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Marginal rate of substitution

Rate of substituting one commodity for the other along the indifference curve to maintain the same level of satisfaction. Diminishing MRS The slope of IC is diminishing because as the consumer increase the units of X in place of Y then the X becomes less attractive & Y becomes more beneficial. Therefore the consumer will forgo less units of Y and buy additional units of x to maintain the level of satisfaction. MRS = change in X/ change in Y Recall that to maximize utility a consumer would set: (MUx/Px) = (MUy/Py) If PY increases this equality would be disturbed: (MUx/Px) > (MUy/Py) To return to equality the consumer must adjust his/her consumption. (Have in mind that the consumer cannot change prices, and he/she has an income constraint.)

What does consumer want? (MUx/Px) > (MUy/Py) In order to make the two sides of the above inequality equal again, given that Px and Py could not be changed, we would have to increase MUY and decrease MUX. Recalling the law of diminishing marginal utility, we can decrease MUx by increasing X and increase MUy by decreasing Y.
Commodity X 10 11 12 13
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Commodity Y 25 20 16 13
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MRS= Y/X _ -5/1 = -5 -4/1= - 4 -3/1= -3


-2/1= -2

INDIFFERENCE CURVE
Given by J.R. Hicks & R.G.D. Allen, an indifference curve is a line drawn in a two dimensional space showing Different combinations of two goods from which the consumer draws the same amount of utility and therefore he/she is indifferent about.

Properties of Indifference curves


Indifference curves for two goods are generally negatively sloped: Indicates that as the quantity of X increases, there should be decrease in qty. of Y if the consumer wants to attain same level of satisfaction. Therefore IC cannot be horizontal, vertical or upward sloping. Indifference curves are generally convex, reflecting the principle of diminishing returns: measures law of diminishing MRS. To substitute X further for Y, the consumer will sacrifice less units of Y in exchange of X to maintain his utility level. Indifference curves never cross/intersect each other: each IC shows specific utility level in an indifference map. It is based on the principle of transitivity. Indifference curves that are farther from the origin represent higher levels of utility

An indifference curve represents all combinations of market baskets that provide same level of satisfaction to a person.

Higher the indifference curve, higher will be the satisfaction level. A curve that lies above and to the right of another I.C represents preferred combination of commodities and thus higher satisfaction.
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Fundamental Concepts 1) Scale of preferences: J.R. Hicks introduced the concept of scale of references as arrangement of combination of various goods set in the order of their preferences/level of significance.

Combination 12 apple+ 12 Banana

Utility Highest

Rank I

10 apple + 19 banana

Lesser than above

II

5 apple +5 banana

Lesser than above two

III

2)Indifference Map: Set of indifference curves.

3)Indifference Schedule: List of alternative combinations in the stock of two goods which yield equal satisfaction to the customer. Here he is indifferent to all combination of goods.
Commodity X 10 11 12 Commodity Y 25 20 16 MRS= Y/X _ -5/1 = -5 -4/1= - 4

13
14

13
11

-3/1= -3
-2/1= -2

Price line or budget line: in order to study consumers equilibrium, we assume that the consumer has the given income that he wants to spend at the given prices on the commodities. The consumer wants to go higher and higher up on his indifference curve. But he is limited by the given combinations of the commodities he can purchase with his given income at the given prices.. When we join these combinations, we get a straight line joining the axis. This is called the PRICE LINE, which shows all those combinations which can be bought by the consumer at given prices. Thus also called price opportunity line or budget line or consumption possibility line. It shows the constant price ratio for the two commodities and the consumer can have more of one commodity only by sacrificing some of the other.

Budget Line: Consumers choice between good X & Y


Y Income = Px .Qx + Py. Qy I/PY

Slope = Px/Py

X O I/Px

Consumer Equilibrium
Given his budget constraint, the consumer reaches the highest possible point in indifference curve. Assumption ordinal theory of maximizing satisfaction no longer means achieving maximum total utility but rather reaching the highest level of Satisfaction The point of tangency of an IC with the price line on the budget constraint determines consumer equilibrium. Assumptions: Consumer has fixed income to spend He intends to buy the combination of goods X & Y Prices of X & Y are given and constant X & Y are homogeneous/substitute goods Consumers taste & preference remains constant Consumer is rational To find out consumer equilibrium we consider indifference map & Budget line simultaneously.

Consumer Equilibrium: All IC lying above the budget line are beyond the
reach of the consumer. so they are irrelevant for the equilibrium condition. Consumer can choose any point on the budget line, but his interest is lying in maximization of satisfaction. Therefore he will choose highest IC within his reach. Hence in the fig given below the equilibrium position is at point E of IC-3
clothing

IC-4
E

IC-3

F IC-2
IC-1