b) Indifference curves and

budget lines
Also, very, very important for the
exam

1
 The Budget Constraint
A budget line (also called a budget constraint) is a schedule or a
curve showing the various combinations of two products a
consumer can purchase with a specific money income.

– Can be between Good A and Good B

– Can be between Good A and All Other Goods

It is similar to a linear PPF or PPC.

2
2
The Budget Line: What is Attainable
Combinations of two products a consumer can purchase with
their money income.

Slope is the ratio of the price of B to the price of A

• Varies with income changes
• Varies with price of products

3
3
The Budget Line: What is Attainable
An increase in the price of one product will shift the budget line
down reflecting the ability to buy fewer units of that product.

A decrease in the price of one product will shift the budget line out
reflecting the ability to buy more units of that product.

If the prices of both goods increase the budget line shifts left
reflecting the loss in ability to purchase as much of both goods as
before.

If the prices of both goods decrease the budget line shifts right
reflecting the increase in ability to purchase as much of both goods
as before.
4
4
 The Budget Line

Units of A Units of B Total 12

(Price = $1.50) (Price = $1) Expenditure Income = $12
10 PA = $1.50

Quantity of A
8 0 $12 8 (Unattainable)
6 3 12 6
4 6 12 Income = $12
4
2 9 12 PB = $1
2 (Attainable)
0 12 12
0
2 4 6 8 10 12
Quantity of B

5
5
The Budget Line – Income Change

6
6
The Budget Line – Price Change

7
7
 Budget Line - Example 1
 
Pizza and beer are the only two goods Jon consumes. The price of beer is $2.00 per beer
and pizza is $1.25 per slice. If Jon has only $10 to spend for the evening, which graph
represents the set of possible combinations of beer and pizza that he can buy? 

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8
 Budget Line - Example 2
Which graph shows a change in the price of X, but no changes in the price of Y and in the
buyer's budget? 

9
9
 Budget Line - Example 3
Which graph shows a change in the buyer's income, but no changes in the prices
of X and Y? 

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10
Indifference Curves: What is Preferred
Combinations of two products that yield the same amount of
total utility.

The consumer is indifferent as to which combination to purchase

along an indifference curve.

Downsloping – The indifference curve is downward sloping

because more of one product means fewer units of the other for
total utility to remain the same.

Convex to the origin – reflecting the MRS (marginal rate of

substitution) of one good for the other.

11
LO6 11
 Indifference Curves
12 j
10
Combination Units of A Units of B

Quantity of A
8
k
j 12 2 6
l
k 6 4 4 m

l 4 6 2 I

m 3 8 0
2 4 6 8 10 12
Quantity of B

12
12
 Substitutes and Compliments

13
LO6 13
 The Indifference Map
Series of indifference curves where each curve reflects different
amounts of utility

Each successive curve

outward reflects a higher
level of utility

Note: Indifference curves cannot cross

14
LO6 14
 Equilibrium at Tangency
The consumer’s equilibrium position

– Indifference curve is tangent to the budget line

– Utility is maximized

– Here the Marginal Rate of Substitution (MRS) equals the

ratio of the price of B to the price of A

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15
 Equilibrium at Tangency

12

10
PB
MRS =
PA
8
Quantity of A

Preferred –
6 W But Requires
More Income
4 X

I4
2 I3
I2
I1
0
2 4 6 8 10 12
Quantity of B

16
LO6 16
 Derivation of the Demand
Curve

17
Derivation of the Demand

Income is increasing this

causes a shift in demand
– price hasn’t changed
Curve

18
Income Rises – Normal Good

19
19
Income Rises – Inferior Good

20
20
 Income Effect
Income effect is the impact that a price change has on a
consumer’s real income and, consequently, on the quantity
demanded of the good.

If the price of a good falls, income is freed up and can be used

to buy more of both, or either, good under consideration.

The income effect is shown by the fact that a decline in price

expands the consumer’s real income and the consumer can
purchase more of this and other products until equilibrium is
once again attained for the new level of real income.

