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1. MICROECONOMICS
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1

2. Indifference Curves & Budget Lines
 Consumers’ budgets are modelled using
budget lines
 Consumer preferences are modelled using
indifference curves and indifference maps
2

3. Indifference Map: Goods
Clothing
(units)
Direction of
increasing
___________
satisfaction
E
Indifference maps:
A • Comprise a set of
U2 indifference curves
G
U1 E is preferred to A.
A is preferred to G.
U0
Food (units)
3

4. Recap Key Concepts from Week 1:
Slope of Indifference Curve
Clothing
(units) 16 A
MRSF for C
SLOPE OF
14 = - C/F INDIFFERENCE
=6 CURVE
12 -6
10 B So MRS is
1
8 -4
MRSF for C represented by
= - C/F
D the absolute
6 =2
1
E value of slope of
-2
4 G the indifference
1 -1
2 1 curve
1 2 3 4 5 Food (units)
4

5. Effects of Price Changes
A decrease in the price of food rotates the
Clothing budget line outward.
(units)
An increase in the price of food rotates the
budget line inward.
L1 L2
L3
Food
(units)
5

6. Effects of Income Changes
An increase in income is shown by a
Clothing
(units)
parallel outward shift in the budget line
80
A decrease in income is shown by a
parallel inward shift in the budget line
60
40
20
L1 L2
Food
0 40 80 120 160 (units)
6

7. Recap Key Concepts from Week 1:
Slope of Budget Line
 Assume income of $80/week, price per unit of
food is $1 and price per unit of clothing is $2
o I = $80
o PF = $1
o PC = $2
 Budget line is PFF + PCC = I
 Using the formula 1F + 2C = 80
Slope
= C/F or - PF/PC
= -1/2 Ratio of Price of F to Price of C;
OR Relative Price of F to C
So Relative Price is represented
by the slope of the budget line
7

8. Recap Key Concepts from Week 1:
Indifference Curves & Budget Lines
 Consumer preferences are modelled using
indifference curves
 MRS (F for C) = Absolute value of slope of
indifference= -C/F
 Consumers’ budgets are modelled using
budget lines
 Relative Price of F to C = Slope of budget line =
-PF/PC
8

9. Recap Key Concepts from Week 1:
Consumer Choice Theory
 Different consumers prefer different
goods  Consumer preferences
 Consumers have limited incomes to
spend  Budget constraint
 Consumers’ choices about
consumption reflect both their
preferences and their budget
constraints Consumer choice
9

10. This Week’s Learning Outcomes
 Understand the traditional theory’s
explanation of how consumers make choices
 Trace the effects of price changes from
consumer choice to the demand curve
 Trace the effects of income changes from
consumer choice to the demand curve
 Gain an understanding of different types of
goods demanded by consumers
 Examine the effects of price changes in terms
of substitution and income effects
10

11. Consumer Choice:
Maximising Consumer Satisfaction
 Traditional theory assumes that consumers are
rational, self-interested maximisers.
 Consumers are assumed to choose combinations of
goods and services (market baskets) that:
 maximise their satisfaction (utility); &
 make full use of their budgets
 For example, suppose I have $500 and I get to choose
among 3 market baskets:
Basket Food Clothing Price of A is unaffordable
basket B is affordable but
does not make full
A 100 units 100 units $1000 use of budget
B 20 units 20 units $200 D is affordable &
D 50 units 50 units $500 makes full use of
budget
The rational consumer chooses D over A & B. 11

12. Consumer Choice:
Maximising Consumer Satisfaction
U1 gives the greatest satisfaction, followed by U2,
Clothing and then U3
(units)
However, A is unaffordable (ABOVE budget
line).
B is affordable but does not make full
40 use of budget (BELOW budget line)
G D, G & H are all affordable & make full
use of budget (ON budget line)
30
A PLUS, D is on higher
indifference curve than G or H
20 D
B
Rational
consumer
10 U1 chooses D
H U3
0 20 40 60 80 Food (units)
12

