INDIFFERENCE ANALYSIS Indifference curvesIndifference curves –constructing an indifference curve...
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INDIFFERENCE ANALYSIS INDIFFERENCE ANALYSIS • Indifference curves Indifference curves – constructing an indifference curve constructing an indifference curve – the shape of an indifference curve the shape of an indifference curve – diminishing marginal rate of diminishing marginal rate of substitution substitution – an indifference map an indifference map • The budget line The budget line – constructing a budget line constructing a budget line – effect of a change in income effect of a change in income – effect of a change in price effect of a change in price
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Transcript of INDIFFERENCE ANALYSIS Indifference curvesIndifference curves –constructing an indifference curve...
INDIFFERENCE ANALYSISINDIFFERENCE ANALYSIS
• Indifference curvesIndifference curves– constructing an indifference curveconstructing an indifference curve
– the shape of an indifference curvethe shape of an indifference curve
– diminishing marginal rate of substitutiondiminishing marginal rate of substitution
– an indifference mapan indifference map
• The budget lineThe budget line– constructing a budget lineconstructing a budget line
– effect of a change in incomeeffect of a change in income
– effect of a change in priceeffect of a change in price
0
2
4
6
8
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16
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26
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30
0 2 4 6 8 10 12 14 16 18 20 22
aP
ear
s
Oranges
Pears
3024201410
86
Oranges
678
10131520
Point
abcdefg
Constructing an indifference curveConstructing an indifference curve
0
10
20
30
0 10 20
Deriving the marginal rate of substitution (Deriving the marginal rate of substitution (MRSMRS))a
b
Un
its o
f goo
d Y
Units of good X
26
6 7
0
10
20
30
0 10 20
a
b
Un
its o
f goo
d Y
Units of good X
26
6 7
Y = 4
X = 1
MRS = 4
Deriving the marginal rate of substitution (Deriving the marginal rate of substitution (MRSMRS))
0
10
20
30
0 10 20
a
b
Un
its o
f goo
d Y
Units of good X
26
6 7
cd
Y = 4
X = 1
Y = 1
X = 1
MRS = 1
MRS = 4
13 14
9
Deriving the marginal rate of substitution (Deriving the marginal rate of substitution (MRSMRS))
0
10
20
30
0 10 20
Un
its o
f goo
d Y
Units of good X
I1
I2
I3
I4
I5
An indifference mapAn indifference map
Un
its o
f goo
d Y
Units of good X
a
b
Units ofgood X
0 51015
Units ofgood Y
302010 0
Point onbudget line
ab
Assumptions
PX = £2PY = £1
Budget = £30
0
10
20
30
0 5 10 15 20
A budget lineA budget line
0
10
20
30
40
0 5 10 15 20
Un
its o
f goo
d Y
Units of good X
Assumptions
PX = £2PY = £1
Budget = £40
16
7
m
n
Budget = £40
Budget = £30
Effect of an increase in income on the budget lineEffect of an increase in income on the budget line
0
10
20
30
0 5 10 15 20 25 30
Effect on the budget line of a fall in the price of good XEffect on the budget line of a fall in the price of good XU
nits
of g
ood
Y
Units of good X
Assumptions
PX = £1PY = £1
Budget = £30
B1B2
a
b c
INDIFFERENCE ANALYSISINDIFFERENCE ANALYSIS
• The optimum consumption pointThe optimum consumption point
– equating the marginal rate of substitution with equating the marginal rate of substitution with the price ratiothe price ratio
• The effect of a change in incomeThe effect of a change in income
– the income–consumption curvethe income–consumption curve
– the Engel curvethe Engel curve
– income elasticity of demand and the income–income elasticity of demand and the income–consumption curveconsumption curve
– the effect of a rise in income on the demand for the effect of a rise in income on the demand for an inferior goodan inferior good
