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Microeconomics
Course: Microeconomics > Unit 5
Lesson 3: Utility maximization with indifference curvesOptimal point on budget line
Using indifference curves to think about the point on the budget line that maximizes total utility. Created by Sal Khan.
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What is Marginal Rate of Substitution?
(Sal Mensioned at4:40)(16 votes)
the Marginal Rate of substitution measures how much you have to give up a certain commodity to get another commodity while still being on the same level of satisfaction.(48 votes)
I was a little confused by the way Sal drew one indifference curve, and then to find the optimal point, he drew a different indifference curve. Is there an optimal point with the original indifference curve? Do you have to actually create a new indifference curve to find the optimal point? I thought the indifference curve was a static thing based on preferences.(21 votes)
The indifference curve is a static thing based on preferences. However, there are an infinite number of indifference curves, each with a different value of utility.
What the indifference curve says is that every point along it gives the same value of utility. All other points, not along that indifference curve give different amounts of utility.
When Sal drew a second indifference curve, he was saying that the amount of utility that that first one gave wasn't right. In this case he wanted a curve with more utility. So he made one.(15 votes)
What is the point of Indifference Curves if you can just put them anywhere you want and have as many on the graph at once as you want? I don't see the point of them even existing at that point, because if you add another indifference curve to the right & above of a previous one, then it essentially just negates the old one, making it useless..Anyone else?(6 votes)
Hello Arjun, if you add another indifference curve to the right and above it does not negates the previous one, because they are not tangent to the budget line. There is only one indifference curve that is tangent to the consumers budget line and only at one point.
At the point where MRS = P1 / P2. The MRS derived from the indifference curve and I believe was not shown in the video but it should be equal to the Price of chocolate divided by the price of fruit, which is 1/2. You are essentially willing to give up one unit of chocolate for twice as many units of the fruit, this is MRS.
So, my point is there is only one indifference curve that is tangent at only one point to the budget line. You can draw other indifference curves above and below that, but they would not negate the one. Since it is at only one point where consumer reaches its equilibrium and derives the maximum utility (pleasure) from the bundle of goods given his budget constraints (depicted by the budget line).
All the other indifference curves depicted as an aid to the example of inferior options or unattainable options.
One thing to keep in mind with this budget line and indifference curve equilibrium is that we are trying to figure out what combination of goods would maximize our utility given our budget constraints.
The budget line shows us simply the quantity of the combination of the products attainable given our limited income. And the indifference curve shows us simply utils derived from this combination.
At the tangency point, we are at optimum.(3 votes)
- Given this example of chocolate and fruit, what dictates the indifference curve? Is it the person's particular feeling / mood at the time of polling?
What dictates the indifference curve points on a wider example (say: a market)?(5 votes)
It's the preferences that dictate the utility funtion, thus the indifference curves. However, preferences are very difficult to measure and create a function from them. Still, they are very useful, as in many cases assuming a given type of utility function (like Cobb-Douglas, perfect substitutes, etc...) can well serve our purposes. Assuming for example in a model, that the consumer has Cobb-Douglas utility function might seem as a too great simplification, but they model usually explains what we experience in the real world, so economists believe it's worth using that utility function, even though we are not completely sure about the preferences of the consumer.(3 votes)
What is the difference between these two equations? 1. Px/Py = MUx/MUy and 2. MUx/Px = MUy/Py. I know that equation 1 is the budget line slope equal to the indifference curve slope which shows the utility maximization point relative to a budget constraint. But isn't equation 2 the same thing? I'm a bit confused. Thanks(2 votes)
Both formulae are the same thing; variables have simply been shifted around.(4 votes)
- Can you have more than one indifference curve that is tangent to the budget line?(1 vote)
You can have more than one indifference curve that is tangent to the budget line, but it means that the indifference curves belong to different person having the same budget constraint.(4 votes)
- Hi Sal,
Is the underlying assumption in this video that "consumption" of either fruits or chocolates are the only ways one could spend money? Or perhaps, is "consumption of any good" the only way to maximize one's utility? Is it possible that "saving money" could be another commodity like fruit or chocolate, and one could plot that in this budget graph and then, plot an indifference curve for that as well, so as to figure out one's optimal point in budget line? Thank you,(2 votes)- When we study the indifference curve,we do assume that there are only two goods in the economy. When we study the "savings" that comes under inter temporal choices where we study the consumption today and consumption in future that count as "savings" which is taken as the other commodity. Hope that solves the doubt!!(2 votes)
- is the shape of the indiffent curve on the original budget lineidentical with the shape of the indifferent curve on the new budget line? I guess these two curves have different shape at each optimal point. and one more. what was his intention of drawing the first indifference curve wich intersects the original budget line at (1, 18) and (8, 4)?He came up with the curve out of thin air?(2 votes)
- Good questions. I'll answer your questions backward, as I think it will make more sense.
