indifference+curves.+Including+assumptions+such+as+transitivity,+completeness++and+more+is+better.+Diminishing+MU

=Indifference Curves= By: Tiffany Mack

THEORY
The theory of indifference curves is based on the idea that individuals can always rank any consumption bundles by order of preference. (LaFrance, 2006)

THE BASICS
Figure 1: Indifference map with three indifference curves represented (Wikipedia)

1. They are only present in the positive quadrant 2. They are always negatively sloped 3. They are complete 4. They are represented to be transitive with respect to points on distinct indifference curves 5. They are absolutely convex
 * There are five ways to identify an indifference curve:**
 * This means that all points on an indifference curve are equally preferred. For example, when looking at two items on a graph, absolutely no two lines can intersect and the consumer will always have a preference. Under no circumstances will a consumer be unable to decide which he/she prefers in relation to the substitutes. (Baye, 2006)
 * For example, each item on L1 is preferred less than items on L2. Items on L3 is preferred more than items on L2. Therefore, you can assume that L3 is preferred more than L1.
 * The substitution effect: If a consumer decreases consumption of product A, there will be an increase of consumption for product B for the consumer’s satisfaction to remain unchanged. The rate at which the consumer is willing to substitute product B for product A explains diminishing marginal rate of substitution. (Baye, 2006)

(Wikipedia)

What Influences Preferences?
A consumer is more likely to prefer bundle A over bundle B is there is more good in bundle A. Consumers determine what they prefer by how much good can be factored into each option. The more good in a bundle, the more satisfied the consumer will be by purchasing that particular bundle. (Baye, 2006)
 * More is Better**

PERFECT SUBSTITUTES AND PERFECT COMPLIMENTS
Figure 2: Goods X and Y are perfect substitutes (Wikipedia) Figure 3: Goods X and Y are perfect compliments (Wikipedia)

If two goods are perfect substitutes, the lines will be parallel. The marginal rate of substitution for perfect substitution is constant. (LaFrance, 2006) If two goods are perfect compliments, the lines will be L-shaped. The marginal rate of substitution for perfect compliments is either O or infinite. (LaFrance, 2006) For example, when baking a cake out of a box, you always need three eggs for every one box of cake mix. Having an extra three eggs will not produce more cake unless you have an additional box of cake mix.

APPLYING INDIFFERENCE CURVES TO REAL LIFE SITUATIONS
Buy One, Get One Free**
 * From the Consumer’s Point of View

A technique offered by retailers to encourage consumers to purchase more is a buy one, get one free sale. For example, you walk into your store of choice and you’re looking to purchase a new pair of socks. The store has a buy one, get one free (limit one free pair of socks per customer) sign posted. You are more likely to consume more socks than if the sale was not active. Instead of purchasing one pair of socks at $5, you are purchasing two pairs of socks at $5. The consumer assumes they are getting a 50% discount. But what is really happening is this: The first pair of socks is sold at regular price, but the second is sold for $0. The offer does not affect the price of units below one pair of socks or above two pairs of socks. Looking at Figure 1: The consumer moves from a point on L1 to a point on L2 because previous to the offer, only one pair of socks was on the consumer’s budget line. The buy one, get one free offer creates a horizontal budget line. The consumer consumes more with the same budget line. (Baye, 2006)

Everybody has received a gift that they were satisfied with but if given a choice would rather have received cash instead to purchase exactly what you wanted. For example, on Christmas morning you open a present from grandma and you reveal a pair of socks. Inside the box is a gift receipt for $10 should you not be satisfied with the socks. You know that there is a video game at another store for $10 that you really wanted, so you choose to return the socks the day after Christmas. Looking at Figure 1: Previous to having the pair of socks valued at $10, you were sitting on L1. After receiving the gift, you automatically move to L2. Now you have cash in hand and just left the store to head towards to toy store. You purchase the $10 game. This was an even exchange on the budget line but your satisfactory level is much higher. Returning to Figure 1: You are still on L2 because the price was the same but shift up the line because you are more satisfied with your new gift valued at $10. (Baye, 2006)
 * Gifts**


 * From the Employee’s Point of View**

//As a manager, how do you maximize sales during the holidays?// Suggestion: Offer gift certificates. (Baye, 2006)
 * · Easy to consume for gift givers
 * · More satisfied receivers
 * · Less returns after the holidays
 * · If selling an inferior good, may result in greater quantity sold
 * · Cannot be exchanged for cash therefore, profits made are not refundable

//How much is your free time at home with your family worth?// Example: You must work Monday through Friday with a fixed income of $25 per day plus $5 per hour. But if you chose to work Saturday and/or Sunday you will make an additional $50 per day plus $10 per hour. Example based on an 8 hour day. So what is the price of being able to spend weekends home with your family versus working and making extra income. E= Total Earnings E=5 ($25 + $5(8)) E=2($50+$10(4)) E= 2($50+$10(8)) Base income working Monday through Friday, 8 hour days = $325 Additional income if working Saturday and Sunday, 4 hour days = $180 Additional income if working Saturday and Sunday, 8 hour days= $260 Least to be made= $325 Most to be made= $585 Decision to be made by employee: How much is your leisure time worth? In relation to Figure 1: Good X represents Income, Good Y represents Leisure. The employee is automatically on L1 at 40 hours, Monday through Friday. If the employee decides, they would rather make extra money versus spend time at home, they move to L2 working 48 hours, 7 days a week. If they decide that they want to maximize their income and work 56 hours, 7 days a week, they jump to L3 valued at $585. In relation to equilibrium: the employee must find the point on the graph making the highest income possible while being satisfied with the amount of leisure time they obtain each week. (Baye, 2006)

QUIZ YOURSELF
(1) What are ways to identify an indifference curve? a. Completeness b. Crossing point c. Positive Quadrant d. A & C Answer: D. Indifference curves are always in the positive quadrant (+,+) and display completeness as discussed under “The Basics” above. (2) The marginal rate of perfect substitutes is equal to: a. 1 b. 0 c. -1 d. Constant Answer: D. The consumer is equally satisfied with either Good A or Good B. Therefore, the marginal rate is just constant. (3) The marginal rate for substitution of perfect compliments is: a. Infinity b. 1 c. 0 d. A & C Answer: D. The marginal rate of substitution for perfect compliments is either 0 or infinity. Example: 1 cake mix = 3 eggs (4) What statement is true? a. Buy one, get one free offers are giving the consumer a 50% discount. b. Buy one, get one free offers reduce the price of all items purchased whether the consumer purchases 1 or more. c. Buy one, get one free offers have a vertical budget line. d. Buy one, get one free offers do not discount the first item purchased. Answer: D. Buy one, get one free offers do not discount the first item. The first item is regular priced and they second is sold at $0. (5) Suppose a worker is offered $5/hr, Monday through Friday and $15/hr on Saturdays. The shop is closed on Sundays and all employees must work 8 hour shifts, no more or no less. Monday through Friday is mandatory but Saturdays are optional. What is the cost of not working Saturdays? a. $125 b. $130 c. $120 d. $115 Answer: C. $15 x 8= $120. The cost of not working Saturdays is $120.

References I. http://en.wikipedia.org/wiki/Image:Simple-indifference-curves.svg II. Bruce R. Beattie and Jeffrey T. LaFrance, “The Law of Demand versus Diminishing Marginal Utility” (2006). //Review of Agricultural Economics//. 28 (2), pp. 263-271. III. Michael R. Baye, “Managerial Economics and Business Strategy” (2006), pp. 135-141. IV. http://economics.about.com/cs/economicsglossary/g/indifference.htm V. http://economics.about.com/od/indifferencecurves/a/indifference.htm