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21
 Income Effect
Price decrease → increase in real income
– Increase quantity demanded of normal goods
– Decrease quantity demanded of inferior goods

Price increase → decrease in real income

– Decrease quantity demanded of normal goods
– Increase quantity demanded of inferior goods

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22
 Substitution Effects
If the price of a product falls, this decreases its relative
expensiveness and thus the consumer will now substitute more
of this good for the other.

When the price of an item declines, the consumer will no longer

be in equilibrium until more of the item is purchased and the
marginal utility of the item declines to match the decline in
price.

More of this item is purchased rather than another relatively

more expensive substitute.

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 Substitution Effect
Price decrease → Quantity demanded increases
– Consumers forego consumption of now relatively more
expensive substitutes

Price increase → Quantity demanded decreases

– Consumers switch to substitutes that are now relatively
less expensive

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24
Income and Substitution Effects
The substitution effect and income effect work simultaneously.

It is often difficult to know which effect dominates

25
25
Income and Substitution Effects

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26
 Income and Substitution Effects
The substitution effect: price change causes consumer to move
from one point on an indifference curve to another point on the
same curve.
– From point A to point B

The income effect: now the consumer moves to the new possible
indifference curve.
– From point B to point C

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27
 Income and Substitution Effects

Good Income Effect Substitution Effect Total Effect

Pepsi The consumer has Pepsi is now relatively The income and substitution
more real income, cheaper than pizza, so effects for Pepsi act in the
thus buys more Pepsi the consumer buys more same direction, thus the
(normal good). Pepsi. consumer buys more Pepsi.

Pizza The consumer has Pizza is now relatively The income and substitution
more real income, more expensive than effects for pizza act in
thus buys more pizza Pepsi, so the consumer opposite directions, thus the
(normal good). buys less pizza. net effect is indeterminate.

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28
Price Decrease – Normal Good
Good Y The consumer is consuming along
budget constraint B1 at point A along
indifference curve I1

I1

B1

Good X
29
Price Decrease – Normal Good
Good Y If the Price of Good X decreases then we can
buy more. This is shown as a shift outward of
the budget constraint from B1 to B2 showing
more of Good X can be afforded.

The result is both an increase in the

consumer’s real income and a change in the
relative price of Good X to Good Y.

A
I1

B1 B2

Good X
30
Price Decrease – Normal Good
Good Y We are now on the new
indifference curve I2

The consumer’s utility is

maximized at Point B.

Quantity consumed of Good X

B has increased from XA to XB
A
I2 Why?
I1

B1 B2

XA XB Good X
31
Price Decrease – Normal Good
The substitution effect is the consumer’s
consumption moving from A→C due to the
Good Y change in relative price.

C is still on I1 but has adjusted for the new

relative price of Good Y/Good X.

(Note the gradient of B2(b) and B2 are the

same, thus have the same relative price)
A C
I1

B1 B2

(S) Good X
B2(b) 32
Price Decrease – Normal Good
The income effect is the consumer’s
Good Y consumption moving from C→B because the
consumer’s real income has risen from B1 to
B2.

B is on I2 along the new budget constraint B2

and thus gives higher utility than I1.

B Consumption of Good X and Good Y have

A C both increased in this example.
I2
I1

B1 B2

(S) (I) Good X

B2(b) 33
Price Decrease – Inferior Good

Good Y The consumer is consuming along

budget constraint B1 at point A along
indifference curve I1

A
I1

B1

Good X
34
Price Decrease – Inferior Good
Good Y If the Price of Good X decreases then
we can buy more. This is shown as a
shift outward of the budget
constraint from B1 to B2 showing
more of Good X can be afforded.

The result is both an increase in the

consumer’s real income and a
change in the relative price of Good
A X to Good Y.

I1

B1 B2

Good X
35
Price Decrease – Inferior Good
Good Y We are now on the new
indifference curve I2

The consumer’s utility is

maximized at Point B.