I1
I2
I3
I4
I5
Un
its o
f goo
d Y
O
Units of good X
Budget line
Finding the optimum consumptionFinding the optimum consumption
I1
I2
I3
I4
I5
Un
its o
f goo
d Y
O
Units of good X
r
s
tY1
X1
v
u
Same slope at Same slope at tt of indifference curve and budget line of indifference curve and budget line
Un
its o
f goo
d Y
O
Units of good X
B1
Effect on consumption of a change in incomeEffect on consumption of a change in income
I1
I2
Un
its o
f goo
d Y
O
Units of good X
B1 B2 I1
Effect on consumption of a change in incomeEffect on consumption of a change in income
I2
Un
its o
f goo
d Y
O
Units of good X
B1 B2 B3 B4 I1
I3
I4
Effect on consumption of a change in incomeEffect on consumption of a change in income
I2
Un
its o
f goo
d Y
O
Units of good X
B1 B2 B3 B4 I1
I3
I4
Income–consumption curve
Effect on consumption of a change in incomeEffect on consumption of a change in income
B1 B2 B3
I3I2I1
Income-consumptioncurveB
read
Inco
me
(£)
CDs
CDs
Qb3
Qb2
Qb1
Y3
Y2
Y1
Qcd3Qcd2
Qcd1
Qcd3Qcd2
Qcd1
ab
c
ab
c
Deriving an Engel curve from an income–consumption curveDeriving an Engel curve from an income–consumption curve
B1 B2 B3
I3I2I1
Income-consumptioncurveB
read
Inco
me
(£)
CDs
CDs
Qb3
Qb2
Qb1
Y3
Y2
Y1
Qcd3Qcd2
Qcd1
Qcd3Qcd2
Qcd1
Engel curve
ab
c
ab
c
Deriving an Engel curve from an income–consumption curveDeriving an Engel curve from an income–consumption curve
Effect of a rise in income on the demand for an inferior goodEffect of a rise in income on the demand for an inferior goodU
nits
of g
ood
Y(n
orm
al g
ood
)
Units of good X(inferior good)
O
I1B1
a
Effect of a rise in income on the demand for an inferior goodEffect of a rise in income on the demand for an inferior goodU
nits
of g
ood
Y(n
orm
al g
ood
)
Units of good X(inferior good)
O
I2
I1B1 B2
a
b
Effect of a rise in income on the demand for an inferior goodEffect of a rise in income on the demand for an inferior goodU
nits
of g
ood
Y(n
orm
al g
ood
)
Units of good X(inferior good)
O
Income–consumption curve
I2
I1B1 B2
a
b
0
10
20
30
0 5 10 15 20 25 30
Effect of a fall in the price of good Effect of a fall in the price of good XXU
nits
of g
ood
Y
Units of good X
Assumptions
PX = £2PY = £1
Budget = £30
B1 I1
j
0
10
20
30
0 5 10 15 20 25 30
Un
its o
f goo
d Y
Units of good X
Assumptions
PX = £1PY = £1
Budget = £30
B1 I1
j
I2
B2
k
Effect of a fall in the price of good Effect of a fall in the price of good XXa
0
10
20
30
0 5 10 15 20 25 30
Un
its o
f goo
d Y
Units of good X
B1 I1
j
I2
B2
k
Price–consumption curve
Effect of a fall in the price of good Effect of a fall in the price of good XXa
B1 B2 B3
I3I2I1
I4
B4
Exp
endi
ture
on
all o
ther
goo
ds
Units of good X
a bc d
Further falls inthe price of X
Deriving a demand curve from a price–consumption curveDeriving a demand curve from a price–consumption curve
B1 B2 B3
I3I2I1
I4
B4
Exp
endi
ture
on
all o
ther
goo
ds
Units of good X
a Price-consumptioncurve
bc d
Deriving a demand curve from a price–consumption curveDeriving a demand curve from a price–consumption curve
B1 B2 B3
I3I2I1
I4
B4
Exp
endi
ture
on
all o
ther
goo
ds
Units of good X
a Price-consumptioncurve
bc d
Pric
e of
goo
d X
Units of good X
a
b
P1
P2
Q1 Q2
Deriving a demand curve from a price–consumption curveDeriving a demand curve from a price–consumption curve
B1 B2 B3
I3I2I1
I4
B4
Exp
endi
ture
on
all o
ther
goo
ds
Units of good X
a Price-consumptioncurve
bc d
Pric
e of
goo
d X
Units of good X
a
b
cd
P1
P2
P3
P4
Q1 Q2 Q3 Q4
Deriving a demand curve from a price–consumption curveDeriving a demand curve from a price–consumption curve
B1 B2 B3
I3I2I1
I4
B4
Exp
endi
ture
on
all o
ther
goo
ds
Units of good X
a Price-consumptioncurve
bc d
Pric
e of
goo
d X
Units of good X
a
b
cd
Demand
P1
P2
P3
P4
Q1 Q2 Q3 Q4