13. Question on Maximising Consumer
Satisfaction
The diagram brings together Grace’s
Big Mac budget line and indifference map. The
two goods are Big Macs and orders of
french fries. Which point maximizes
11 B Grace’s satisfaction?
A. 11 orders of french fries
B. 11 Big Macs
7
D C. 7 Big Macs & 4 orders of fries
D. 4 Big Macs & 7 orders of fries
E. None of the above
4
C
Easy question from a past
A year test which most
0 4 7 11 students got right. 13
French fries

14. Consumer Choice:
Maximising Consumer Satisfaction
•To fully understand the traditional theory, we need to
delve more deeply into the meaning of MRS and the
significance of the tangency point shown on the last
diagram
14

15. Consumer Choice:
Maximising Consumer Satisfaction
Consumer satisfaction is maximised at D, where
Clothing the Slope of indifference curve = Slope of budget
(units)
line
Recall MRS is represented by the
slope of indifference curve
40
Recall RELATIVE PRICE is represented
by the slope of budget line
30
Consumer satisfaction is
maximised at D when:
20 D MRS = RELATIVE PRICE
Point of MRS (F for C) = PF/PC
10 tangency MRS (C for F) = PC/PF
0 20 40 60 80 Food (units)
15

16. Now for some more details on MRS
 Recall all market baskets on the same
indifference curve give the same level of utility
 Also recall that the slope of indifference curves
conveys information on the amount of value
(utility) consumers get from the different goods
 A utility function gives a numerical
interpretation of these ideas
 If a person’s utility function is
U(F,C) = F + 2C
8 units of F & 3 units of C gives her utility of
U(F,C) = 8 + 2(3) = 14 16

17. Another really important
concept!
Consumer Choice & Marginal Utility
 Marginal utility (MU) measures the additional (marginal)
satisfaction obtained from consuming 1 additional unit of
a good.
 It is the key measure of the consumer’s valuation of
different commodities
 Using the example of U(F,C) = F + 2C
Food Clothing Utility = F+2C MU
2 3 2 + 2(3) = 8
2 4 2 + 2(4) = 10 2
2 5 2 + 2(5) = 12 2
17

18. Consumer Choice & Marginal Utility
Comparing the MU of two different
goods gives us MRS
MUF/MUC = MRS (F for C)
Logic: The more utility I get from a good,
The more I’m willing to give up to get more of it
If I derive 5 times as much utility
from an extra unit of food as I do MUF/MUC = 5
from an extra unit of clothing,
then I should be willing to give
up 5 units of clothing to get an MRS (F for C) = 5
additional unit of food.

19. Consumer Choice: 4 Formulas
Clothing
(units) Consumer satisfaction is maximised at
D, where
40 MRS (F for C) = PF/PC
30
Therefore
MUF/MUC = PF/PC
20 D
Therefore
Point of MUF/PF = MUC /PC
10 tangency
0 20 40 60 80 Food (units)
19

20. Consumer Choice: Understanding the
Key Formula
MUF/PF = MUC /PC or MUF/MUC = PF/PC
This tells us the
extra value the This tells us the
consumer will get extra value the
from spending $1 consumer will get
extra on food from spending $1
extra on clothing
When the ratios are equal (i.e. At the
point of tangency) the consumer won’t
increase her utility by spending more on
clothing and less on food or vice versa
20

21. Consumer Choice: Understanding the
Key Formula
Clothing
(units) Consumer satisfaction is NOT maximised
at C, because
40 MRS (F for C) ≠ PF/PC
30
Therefore
MUF/MUC ≠ PF/PC
20 D
Therefore
MUF/PF ≠ MUC /PC
10
C
0 20 40 60 80 Food (units)
21

22. Consumer Choice: Understanding the
Key Formula
At point C the IC is flatter than the budget
line, so
MU F PF
 or
MU C PC
MU F MU C