B Quantity consumed of Good X

has increased from XA to XB
I2
A
I1 Why?

B1 B2
XA X B
Good X
36
Price Decrease – Inferior Good
The substitution effect is the consumer’s
Good Y consumption moving from A→C due to the change
in relative price.

C is still on I1 but has adjusted for the new relative

price of Good Y/Good X.

(Note the gradient of B2(b) and B2 are the same, thus

have the same relative price)
A C
I1

B1 B2
(S)
Good X
B2(b) 37
Price Decrease – Inferior Good
The income effect is the consumer’s consumption
Good Y moving from C→B because the consumer’s real
income has risen from B1 to B2.

B is on I2 along the new budget constraint B2 and

thus gives higher utility than I1.

B Note the income effect here is negative, meaning

Good X is an inferior good.
I2
A C
I1

B1 B2
(S) (I)
Good X
B2(b) 38
 Price Decrease – Giffen Good

Good Y The consumer is consuming along

budget constraint B1 at point A along
indifference curve I1

I1

B1

Good X
39
 Price Decrease – Giffen Good
If the Price of Good X decreases then
Good Y
we can buy more. This is shown as a
shift outward of the budget
constraint from B1 to B2 showing
more of Good X can be afforded.

The result is both an increase in the

consumer’s real income and a
A change in the relative price of Good
X to Good Y.

I1

B1 B2

Good X
40
 Price Decrease – Giffen Good
Good Y We are now on the new
indifference curve I2

The consumer’s utility is

maximized at Point B.
B
Quantity consumed of Good X
I2 has decreased from XA to XB
A

Why?
I1

B1 B2
X B XA
Good X
41
 Price Decrease – Giffen Good
Good Y The substitution effect is the consumer’s consumption
moving from A→C due to the change in relative price.

C is still on I1 but has adjusted for the new relative price

of Good Y/Good X.

(Note the gradient of B2(b) and B2 are the same, thus have
the same relative price)
A
C
I1

B1 B2
(S)
Good X
B2(b) 42
 Price Decrease – Giffen Good
The income effect is the consumer’s consumption
Good Y moving from C→B because the consumer’s real income
has risen from B1 to B2.
B is on I2 along the new budget constraint B2 and thus
gives higher utility than I1.
Note the income effect here is negative, meaning Good X
B
is an inferior good; also although the price decreased
less total is consumed, meaning it is a Giffen good.
I2
A
C
I1

B1 B2
(I) (S)
Good X
B2(b) 43
Price Increase – Normal Good
The consumer is consuming along
Good Y budget constraint B1 at point A along
indifference curve I1

I1

B1

Good X
44
Price Increase – Normal Good
If the Price of Good X increases then we can
Good Y
buy less. This is shown as a shift inward of
the budget constraint from B1 to B2 showing
less of Good X can be afforded.

The result is both an decrease in the

consumer’s real income and a change in the
relative price of Good X to Good Y.
A

I1

B1
B2
Good X
45
Price Increase – Normal Good
Good Y We are now on the new indifference curve I2

The consumer’s utility is maximized at Point B.

Quantity consumed of Good X has decreased

from XA to XB

Why?
A
B
I1
I2

B1
B2
XB XA Good X
46
Price Increase – Normal Good
The substitution effect is the
Good Y
consumer’s consumption moving from
A→C due to the change in relative price.

C is still on I1 but has adjusted for the

new relative price of Good Y/Good X.

C (Note the gradient of B2(b) and B2 are the

A same, thus have the same relative price)

I1

B1
B2
(S)
Good X
B2(b) 47
 Price Increase – Normal Good
Good Y The income effect is the consumer’s
consumption moving from C→B because
the consumer’s real income has fallen
from B1 to B2.

