♪ [music] ♪ [Joana] As we make choices
about what to buy, we're constrained by our own income
and the prices of things. But our tastes or our preferences for what we like, or don't,
are just as important. For simplicity's sake, let's stay in our two-good world, and look at how you might choose
between pizzas and coffee. Suppose I asked you
which of the following combinations you would rather have. This is like me asking you to rank them
in order of preferences. Let's plot them on a graph. On the x-axis we have
the number of pizzas per week, and on the y-axis we have
cups of coffee per week. Because we view pizza and coffee
as good things, things that bring us utility, we always want more of them. Well, at least I do. Obviously, three pizzas and three cups of coffee
are preferred to just two pizzas
and two cups of coffee. Similarly, one pizza and one cup
of coffee are less preferred to two pizzas
and two cups of coffee. Consider this combination --
two pizzas and two cups of coffee. In general, any combination
in this region is preferred to the original combination. Think about why that is. Any point here represents
a combination of pizza and coffee, such that you get more
of at least one of them -- maybe even more of both. And having more of what
brings us utility is better. Any combination of goods
in this region, however, means you'll be getting less
of at least one of the goods -- maybe even less of both -- and that will leave you worse off. Now that we know what you prefer
and what you don't prefer, let's think about
the combinations of goods that will leave you indifferent. You may not mind if instead
of having two pizzas and two cups of coffee,
you have just one pizza and three cups of coffee. Or three pizzas
and one cup of coffee. Any time someone asks you
if you would rather have one combination of goods
versus another, and you go, "Uh, I don't care," you are saying you are indifferent
between the two. The line that connects
the combinations that leave you indifferent is called
your "indifference curve," and each point
on the line represents the same amount
of satisfaction, or utility. Just like we drew
the indifference curve for that first
combination of goods -- two pizzas
and two cups of coffee -- we could draw several other curves, each of which representing
different levels of utility. This would be
your indifference map. Notice your indifference curve
isn't a straight line. That's because its slope changes as you move between
different combinations of goods. The slope of the indifference curve is called the "marginal rate
of substitution," and it measures the rate
at which you are willing to forego cups of coffee
in order to get one more pizza, while keeping
your utility constant. The easiest non-calculus way to find the marginal rate
of substitution at a given point on the indifference curve
is to draw a straight line tangent to the curve at that point. For example, suppose you're
considering this combination. Note it has very few pizzas
and many cups of coffee. The marginal rate
of substitution is four. This means that you are willing
to forego four cups of coffee to consume one more pizza. As you move along
the indifference curve and start consuming more pizza, your marginal rate
of substitution falls. Why is that? If you are thinking
marginal utility, you nailed it! Each additional pizza you consume
provides you with less utility than the previous one. But now remember, you are on an indifference curve, so maintaining
your level of utility implies giving up one cup of coffee
after another. But here's the thing -- as you are left with fewer
and fewer cups of coffee, their marginal utility increases and the harder it is
for you to give them up to get that additional pizza. Your marginal rate
of substitution is two. This means that you were willing
to give up two cups of coffee to consume one more pizza. That's two fewer cups of coffee
than you were willing to give up when you had less pizza
and more cups of coffee. It's because your willingness
to give up cups of coffee decreases the more pizza you have that the marginal rate
of substitution decreases along an indifference curve. Most indifference curves look
just like the one in our example. They are bowed inward. This is because the marginal rate
of substitution changes depending on how much
of the goods you have and your willingness
to substitute between them. But there are exceptions, and indifference curves
can look very different. Suppose you view
two goods as substitutes. To me, that's juice. Maybe you too don't care if you drink orange juice
or apple juice. In this case,
you will be equally happy if you drink two glasses
of orange juice and two of apple juice, or if you drink three glasses
of orange juice and one of apple juice. Here your marginal rate
of substitution is constant along your indifference curves,
and is one. Perfect complements
are another extreme case. Suppose you're eating hot dogs. You want one hot dog bun
for every hot dog. If I give you two hot dog buns
but just one hot dog, you will not be better off, because you like your hot dogs
with hot dog buns. In this case, your indifference curves
will look like right angles. Indifference curves come
in many shapes and sizes, but they do have
a few things in common. When we talk about goods,
the first thing you note is that indifference curves
slope downward. Why? Because the only way for us
to keep utility constant when consuming more of one good is by consuming less of the other. We also assume that more is better. That means that indifference curves that are farther away
from the origin -- I mean are farther to the right -- represent higher levels of utility. However, if we're talking
about bads -- say, pollution, or trash -- then the less we have
of them, the better. In this case, we are better off
when we get closer to the origin. Another important property
of indifference curves is that they cannot
intersect each other. This makes sense. If we allow two
indifference curves to cross, we are saying that
the combination of goods at the intersection point
represents, at the same time, different levels of utility. This makes no sense. Economists don't like things
that don't make sense, so we assume this cannot happen, despite people being different and exhibiting different
preferences towards goods. While preferences are solely
about our tastes and dreams, our actual decisions require us
to get reality into the picture. We do that when we make
our decisions constrained, by our income and the prices
the market invisibly determines. We look at that next. - [Narrator] You're on your way
to mastering economics. Make sure this video sticks by taking a few quick
practice questions. Or, if you're ready
for more microeconomics, click for the next video. Still here? Check out Marginal Revolution
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