IndifferenceCurves - Chapter 5 Appendix: Indifference...

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Chapter 5 Appendix: Indifference Curves In Chapter 5 we showed why the rational spending rule is a simple consequence of diminishing marginal utility. In this appendix, we introduce the concept of indifference curves to show how the same rule can be developed in another way. As before, we begin with the assumption that consumers enter the marketplace with well-defined preferences. Taking prices as given, their task is to allocate their incomes to best serve these preferences. There are two steps required to carry out this task. The first is to describe the various combinations of goods the consumer is able to buy. These combinations depend, we will see, on both her income level and on the prices of the goods she faces. The second step is then to select from among the feasible combinations, the particular one that she prefers to all others. Analysis of this step will require some means of describing her preferences, in particular a summary of the rank ordering she assigns to all feasible combinations. Development of these two elements of the theory will occupy our attention throughout this appendix. Because the first element-- describing the set of possibilities-- is much less abstract than the second, let us begin with it. The Budget Constraint For simplicity, let us begin by considering a world with only two goods, 1 food and shelter. A bundle of goods is the term used to describe a particular combination of food, measured in pounds per week, and shelter, measured in square yards per week. Thus, in Figure A5.1, one bundle (bundle A) might consist of 5 square yards per week of shelter and 7 pounds per week of food, while another (bundle B) consists of 3 square yards per week of shelter, 8 pounds per week of food. For brevity's sake, we may use the notation (5, 7) to denote bundle A, and (3, 8) to denote bundle B. More generally, (S 0 , F 0 ) will denote the bundle with S 0 sq yds/wk of shelter and F 0 lbs/wk of food. By convention, the first number of the pair in any bundle represents the good measured along the horizontal axis. Shelter Food (lbs/wk) B A 8 7 3 5 (sq yds/wk) Figure A5.1. Two Bundles of Goods. A bundle is a specific combination of goods. Bundle A has 5 units of shelter, 7 units of food. Bundle B has 3 units of shelter, 8 units of food. Note that the units on both axes are flows , which means physical quantities per unit of time-- lbs/wk, sq yds/wk. Consumption is always measured as a flow. It is 1 As economists use the term, a "good" may refer to either a product or a service.
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Appendix to Chapter 5    Page 2 important to keep track of the time dimension because, without it, there would be no way to evaluate whether a given quantity of consumption was large or small. (Suppose all you know is that your food consumption is 4 pounds. It that's how much you eat each day, it's a lot. But if that's all you eat in a month, you should submit your application for a tuition refund right away, because you won't be with us much longer.) Suppose the consumer's income is M=$100/wk, all of which she spends on some
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This note was uploaded on 05/26/2010 for the course FINA 6260 taught by Professor Fort during the Spring '10 term at University of Arkansas for Medical Sciences.

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IndifferenceCurves - Chapter 5 Appendix: Indifference...

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