Yes, he created those curves out of thin air. The indifference curves he drew are hypothetical examples—to derive one would be beyond the scope of this video (and in fact, this site, as it currently deals with first year microeconomics).
His purpose of drawing the first IC—which intersects (1,18) and (8,4)—is to show that there are two bundles (those two mentioned) that provide a certain level of utility and are "possible" (i.e., they can be purchased within a particular budget). What this means, which he goes on to show later in the video, is that there is another indifference curve—a "higher" IC—that only touches the budget line at one point. The point where an IC just touches (i.e., is tangential) to the budget curve is the bundle that provides the highest utility within the constraints of a budget (starting at4:14).
Because the slope of the indifference curve is constantly changing at each point along it, it will "look different" depending on the point of the IC that intersects or touches the budget curve. The optimal point on the first budget line will likely have a different slope than the optimal point on the second (i.e., "new") budget line.(2 votes)
- I was reviewing my microeconomic concepts and don't really want to open Varian. Question. We choose the point where the indifference curve is tangent to the budget constraint because at any point where the bc crosses the ic, there is another point which is affordable and at a higher ic? So in other words we can afford another bundle that gives us a higher utility(2 votes)
Exactly. Indifference curves are plotted for a particular value of 'total utility', and how different combinations of goods would add up to that value of total utility. If the Budget Line crosses the IC, it signifies that a higher value of 'total utility' is achievable, so we plot Indifference curves for those higher values, till we achieve the curve where the Budget line is tangent at exactly one point - giving the maximum value attainable of 'total utility'.(1 vote)
- what happens when the inflation increases the price of apple by 20 percent and orange by 35 percent. Does the budget line shift parallel or rotate inward, outward or not at all for these two commodities and why(2 votes)
4:40Video transcript
So let's just review what
we've seen with budget lines. Let's say I'm
making $20 a month. So my income is $20 per month. Let's say per month. The price of chocolate
is $1 per bar. And the price of
fruit is $2 per pound. And we've already
done this before, but I'll just redraw
a budget line. So this axis, let's say this
is the quantity of chocolate. I could have picked
it either way. And that is the
quantity of fruit. If I spend all my
money on chocolate, I could buy 20 bars
of chocolate a month. So that is 20. This is 10 right over here. At these prices, if I
spent all my money on fruit I could buy 10 pounds per month. So this is 10. So that's 10 pounds per month. That would be 20. And so I have a budget
line that looks like this. And the equation of this budget
line is going to be-- well, I could write it like this. My budget, 20, is going
to be equal to the price of chocolate, which is 1, times
the quantity of chocolate. So this is 1 times the
quantity of chocolate, plus the price of
fruit, which is 2 times the quantity of fruit. And if I want to
write this explicitly in terms of my
quantity of chocolate, since I put that
on my vertical axis and that tends to be
the more dependent axis, I can just subtract 2
times the quantity of fruit from both sides. And I can flip them. And I get my
quantity of chocolate is equal to 20 minus 2
times my quantity of fruit. And I get this budget
line right over there. We've also looked at the idea
of an indifference curve. So for example,
let's say I'm sitting at some point on my
budget line where I have-- let's say I am
consuming 18 bars of chocolate and 1 pound of fruit. 18-- and you can
verify that make sense, it's going to be $18
plus $2, which is $20. So let's say I'm at this
point on my budget line. 18 bars of chocolate,
so this is in bars, and 1 pound of fruit per month. So that is 1. And this is in pounds. And this is chocolate, and
this is fruit right over here. Well, we know we have this
idea of an indifference curve. There's different combinations
of chocolate and fruit to which we are
indifferent, to which we would get the same
exact total utility. And so we can plot
all of those points. I'll do it in white. It could look
something like this. I'll do it as a dotted line, it
makes it a little bit easier. So let me draw it like this. So let's say I'm
indifferent between any of these points, any of those
points right over there. Let me draw it a
little bit better. So between any of these
points right over there. So for example, I could
have 18 bars of chocolate and 1 pound of fruit,
or I could have-- let's say that is
4 bars of chocolate and roughly 8 pounds of fruit. I'm indifferent. I get the same
exact total utility. Now, am I maximizing
my total utility at either of those points? Well, we've already
seen that anything to the top right
of our indifference curve of this white curve right
over here-- let me label this. This is our indifference curve. Everything to the top right
of our indifference curve is preferable. We're going to get
more total utility. So let me color that in. So everything to the top right
of our indifference curve is going to be preferable. So all of these other
points on our budget line, even a few points
