Consumer Equilibrium with Indifference Curves

The combination of an individual's indifference curves and budget line allows us to represent consumer equilibrium in a way that is equivalent to the method of marginal utility analysis.

At A, the relevant indifference curve is exactly tangent to the budget line. This means that the slope of the budget line is equal to the slope of the indifference curve. We therefore know that in equilibrium the ratio of the marginal utility of the good on the horizontal axis (oranges) to the marginal utility of the good on the vertical axis (apples), indicated by the slope of the indifference curve, is equal to the ratio of the price of oranges to the price of apples, indicated by the slope of the budget line. Or, expressed somewhat differently:

 

Marginal utility of oranges = Price of oranges

Marginal utility of apples Price of apples

 

Apples per week (1$ per pound)

 

 

 

0 5 Oranges per week ($ per pound)

Figure 8. Determining Consumer Equilibrium with Indifference Curves

 

With terms rearranged, this formula is exactly the same result we arrived at earlier in the chapter when we discussed consumer equilibrium in marginal utility terms without the aid of indifference curves That is, the above expression is equivalent to:

Marginal utility of oranges = Marginal utility of apples

Price of oranges Price of apples

The two approaches thus yield similar predictions about consumer behavior.

Indifference Curves and the Law of Demand

Indifference curve analysis can also be used to demonstrate the law of demand. Demand curves are obtained by allowing the price of one of two goods to change and finding the new equilibrium quantities demanded of the two goods.

Apples per week (1$ per pound)

 

 

A₂

A₁

 

0 O₁ O₂ 5 10 Oranges per week (1$ per pound)

Figure 9. Indifference Curves and the Law of Demand

The increase in the quantity demanded of oranges from O₁ to O₂is composed of a substitution effect and an income effect. The substitution effect is reflected in the lower relative price of oranges as the budget line shifts outward. This lower relative price leads to increased orange consumption, just as the law of demand predicts The income effect measures the degree to which the consumer's real income has increased owing to the fall in the price of oranges In other words, the shift of the budget line outward means that the consumer is now wealthier Part of this increased wealth is spent on oranges and part on apples, the consumption of which rises from A₁ to A₂.

As the price of oranges falls from $2 a pound to $1 a pound the budget line shifts to the right from B₁ to B₂. The consumer reaches a higher level of utility and maximizes satisfaction by obtaining the highest indifference curve, I₂rather than I₁, possible. As the price of oranges falls the consumer purchases a larger quantity from O₁ to O₂.This is precisely what the law of demand predicts—that other things being equal quantity demanded vanes inversely with price.

 

LECTURE 3: PERFECT COMPETITION

1. Definition of Perfect Competition

2. The perfect competitor's demand curve

3. The short run and the long run

4. Economic and accounting profits

5. Decreasing, constant, and increasing cost industries

 

Definition of Perfect Competition

Perfect competition, as economists fondly point out, is an ideal state of affairs, which, unfortunately, does not exist in any industry. Perfect competition attains the ideal of always being right.

Under perfect competition, there are so many firms that no one firm is large enough to have any influence overprice.

No influence.

- If any action taken by the firm has any effect on price, that's influence.

- If a firm, by withholding half its output from the market was able to push up price, that would be influence.

- If a firm doubled its output and forced down price, that too would be influence.

- If a firm left the industry, which would make price go up, that would be influence on price.

Number of firms.

The industry under perfect competition includes many firms. So many that no one firm has any influence on price.

3. The perfect competitor is a price taker rather than a price maker. Price is set by industry wide supply and demand; the perfect competitor can take it or leave it.

Product.

For perfect competition to take place, all the firms in the industry must sell an identical, or standardized, product. That is, those who buy the product cannot distinguish between what one seller and another sells. So, in the buyer's mind, the product is identical. The buyer has no reason to prefer one seller to another.

A perfectly competitive industry has many firms selling an identical product. How many is many? So many that no one firm can influence price. What is identical? A product that is identical in the minds of buyers so that they have no reason to prefer one seller to another.

We've already discussed the two most important characteristics—actually, requirements—of perfect competition: many firms and an identical product. Two additional characteristics are perfect mobility and perfect knowledge.