<7.2  INDIFFERENCE CURVES & BUDGET LINES>

• BUDGET LINES: As shown in Chapter 2, consumers are constrained in what they are able to buy due to their limited income and the prices of goods they wish to buy. Th ese two important underpinning principles of consumer behaviour are brought together in the idea of a budget line. Th is shows numerically all the possible combinations of two products that a consumer can purchase with a given income and fi xed prices.

• Suppose someone has $200 to spend on two products, A and B. Assume the price of A is $20 and the price of B is $10. Table 7.2 shows the possible combinations that can be purchased. Each of the combinations would cost $200 in total. Figure 7.1a shows the budget line for this situation. Any point along this line will produce an outcome where consumption is maximised for this level of income. 

• If there is a change in the price of one good, with income remaining unchanged, then the budget line will pivot. For example, if the price of product B falls, then more of this product can be purchased at all levels of income. Th e budget line will shift outwards, from its pivot at point A. Th is is shown in Figure 7.1b. So, if the price of B falls by a third, then 30 of good B can now be purchased with an income of $200. 

• As the price of B has fallen relative to that of A, which is unchanged, consumers will substitute B for A. This is known as the substitution effect of a price change. It is always the case that the rational consumer will substitute towards the product which has become relatively cheaper. With the fall in the price of B, the consumer actually has more money to spend on other products, B included. Real income has therefore increased, which may mean that a consumer may now actually purchase more of product B. Th is is called the income effect of a price change.

INDIFFERENCE CURVES

Th e budget constraint referred to above showed what

combination of goods a consumer could buy with given

income and the prices of goods. Th is is only part of the reason why consumers buy particular goods – what is also

relevant is consumer preference. Consumers will only buy

a particular good if it is something that they actually want

or prefer when having to choose between alternatives.

Consumer preferences can be represented diagrammatically

by what are known as indiff erence curves.

Indiff erence curve: this shows the diff erent combinations

of two goods that give a consumer equal satisfaction.

KEY TERM

As the name suggests, an indiff erence curve shows

the diff erent combinations of two goods that give the

consumer equal satisfaction. Figure 7.2 shows two such

indiff erence curves out of the many that can apply to a

particular consumer. Considering indiff erence curve I1,

the consumer is indiff erent with respect to combinations

X, Y or Z since each are on the same indiff erence curve.

If the consumer moves from point Z to Y, then the

consumption of good B falls at the expense of an increase

in consumption of good A. Point Y though still represents

a situation where the consumer is still equally happy with

the combination of goods that are being consumed.

Th e slope of the indiff erence curve is important – it

represents the extent to which the consumer is willing to

substitute one good for another. Looking at Figure 7.2,

both the curves slope more steeply from left to right

showing that when consuming large amounts of good A,

the consumer is willing to give up rather more of this good

when consumption of good B is small. Th e rate at which

the consumer is willing to substitute one good for another

in this way is known as the marginal rate of substitution.

Th e budget line constraint and the indiff erence curve

can now be used together to show the eff ect of a change

in income on the consumption of two goods. Th is is

indicated in Figure 7.3. A consumer’s choice is optimal at

the point where the budget line touches or is at a tangent

to the highest indiff erence curve. So, E1 will give the

consumer the maximum combined consumption of goods

A and B given the budget constraint shown by the budget

line B1.

If income increases then this will allow the consumer

to choose a better combination of goods A and B. Th is will

usually be more of each good. So, if the budget constraint

rises to B2, then the consumer will increase consumption

of good A and also of good B, albeit to a lesser extent.

E2 is the new optimal position, where more of both goods are being consumed. Th e change in position from E1 to E2

is what occurs when both goods are normal goods. If the

increase in income or budget constraint results in less of

one good being consumed then this is an inferior good.

When there is a fall in consumer income, the budget

line shift s to the left in a parallel way. Th is indicates

that both goods are normal and that less of each will be

consumed.

Income and substitution eff ects of a price change using indiff erence curves

Th e income and substitution eff ects of a price change were

briefl y outlined earlier. Th ese eff ects can now be interpreted

using indiff erence curves. Th is is shown in Figure 7.4.

If the price of good A falls, then this means that the

consumer has more spending power. Th is is represented

by the new budget constraint B2. Th e price of good B

remains the same which is why B2 pivots upwards to a

new position. Th e extent of change that occurs consists of

two stages. Th ese are:

1 A movement along the initial indiff erence curve I1 to point

E2. This is the substitution eff ect. It is so-called since the

consumer buys less of good B as it is now relatively more

expensive than good A.

2 A shift upwards to a higher indiff erence curve, moving from

point E2 to E3. This is the income eff ect. As the consumer

has more spending power, it is positive in the case of both

goods, resulting in an increase in consumption of good B as

well as good A.

In the case of good A, the income and substitution eff ects

are both positive, resulting in a substantial increase

in consumption. For good B, the substitution eff ect is

negative but the fall in consumption is to some extent

off set by the positive income eff ect. So here, the income and substitution eff ects are pulling in opposite directions.

In Figure 7.4 there is a fall in consumption of good B as the

substitution eff ect is stronger than the income eff ect.

In the case of inferior goods, as we saw in Chapter 2,

when incomes rise above a certain point consumers tend to

substitute more expensive and better quality alternatives.

Here, the income eff ect is negative. Whether this leads to

a fall in consumption will depend on the relative strength

of the substitution eff ect. If this is greater than the income

eff ect, then more of the inferior good will be consumed.

Budget lines and indiff erence curves assume we are

dealing with rational consumers; the reality is that this is

not necessarily true for many consumers.