PF PC
22

23. Effects of Price Changes in MILK …
on Consumer Choice
“Coles instigated a price war in January by slashing
the price of its no-name milk to $1 a litre, forcing
Woolworths, Aldi and Franklins to also reduce
prices.…. The no-name milk now accounts for 51 per
cent of all milk sales and 72 per cent of full-cream
milk sold in the country's supermarkets, according to
the group. That is up from 25 per cent in the late
1990s.”
 Annabel Hepworth, Milk wars 'could cost suppliers $730m‘, The Australian March 04,
2011
23

24. Consumer Choice: Understanding the
Key Formula
MUF/PF <MU C /PC or MUF/MUC < PF/PC
Suppose at point C
This tells us the This tells us the I’m getting 4 units of
extra value the extra value the value for each $1
consumer will get consumer will get I’m spending on
from spending $1 from spending $1 clothing and 1 unit
extra on food extra on clothing of value from each
$1 I’m spending on
When the ratios are NOT food.
equal the consumer CAN
If I spend $1 less on
increase her utility by
food and $1 more
spending more on
on clothing my U will
clothing and less on food increase by 3
or vice versa.
24

25. Effects of Price Changes ….
on Consumer Choice
Other
Assume: I = $50, PM = $2.50, $2, $1
goods
(units) 1. PM decreases: Budget line rotates outwards
along milk axis
2. One utility-maximisation point per
A budget line.
D
U1
3. Trace utility-
B
U3 maximising basket
at each price of milk
to get Price
PM=$1 consumption curve
PM=$2.50 U2
(PCC)
PM=$2
Milk
(cartons)
25

26. Price Consumption Curve
This joins up the utility maximising
points as one price changes while
holding income and the other price
constant.
26

27. Effects of Price Changes ….
on Individual Demand for Milk
4. Derive demand schedule for MILK using PCC
Other
goods Individual Demand Schedule
(units) for MILK
Price ($) Quantity (units)
9 A
$2.50 2
U1
D
$2 10
7 $1 15
B U3
6
PM=$1
PM=$2.50 U2
PM=$2
2 Milk
10 15 (cartons)
27

28. Effects of Price Changes ….
on Individual Demand for Milk
Price 5. Draw demand curve for MILK using demand
of MILK
schedule
A
$2.50 Individual Demand
Schedule for MILK
Price ($) Quantity (units)
B $2.50 2
$2
$2 10
$1 15
$1 D
Individual Demand Curve
Milk (cartons)
2 10 15
28

29. Effects of Price Changes ….
on Individual Demand for Milk
Price
of MILK
A Increase in price =
$2.50 Movement up demand curve
Decrease in price =
Movement down demand curve
$2 B
$1 D
Milk (cartons)
2 10 15
29

30. Income Consumption Curve
This joins up the utility maximizing
points as income changes, while
holding all prices constant.
30

31. Effects of Income Changes ….
on Consumer Choice
Assume: PC = $2, PF = $1, I = $10, $20, $30
Clothing
(units) 1. Income increases: Budget line shifts
I=$30
outwards in a parallel manner
2. One utility-maximisation point per
budget line
I=$20 3. Trace utility-
maximising basket
D at each income level
U3
to get Income
I=$10 U2 consumption curve (ICC)
B
A U1
Food (units)
31

32. Effects of Income Changes ….
on Individual Demand for Food
4.Derive demand schedule for FOOD
Clothing
(units) Using ICC
I=$30
Individual Demand Schedule
for FOOD
Price ($) Quantity (units)
I=$20 (fixed)
$1.00 4
7 D
U3
$1.00 10
5
B
U2 $1.00 16
I=$10 3
A U1
4 10 16 Food (units)
32

33. Effects of Income Changes ….
on Individual Demand for Food
5. Draw demand curve for FOOD using
Price
of demand schedule
food
Individual Demand
Schedule for FOOD
Price ($) Quantity
(fixed) (units)
A B D
$1.00 $1.00 4
$1.00 10
$1.00 16
D3
D2
D1
4 10 16 Food (units)
33

34. Effects of Income Changes ….
on Individual Demand for Food
Price
of
food
Increase in income =
Shift to the right by
demand curve
Decrease in income =
Shift to the left by
A B D demand curve
$1.00
D3
D2
D1
4 10 16 Food (units)
34

