Indifference Curves

An indifference curve shows a set of

consumption bundles among which the
individual is indifferent
Quantity of X
Quantity of Y
X
1

Y
1

Y
2

X
2

U
1

Combinations (X
1
, Y
1
) and (X
2
, Y
2
)
provide the same level of utility
Marginal Rate of Substitution
The negative of the slope of the
indifference curve at any point is called
the marginal rate of substitution (MRS)
Quantity of X
Quantity of Y
X
1

Y
1

Y
2

X
2

U
1

1
U U
dX
dY
MRS
=
=
Marginal Rate of Substitution
MRS changes as X and Y change
reflects the individuals willingness to trade Y
for X
Quantity of X
Quantity of Y
X
1

Y
1

Y
2

X
2

U
1

At (X
1
, Y
1
), the indifference curve is steeper.
The person would be willing to give up more
Y to gain additional units of X
At (X
2
, Y
2
), the indifference curve
is flatter. The person would be
willing to give up less Y to gain
additional units of X
Indifference Curve Map
Each point must have an indifference
curve through it
Quantity of X
Quantity of Y
U
1

U
2

U
3

U
1
< U
2
< U
3

Increasing utility
Transitivity
Can two of an individuals indifference
curves intersect?
Quantity of X
Quantity of Y
U
1

U
2

A
B
C
The individual is indifferent between A and C.
The individual is indifferent between B and C.
Transitivity suggests that the individual
should be indifferent between A and B
But B is preferred to A
because B contains more
X and Y than A
Convexity
A set of points is convex if any two points
can be joined by a straight line that is
contained completely within the set
Quantity of X
Quantity of Y
U
1

The assumption of a diminishing MRS is
equivalent to the assumption that all
combinations of X and Y which are
preferred to X* and Y* form a convex set
X*
Y*
Convexity
If the indifference curve is convex, then
the combination (X
1
+ X
2
)/2, (Y
1
+ Y
2
)/2
will be preferred to either (X
1
,Y
1
) or (X
2
,Y
2
)
Quantity of X
Quantity of Y
U
1

X
2

Y
1

Y
2

X
1

This implies that well-balanced bundles are preferred
to bundles that are heavily weighted toward one
commodity
(X
1
+ X
2
)/2
(Y
1
+ Y
2
)/2
Utility and the MRS
Suppose an individuals preferences for
hamburgers (Y) and soft drinks (X) can
be represented by

Y X = = 10 utility
Solving for Y, we get
Y = 100/X

Solving for MRS = -dY/dX:
MRS = -dY/dX = 100/X
2
Utility and the MRS
MRS = -dY/dX = 100/X
2
Note that as X rises, MRS falls
When X = 5, MRS = 4
When X = 20, MRS = 0.25


Marginal Utility
Suppose that an individual has a utility
function of the form
utility = U(X
1
, X
2
,, X
n
)
We can define the marginal utility of
good X
1
by
marginal utility of X
1
= MU
X1
= cU/cX
1

The marginal utility is the extra utility
obtained from slightly more X
1
(all else
constant)
Marginal Utility
The total differential of U is

n
n
dX
X
U
dX
X
U
dX
X
U
dU
c
c
+ +
c
c
+
c
c
= ...
2
2
1
1
n X X X
dX MU dX MU dX MU dU
n
+ + + = ...
2 1
2 1
The extra utility obtainable from slightly
more X
1
, X
2
,, X
n
is the sum of the
additional utility provided by each of
these increments

Deriving the MRS
Suppose we change X and Y but keep
utility constant (dU = 0)
dU = 0 = MU
X
dX + MU
Y
dY
Rearranging, we get:
Y U
X U
MU
MU
dX
dY
Y
X
c c
c c
= =
=
/
/

constant U
MRS is the ratio of the marginal utility of
X to the marginal utility of Y
Diminishing Marginal Utility
and the MRS
Intuitively, it seems that the assumption
of decreasing marginal utility is related to
the concept of a diminishing MRS
Diminishing MRS requires that the utility
function be quasi-concave
This is independent of how utility is measured
Diminishing marginal utility depends on how
utility is measured
Thus, these two concepts are different


Marginal Utility and the MRS
Again, we will use the utility function



5 0 5 0 . .
utility Y X Y X = =
The marginal utility of a soft drink is
marginal utility = MU
X
= cU/cX = 0.5X
-
0.5
Y
0.5

The marginal utility of a hamburger is
marginal utility = MU
Y
= cU/cY = 0.5X
0.5
Y
-
0.5






X
Y
Y X
Y X
MU
MU
dX
dY
MRS
Y
X
= = = =

=
5 0 5 0
5 0 5 0
5
5
. .
. .
constant U
.
.

Examples of Utility Functions
Cobb-Douglas Utility
utility = U(X,Y) = X
o
Y
|

where o and | are positive constants
The relative sizes of o and | indicate the
relative importance of the goods
Examples of Utility Functions
Perfect Substitutes
utility = U(X,Y) = oX + |Y
Quantity of X
Quantity of Y
U
1

U
2

U
3

The indifference curves will be linear.
The MRS will be constant along the
indifference curve.
Examples of Utility Functions
Perfect Complements
utility = U(X,Y) = min (oX, |Y)
Quantity of X
Quantity of Y
The indifference curves will be
L-shaped. Only by choosing more
of the two goods together can utility
be increased.
U
1

U
2

U
3

Examples of Utility Functions
CES Utility (Constant elasticity of
substitution)
utility = U(X,Y) = X
o
/o + Y
o
/o
when o = 0 and
utility = U(X,Y) = ln X + ln Y
when o = 0
Perfect substitutes o = 1
Cobb-Douglas o = 0
Perfect complements o = -
Examples of Utility Functions
CES Utility (Constant elasticity of
substitution)
The elasticity of substitution (o) is equal to
1/(1 - o)
Perfect substitutes o =
Fixed proportions o = 0

Homothetic Preferences
If the MRS depends only on the ratio of
the amounts of the two goods, not on
the quantities of the goods, the utility
function is homothetic
Perfect substitutes MRS is the same at
every point
Perfect complements MRS = if Y/X >
o/|, undefined if Y/X = o/|, and MRS = 0 if
Y/X < o/|
Nonhomothetic Preferences
Some utility functions do not exhibit
homothetic preferences
utility = U(X,Y) = X + ln Y
MU
Y
= cU/cY = 1/Y
MU
X
= cU/cX = 1
MRS = MU
X
/ MU
Y
= Y
Because the MRS depends on the
amount of Y consumed, the utility function
is not homothetic

Important Points to Note:
If individuals obey certain behavioral
postulates, they will be able to rank all
commodity bundles
The ranking can be represented by a utility
function
In making choices, individuals will act as if they
were maximizing this function
Utility functions for two goods can be
illustrated by an indifference curve map
Important Points to Note:
The negative of the slope of the
indifference curve measures the marginal
rate of substitution (MRS)
This shows the rate at which an individual
would trade an amount of one good (Y) for one
more unit of another good (X)
MRS decreases as X is substituted for Y
This is consistent with the notion that
individuals prefer some balance in their
consumption choices
Important Points to Note:
A few simple functional forms can capture
important differences in individuals
preferences for two (or more) goods
Cobb-Douglas function
linear function (perfect substitutes)
fixed proportions function (perfect
complements)
CES function
includes the other three as special cases