Indifference curves and budget lines

Economics A2 · The price system and the microeconomy. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

An indifference curve joins all the combinations of two goods that give a consumer the same total satisfaction. It slopes downwards and is convex to the origin, because the consumer gives up less and less of one good to gain each extra unit of the other. Curves further from the origin show higher satisfaction.

A budget line shows the combinations the consumer can just afford with a given income and given prices. The consumer chooses the point where the budget line touches the highest possible indifference curve.

A price change has two parts. The substitution effect comes from the change in relative prices. The income effect comes from the change in real income. Together they make the price effect.

Rules to remember

Slope of the budget line = price of X ÷ price of Y (X on the horizontal axis).
Intercepts of the budget line: income ÷ price of X, and income ÷ price of Y.
A change in income shifts the budget line parallel. A change in one price pivots it about the other good’s intercept.
At the best choice: marginal rate of substitution = price of X ÷ price of Y.
Substitution effect: a fall in price always raises the quantity demanded.
Income effect of a price fall: raises quantity for a normal good, lowers it for an inferior good.
Giffen good: an inferior good whose income effect is larger than its substitution effect, so a price fall lowers the quantity demanded.

Common mistake

Students say every inferior good is a Giffen good. For most inferior goods the substitution effect is larger, so demand still rises when the price falls.

Worked example

A consumer has an income of $60. Good X costs $5 and good Y costs $10, with X on the horizontal axis. The price of X falls to $4. What happens to the budget line?

Original intercepts: X = 60 ÷ 5 = 12 units, Y = 60 ÷ 10 = 6 units.
New X intercept: 60 ÷ 4 = 15 units. The Y intercept stays at 6 units because income and the price of Y are unchanged.
Slope changes from 5 ÷ 10 = 0.5 to 4 ÷ 10 = 0.4, so the line is flatter.

Answer: The budget line pivots outwards about the Y intercept (6 units), and the X intercept moves from 12 to 15 units.

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