35. Normal goods
Steak
(units)  Consumer wants more
steak as income
increases: Steak is a
normal good
 Consumer also wants
ICC more designer clothes as
C
15 income increases:
10 U3 Designer clothes are
B U2 normal goods
5
A
 Normal good: You buy
U1
more when your income
increases.
4 10 16 Designer clothes
(units)
35

36. Inferior goods
Steak
Between A & B:
(units)  Both steak & hamburger are
normal goods. You buy more of
both as your income increases.
C
15 Between B & C:
U3  Steak is still a normal good.
 Hamburgers become an
B inferior good – consumer wants
9
less hamburgers (106) as
income increases.
U2
5
 ICC:
A
U1  upward-sloping between A &
Hamburger
B, backward-bending
4 6 10
(units) between B & C.
36

37. Engel Curves
Engel curves relate the quantity of a good to INCOME.
Income 30
($ per
month)
Engel curves slope
20 upward for
normal goods.
10
Steak (units
4 8 12 16 per month)
37

38. Engel Curves
Income 30
($ per
month) Inferior
Engel curves are
20 backward bending
for inferior goods.
Normal
10
Hamburger (units
4 8 12 16 per month)
38

39. Income and Substitution Effects
 A change in price can be broken down into 2
effects:
 Substitution Effect
 Income Effect
39

40. Substitution Effect
 Occurs because the RELATIVE PRICE of a good
changes
 Example: when the price of apples increases, apples
become more expensive relative to pears
 You buy fewer apples but more pears, that is, you
SUBSTITUTE pears for apples to keep your
UTILITY CONSTANT
 Definition: The substitution effect is the change in a
good’s consumption associated with a change in the
RELATIVE PRICE
__________________ of the good, with the level of
UTILITY CONSTANT
____________________.
40

41. Finding the Substitution Effect
 Following a price change, move the
budget line back until it is just tangent to
the original IC. The SUBSTITUTION
EFFECT is the movement around the
original IC.
41

42. Substitution Effect When Price Falls:
Graphical Representation
Clothing Price of food decreases: Budget line rotates
(units) outward from L1 to L2.
Recall Substitution effect:
Change in relative price; Utility constant
Change in relative price 
Change in slope of original budget line L1
A
Utility constant 
Stay at original indifference curve U1
D B The substitution is F1E
(move from A to D).
Substitution U2
effect U1
L1 L2
F1 E F2 Food (units)
Total effect
42

43. Income Effect
 Occurs because consumers experience a
change in REAL PURCHASING POWER when
price changes
 Example: when the price of apples
increases, your overall ability to purchase goods
decreases.
 Definition: The income effect is the change in a
REAL PURCHASING POWER
good’s consumption brought about by a change
in ___________________________.
43

44. Finding the Income Effect
 The Income effect is the movement
between the ARTIFICIAL optimum used
to find the Substitution effect, and the
consumer’s new utility maximising
position.
44

45. Income Effect When Price Falls:
Graphical Representation
Clothing Recall Income effect:
(units) Change in overall real purchasing power
Change in real purchasing power 
Parallel shift from dotted red line to budget line L2
The income effect is EF2
(move from D to B).
A
TIP:
The dotted red line
must ALWAYS be
D
B PARALLEL to L2.
Substitution Income U2
effect U1
effect
L L2
1
F1 E F2 Food (units)
Total effect
45

46. Income Effect When Price Falls:
Normal Good
Clothing
(units) This graph shows that food
is a NORMAL good.
Recall: A normal good is a good you buy
MORE of as your income increases.
A Consumer moves from D to B,
so the units of food INCREASE
from E to F2
D
B
Substitution Income U2
effect effect U1
L1 L2
F1 E F2 Food (units)
46

47. Income Effect When Price Falls:
Inferior Good
Clothing
This graph shows that food is an
(units) INFERIOR good.
Recall: An inferior good is a good you
buy LESS of as your income increases.
Consumer moves from D to
A B, so the units of food
B DECREASE from E to F2
U2
D
Income
Substitution effect
effect U1
L 1 L2
F1 F2 E Food (units)
47