below or budget line, where we would actually
save money, are preferable. So either of these
points are not going to maximize
our total utility. We can maximize or total utility
at all of these other points in between, along
our budget line. So to actually maximize
our total utility what we want to do is find
a point on our budget line that is just tangent, that
exactly touches at exactly one point one of our
indifference curves. We could have an infinite
number of indifference curves. There could be another
indifference curve that looks like that. There could be another
indifferent curve that looks like that. All that says is that we are
indifferent between any points on this curve. And so there is an indifference
curve that touches exactly this budget line, or exactly
touches the line at one point. And so I might have
an indifference curve that looks like this. Let me do this in a
vibrant color, in magenta. So I could have an indifference
curve that looks like this. And because it's tangent, it
touches at exactly one point. And also the slope of
my indifference curve, which we've learned
was the marginal rate of substitution, is the exact
same as the slope of our budget line right over there,
which we learned earlier was the relative price. So this right about here
is the optimal allocation on our budget line. That right here is optimal. And how do we know
it is optimal? Well, there is no other
point on the budget line that is to the top right. In fact, every other
point on our budget line is to the bottom left of
this indifference curve. So every other point on our
budget line is not preferable. So remember, everything
below an indifference curve-- so all of this shaded area. Let me actually do
it in another color. Because indifference
curve, we are different. But everything below an
indifference curve, so all of this area in green,
is not preferable. And every other point
on the budget line is not preferable to that
point right over there. Because that's the only point--
or I guess you could say, every other point
on our budget line is not preferable to the points
on the indifference curve. So they're also not preferable
to that point right over there which actually is on
the indifference curve. Now, let's think
about what happens. Let's think about what
happens if the price of fruit were to go down. So the price of fruit were to
go from $2 to $1 per pound. So if the price of fruit
went from $2 to $1, then our actual budget line
will look different. Our new budget line. I'll do it in blue,
would look like this. If we spent all our
money on chocolate, we could buy 20 bars. If we spent all of our money
on fruit at the new price, we could buy 20 pounds of fruit. So our new budget line would
look something like that. So that is our new budget line. So now what would be
the optimal allocation of our dollars or the best
combination that we would buy? Well, we would do the
exact same exercise. We would, assuming
that we had data on all of these
indifference curves, we would find the
indifference curve that is exactly tangent to
our new budget line. So let's say that this
point right over here is exactly tangent to
another indifference curve. So just like that. So there's another indifference
curve that looks like that. Let me draw it a
little bit neater. So it looks something like that. And so based on how the price--
if we assume we have access to these many, many, many,
many, many indifference curves, we can now see based
on, all else equal, how a change in
the price of fruit changed the quantity
of fruit we demanded. Because now our optimal spent
is this point on our new budget line which looks like it's
about, well, give or take, about 10 pounds of fruit. So all of a sudden,
when we were-- so let's think about just the fruit. Everything else
we're holding equal. So just the fruit, let's
do, when the price was $2, the quantity demanded
was 8 pounds. And now when the price
is $1, the quantity demanded is 10 pounds. And so what we're
actually doing, and once again, we're kind of
looking at the exact same ideas from different directions. Before we looked at it in terms
of marginal utility per dollar and we thought about
how you maximize it. And we were able to
change the prices and then figure out and derive
a demand curve from that. Here we're just looking at it
from a slightly different lens, but they really are
all of the same ideas. But by-- assuming
if we had access to a bunch of
indifference curves, we can see how a change in
price changes our budget line. And how that would change
the optimal quantity we would want of
a given product. So for example, we
could keep doing this and we could plot
our new demand curve. So I could do a demand
curve now for fruit. At least I have two points
on that demand curve. So if this is the
price of fruit and this is the quantity demanded of
fruit, when the price is $2, the quantity demanded is 8. And when the price
is-- actually, let me do it a
little bit different. When the price is $2--
these aren't to scale-- the quantity demanded is 8. Actually let me
do it here-- is 8. And these aren't to scale. But when the price is $1,
the quantity demanded is 10. So $2, 8, the quantity
demanded is 10. And so our demand curve,
these are two points on it. But we could keep changing
it up assuming we had access to a bunch of
indifference curves. We could keep changing
it up and eventually plot our demand curve, that might
look something like that.