In this video we will bring budget lines and indifference curves together.
After this video, you should be able to explain how a consumer maximises utility within a
given budget constraint.
Now we will combine what we’ve learned in the previous two videos about budget lines
and indifference curves.
First we’ll plot the budget line and then introduce three separate indifference curves.
Assuming a budget of $25 with juice boxes costing $5 each and a piece of cheese costs
$2.50 each.
Within that budget constraint, you can buy 5 boxes of juice or ten pieces of cheese.
As we bring in our three indifference curves we should recall that IC1 represents a lower
level of utility than IC2 which represents a lower level of utility than IC3.
To find the combination that would maximise utility within a given budget constraint we
look for a point along the budget line that is tangential to the furthest possible indifference
curve.
In this case, the budget line is tangential to IC2 at point B. While the budget line also
intersects IC1 at points A and C, the consumer would prefer combination B because it provides
the highest level of utility given the budget constraint.
Next we will look at changes in price and income and the impact they have on the combination
of goods that consumers purchase.
First let’s take a look at how the combination of choices changes when there is a change
in price.
Similar to the video before we increase the price of cheese to $5 a piece which reduces
the maximum amount of cheese we can buy to 5 pieces.
This causes the budget line to pivot inwards.
This will impact our previous diagram and change the utility maximising combination.
Let’s bring back the indifference curves to see what happens.
If we look at the original budget line before the change in price we can see that point
B is the preferred combination.
However, after the price of cheese increases…
Our budget line shifts inwards and the new point of preference is D. It represents a
lower amount of total goods due to the rise in the price of cheese.
Now suppose there is a change in income.
Similar to before, we reduce income from $25 to $10 and this results in shifting the budget
line inwards.
If we bring back the indifference curves from before we should be able to find a new optimal
point.
The initial utility maximising point would be point V because it is part of the budget
line that touches, or is tangential to, the farthest possible indifference curve, IC3.
After income reduces, the budget line shifts inwards.
We again look for the point that is tangential to the farthest possible indifference curve,
which is now point Y.
After watching this video you should have a better understanding of how budget lines
and indifference curves can be analysed together to find an optimal consumption bundle for
a consumer given a fixed budget and constant prices.
If you have any questions or comments, leave them below or email me at enhancetuition@gmail.com.
You can visit me online at www.enhancetuition.co.uk and check out some additional resources posted
there.
That wraps up this video and this topic, so I will see you all in the next one.