48. Income Effect When Price Falls:
Giffen Good
Clothing
(units) This graph shows that food is a
GIFFEN good.
A Giffen good is a special case of
an inferior good.
A U2
The income effect is so
large that it is greater than
D
the substitution effect.
Income
effect
Substitution
U1
effect L1 L2
F2F1 E Food (units)
48

49. Summary of Price Falls
1. Normal Good
Income effect reinforces Substitution effect.
2. Inferior Good, Not Giffen
Income effect offsets Substitution effect but
does not dominate.
3. Inferior Good, Giffen
Income effect offsets Subsitution effect and
dominates.
49

50. Substitution & Income Effects When
Price Rises When the price of food rises, the budget line
rotates inward from L1 to L2.
Clothing The substitution effect is F1E
(units) (move from A to D).
The income effect is EF2
(move from D to B).
B
D
Note we are assuming that
food is a NORMAL good
here. Why?
The income effect is
A going in the same
direction as the
U2 substitution effect.
Income Substitution U1
effect Leffect
2
L1
F2 E F1 Food (units)
50

51. Income Effect:
Normal, Inferior and Giffen Goods
When price decreases When price increases
Substitution Income Income Substitution
effect effect
Normal effect effect
Total effect Total effect
Substitution Substitution
effect effect
Inferior
Income Income
effect effect
Total effect Total effect
Substitution Substitution
effect effect
Giffen
Income Income
effect effect Total effect
Total effect
51

52. Question on Substitution & Income
Effects
Assume that beer is an inferior good. If the price of
beer falls, then the substitution effect results in the
person buying ______ of the good and the income
effect results in the person buying ________ of the
good.
A. more, more Substitution effect:
B. less, less Price  - buy more
C. less, more
Income effect:
D. more, less Inferior good – so the income effect
must work in the opposite direction from
the substitution effect - buy less
52

53. Question on Substitution & Income
Effects
You have just won a cash
award of $500 for academic
excellence.
A. The substitution effect of
this award will be larger than Almost everyone got this
its income effect. one wrong in a past year
test!
B. The income effect of this
award will be larger than its
substitution effect.
C. The substitution and Assignment Tip:
income effects will be of A cash award OR
identical size. CASH BONUS is like
giving ‘income’ to
D. It is impossible to know someone.
whether the substitution
effect is larger than the
income effect or vice versa. 53

54. Substitution & Income Effects:
Policy Application (Carbon Tax)
All other The Australian government is proposing
goods
to tax carbon which will increase
electricity prices
Substitution effect is F1E (move
D
from A to D).
B
The income effect is EF2 (move
from D to B, implying that
A electricity is a NORMAL good).
U1 NB the income
Income Substitution
L2 effect also causes
effect effect U2 L1
O F2 Electricity
the demand for all
E F1
other goods to fall
54

55. Substitution & Income Effects:
Policy Application (Carbon Tax)
However, the government is also planning to
All other compensate low income families by reduced
goods
their income tax.
When the government reduces income
tax, it is giving cash back to taxpayers.
D
B If it fully compensates for the
effects of tax this will cancel out
the income effect resulting in
budget line L3.
A
U1 NB the tax will still
Income Substitution affect the use of
L2 L3
effect effect U L1 electricity, due to
2
O F2 E F1 Electricity the substitution
effects
55

56. Learning Outcomes
 Understand how consumers maximise satisfaction
 Graphical representation and formula
 Trace the effects of price changes from consumer choice
to the demand curve
 Price consumption curve
 Trace the effects of income changes from consumer
choice to the demand curve
 Income consumption curve
 Gain an understanding of different types of goods
demanded by consumers
 Normal goods, inferior & Giffen goods
 Engel curve
56

57. Learning Outcomes
 Examine the effects of price changes in terms of
substitution and income effects
 Substitution effects
 Income effects
 Tip: Learn to draw the diagrams accurately!
Practice … p
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