. While one indifference curve shows all the combinations of two products that result in one level of utility, a map of indifference curves shows multiple indifference curves, with each one representing a different level of utility provided. As you move northeast on the map, the level of utility provided by each curve increases. Chips & Dip Chicken Wings 5 utils 0 utils 15 utils utils John is at a football game and enjoys eating chips & dip as well as buffalo chicken wings when he goes to a game. This indifference map shows all the different combinations of chips & dip and buffalo wings that John could buy and consume as well as the different levels of utility that John would receive for each of the different combinations. All of the combinations shown at the different points on this curve provide 0 utility to John. Notice that as the curves move outward up and to the right the levels of utility of each curve increase.

3 So, what combination of chips & dip and buffalo wings should John choose to enjoy? Well, it depends on John s budget constraint. YES! It all comes together! Remember the budget line from Lesson 7-1? Well, we re going to lay it over the indifference map to see how we can maximize John s utility. Let s say that Buffalo Wings are $0.50 each and Chips & Dip are $0.50 each. Suppose that John has $.00 to spend on food. John can afford a maximum of 1 chips & dip. John can afford a maximum of 1 buffalo wings. John s budget line is a line connecting (0,1) and (1,0). Chips & Dip Chicken Wings 5 utils 0 utils 15 utils utils Here is John s indifference map again with his budget line drawn in. John can afford many combinations on the Utils indifference curve, so we know that he will get at least that much utility. But can he possibly get 15 Utils of satisfaction with his limited budget? Look at that point the combination of 7 wings and 5 chips & dip. His budget line just barely touches the 15 Utils curve at one point only (we call that tangent ). Wherever the budget line touches an indifference curve at a single point is the Utility Maximizing Combination. John should buy 7 wings and 5 chips & dip if he wants to get maximum satisfaction from his ball game experience. Chips & Dip utils 0 utils 15 utils utils Chicken Wings Look at that point of wings and chips & dip. That combination of snacks is exactly on John s budget line, but it provides him just barely more than Utils maybe 11 Utils. Imagine if John liked the chips & dip so much that he just kept buying them and only had wings. He would have missed out on at least more points of utility by choosing a more moderate combination. We often make this mistake in life. We like something and then overconsume it, thinking that every one we consume will give us the same pleasure. But the Law of Diminishing Returns won t allow that. Essential Questions EQ: How much consumer satisfaction can I afford to buy? Your budget constraint will give you the most satisfaction if you really understand what kinds of things make you happy, not just buying what your habits tend toward. Critically think about how much satisfaction you get from the things you buy. Maybe you could spend less money and get more satisfaction if you live life in moderation. EQ: How can I get the most consumer satisfaction with my limited income? Buy a combination of goods/services rather than a whole lot of one thing. Remember that the Law of Diminishing Returns is working against you when you try to get all your satisfaction from one product.

4 Utility Maximization Businesses try to get as much profit as possible given their limited factors of production. People try to get as much consumer satisfaction (utility) as possible given their limited incomes. Previously, we looked at how we can determine the maximum utility possible given a limited income. But what about making specific decisions when choosing between two products? Let s look at the Utility Maximization Rules. EQ What is Marginal Utility? Remember that Marginal Utility is the amount of added utility you receive from consuming one more unit of a product. Well, if you are trying to decide whether you should buy a slice of pizza or a big cookie, then Marginal Utility is what it s all about. Will the slice of pizza or the big cookie give you more satisfaction given the price of each? If the pizza will give you more satisfaction per dollar, then you ll want to buy the pizza. But if the cookie gives you more satisfaction per dollar, then you ll want to buy the cookie. There are rules for maximizing utility when purchasing a combination of two or more products. Utility Maximization Rule #1: Always choose the marginal unit of the good that yields the most marginal utility per price. Utility Maximization Rule #: Always choose the combination of goods that equalizes the ratio of marginal utility per price for all goods. Following these rules will always result in achieving the most utility possible given a limited income. Price of X = $3 Price of Y = $3 Income = $1 Good X = Good Y =

5 - First, you need to create columns for marginal utility. - Remember marginal utility is the added utility from consuming one more unit MU = TU TU Utility Maximization Rule #1 says to choose a unit of the good that offers the highest marginal utility per price. This is what we will do for each step. Since both X and Y have the same price, we don t have to compare MU per price. 1. MU of X1 = 50 MU of Y1 = 0 Buy 1 unit of X for $3, leaving $1. We now have X = 1 and Y = 0.. MU of X = 5 MU of Y1 = 0 Buy 1 unit of X for $3, leaving $15. We now have X = and Y = MU of X3 = 0 MU of Y1 = 0 Buy 1 unit of Y for $3, leaving $1. We now have X = and Y = 1.. MU of X3 = 0 MU of Y = 37 Buy 1 unit of X for $3, leaving $9. We now have X = 3 and Y = MU of X = 35 MU of Y = 37 Buy 1 unit of Y for $3, leaving $. We now have X = 3 and Y =.. MU of X = 35 MU of Y3 = 3 Buy 1 unit of X for $3, leaving $3. We now have X = and Y =. 7. MU of X5 = 30 MU of Y3 = 3 Buy 1 unit of Y for $3, leaving $0. We now have X = and Y = 3. Total Utility = = 1 If we chose X=3 and Y=, Total Utility would = 77 If we chose X=5 and Y=, Total Utility would = 77 So X= and Y=3 is the utility maximizing combination. Price of X = $3 Price of Y = $3 Income = $1 Good X = Good Y = 3 What if the prices of the goods were different? Price of X = $5 Price of Y = $3 Income = $33 Good X = Good Y =

6 - You need to create columns for MU and MU per price. - Divide each MU by the unit price for each line. - For X1, MU=50 and price is $5, so MU per price is 50 / 5 =. 5 = 3 = Utility Maximization Rule #1 says to choose a unit of the good that offers the highest marginal utility per price. This is what we will do for each step. We have created a column for MU per price, so we can compare each good based on that column in each step. 1. MU/$ of X1 = MU/$ of Y1 = 13 Buy 1 unit of Y for $3, leaving $30. We now have X = 0 and Y = 1.. MU/$ of X1 = MU/$ of Y = 1 Buy 1 unit of Y for $3, leaving $7. We now have X = 0 and Y =. 3. MU/$ of X1 = MU/$ of Y3 = 11 Buy 1 unit of Y for $3, leaving $. We now have X = 0 and Y = 3.. MU/$ of X1 = MU/$ of Y = Buy 1 unit of X for $5, leaving $19. We now have X = 1 and Y = MU/$ of X = 9 MU/$ of Y = Buy 1 unit of Y for $3, leaving $1. We now have X = 1 and Y =.. MU/$ of X = 9 MU/$ of Y5 = 9 Buy 1 unit of X for $5, leaving $11. We now have X = and Y =. 7. MU/$ of X3 = MU/$ of Y5 = 9 Buy 1 unit of Y for $3, leaving $. We now have X = and Y = 5.. MU/$ of X3 = MU/$ of Y = Buy 1 unit of X for $5, leaving $3. We now have X = 3 and Y = MU/$ of X = 7 MU/$ of Y = Buy 1 unit of Y for $3, leaving $0. We now have X = 3 and Y =. Total Utility = = 3 If we chose X= and Y=7, Total Utility would = 305 We can t afford X= and Y=5. So X=3 and Y= is the utility maximizing combination. This is also the point where the MU per price is equal for both goods ( for both): Rule #. Price of X = $5 Price of Y = $3 Income = $33 Good X = 3 Good Y =