Deriving a demand curve from a price–consumption curveDeriving a demand curve from a price–consumption curve
INDIFFERENCEINDIFFERENCE ANALYSISANALYSIS
• The effect of changes in priceThe effect of changes in price
– the price–consumption curvethe price–consumption curve
– deriving the individual's demand curvederiving the individual's demand curve
• Income and substitution effects of a price Income and substitution effects of a price changechange
– a normal gooda normal good
– an inferior goodan inferior good
– a Giffen good (a special type of inferior good)a Giffen good (a special type of inferior good)
Units of Good XUnits of Good X
Un
its o
f goo
d Y
I1I2
I3I4I5I6
f
B1
Income and substitution effects: normal goodIncome and substitution effects: normal good
QX1
Units of Good XUnits of Good X
Un
its o
f goo
d Y
I1I2
I3I4I5I6
f
B1
Income and substitution effects: normal goodIncome and substitution effects: normal good
QX1
h
B2
QX3
Rise in the price of good X
Units of Good XUnits of Good X
Un
its o
f goo
d Y
I1I2
I3I4I5I6
f
B1
Income and substitution effects: normal goodIncome and substitution effects: normal good
QX1
h
B2
Substitutioneffect
g
QX2
B1a
Substitution effectof the price rise
Units of Good XUnits of Good X
Un
its o
f goo
d Y
I1I2
I3I4I5I6
f
B1
Income and substitution effects: normal goodIncome and substitution effects: normal good
QX1
h
B2
QX3Substitution
effect
g
QX2
B1a
Income effectof the price rise
Income
effect
Units of Good Y
Units of Good XUnits of Good X
Un
its o
f goo
d Y
f
B1
Income and substitution effects: Inferior (non-Giffen) goodIncome and substitution effects: Inferior (non-Giffen) good
QX1
I1
I2
Units of Good Y
Units of Good XUnits of Good X
Un
its o
f goo
d Y
f
B1
Income and substitution effects: Inferior (non-Giffen) goodIncome and substitution effects: Inferior (non-Giffen) good
QX1
B2
h
QX3
I1
I2
Rise in the price of good X
Units of Good Y
Units of Good XUnits of Good X
Un
its o
f goo
d Y
f
B1
Income and substitution effects: Inferior (non-Giffen) goodIncome and substitution effects: Inferior (non-Giffen) good
QX1
B2
g
h
QX2
I1
I2
Substitution effect
B1a
Substitution effectof the price rise
Units of Good Y
Units of Good XUnits of Good X
Un
its o
f goo
d Y
f
B1
Income and substitution effects: Inferior (non-Giffen) goodIncome and substitution effects: Inferior (non-Giffen) good
QX1
B2
g
h
QX2QX3
I1
I2
Substitution effectIncome effect
B1a
Income effect ofthe price rise
Units of Good Y
Units of Good XUnits of Good X
Un
its o
f goo
d Y
f
B1
Income and substitution effects: Giffen goodIncome and substitution effects: Giffen good
QX1
I1
I2
Units of Good Y
Units of Good XUnits of Good X
Un
its o
f goo
d Y
f
B1
Income and substitution effects: Giffen goodIncome and substitution effects: Giffen good
QX1
B2
h
QX3
I1
I2
Rise in the price of good X
Units of Good Y
Units of Good XUnits of Good X
Un
its o
f goo
d Y
f
B1
Income and substitution effects: Giffen goodIncome and substitution effects: Giffen good
QX1
B2
h
QX3
I1
I2
g
QX2
B1a
Substitution effect
Substitution effectof the price rise
Units of Good Y
Units of Good XUnits of Good X
Un
its o
f goo
d Y
f
B1
Income and substitution effects: Giffen goodIncome and substitution effects: Giffen good
QX1
B2
h
QX3
I1
I2
g
QX2
Substitution effectIncome effect
Income effect ofthe price rise
B1a
INDIFFERENCE ANALYSISINDIFFERENCE ANALYSIS
• The effect of a change in price on the The effect of a change in price on the demand for demand for otherother goods goods
• The usefulness of indifference analysisThe usefulness of indifference analysis
– superiority of using ordinal measuressuperiority of using ordinal measures
– limitations of indifference analysislimitations of indifference analysis
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