B is on I2 along the new budget

constraint B2 and thus gives higher utility
C than I1.
A
B Note the income effect here is negative,
I1 meaning Good X is normal good.
I2

B1
B2
(I) (S)
Good X
B2(b) 48
Price Increase – Inferior Good

Good Y The consumer is consuming along

budget constraint B1 at point A along
indifference curve I1

I1

B1

Good X
49
 Price Increase – Inferior Good

Good Y If the Price of Good X increases then we can

buy less. This is shown as a shift inward of the
budget constraint from B1 to B2 showing less of
Good X can be afforded.

The result is both an decrease in the

consumer’s real income and a change in the
relative price of Good X to Good Y.
A

I1

B1
B2
Good X
50
Price Increase – Inferior Good
Good Y We are now on the new indifference curve I2

The consumer’s utility is maximized at Point B.

Quantity consumed of Good X has decreased from

XA to XB

Why?
A

I1
B

B1
B2 I2
XB XA Good X
51
Price Increase – Inferior Good
The substitution effect is the consumer’s
Good Y consumption moving from A→C due to the
change in relative price.

C is still on I1 but has adjusted for the new

C relative price of Good Y/Good X.

(Note the gradient of B2(b) and B2 are the same,

thus have the same relative price)
A

I1

B1
B2
(S) Good X
Budget 2(b)
52
Price Increase – Inferior Good
The income effect is the consumer’s
Good Y consumption moving from C→B because the
consumer’s real income has fallen from B1 to B2.

B is on I2 along the new budget constraint B2 and

C thus gives higher utility than I1.

Note the income effect here is positive, meaning

A Good X is an inferior good.

I1
B

I2 B1
B2
(I) (S) Good X
Budget 2(b)
53
 Price Increase – Giffen Good

Good Y The consumer is consuming along

budget constraint B1 at point A along
indifference curve I1

I1

B1

Good X
54
 Price Increase – Giffen Good
If the Price of Good X increases then we can
Good Y buy less. This is shown as a shift inward of the
budget constraint from B1 to B2 showing less of
Good X can be afforded.

A The result is both an decrease in the

consumer’s real income and a change in the
I1 relative price of Good X to Good Y.

B1
B2
Good X
55
Price Increase – Giffen Good
We are now on the new indifference curve I2
Good Y
The consumer’s utility is maximized at Point B.

Quantity consumed of Good X has increased from

A XA to XB

I1 Why?

I2
B1
B2
XA XB Good X
56
Price Increase – Giffen Good
The substitution effect is the consumer’s
consumption moving from A→C due to the
Good Y
change in relative price.

C C is still on I1 but has adjusted for the new relative

A price of Good Y/Good X.

I1 (Note the gradient of B2(b) and B2 are the same,

thus have the same relative price)

B1
B2
(S) Good X
Budget 2(b)
57
Price Increase – Giffen Good
The income effect is the consumer’s
consumption moving from C→B because the
Good Y
consumer’s real income has fallen from B1 to
B2.
C
A B is on I2 along the new budget constraint B2
and thus gives higher utility than I1.
I1
Note the income effect here is positive,
meaning Good X is an inferior good; also
although the price increased more is
consumed, meaning it’s a Giffen good.
B

I2
B1
B2
(S) (I) Good X
Budget 2(b)
58
 I & S Review
Good X (horizontal axis)

Substitution Income
Normal Increase Increase
Price
Decrease Inferior Increase > Decrease <
Giffen increase < Decrease >

Substitution Income
Normal Decrease Decrease
Price
Increase Inferior Decrease > Increase <
Giffen Decrease < Increase >
59
I&S Effect For Normal Good

60
60
I&S Effect For Inferior Good

61
61
 I&S Effect For Giffen Good

• Review: Giffen Good

• Goods that violate the Law of Demand;
their demand curves slope upward
• Inferior goods for which the income
effect dominates the substitution effect
• “Giffen Paradox” where an inferior good
that becomes more expensive is then
consumed more!
62
62
I&S Effect For Giffen Good

63
63
I&S Effect For Giffen Good

64
64