Download - INDIFFERENCE ANALYSIS Indifference curvesIndifference curves –constructing an indifference curve –the shape of an indifference curve –diminishing marginal.

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

10

12

14

16

18

20

22

24

26

28

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


• 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


I2

Un

its o

f goo

d Y

O

Units of good X

B1 B2 B3 B4 I1

I3

I4


I2

Un

its o

f goo

d Y

O

Units of good X

B1 B2 B3 B4 I1

I3

I4

Income–consumption curve


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


nits

of g

ood

Y(n

orm

al g

ood

)


O

I2

I1B1 B2

a

b


nits

of g

ood

Y(n

orm

al g

ood

)


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


B1 B2 B3

I3I2I1

I4

B4

Exp

endi

ture

on

all o

ther

goo

ds

Units of good X


bc d

Pric

e of

goo

d X

Units of good X

a

b

P1

P2

Q1 Q2


B1 B2 B3

I3I2I1

I4

B4

Exp

endi

ture

on

all o

ther

goo

ds

Units of good X


bc d

Pric

e of

goo

d X

Units of good X

a

b

cd

P1

P2

P3

P4

Q1 Q2 Q3 Q4


B1 B2 B3

I3I2I1

I4

B4

Exp

endi

ture

on

all o

ther

goo

ds

Units of good X


bc d

Pric

e of

goo

d X

Units of good X

a

b

cd

Demand

P1

P2

P3

P4

Q1 Q2 Q3 Q4


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


Un

its o

f goo

d Y

I1I2

I3I4I5I6

f

B1


QX1

h

B2

QX3

Rise in the price of good X


Un

its o

f goo

d Y

I1I2

I3I4I5I6

f

B1


QX1

h

B2

Substitutioneffect

g

QX2

B1a

Substitution effectof the price rise


Un

its o

f goo

d Y

I1I2

I3I4I5I6

f

B1


QX1

h

B2

QX3Substitution

effect

g

QX2

B1a

Income effectof the price rise

Income

effect

Units of Good Y


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


Un

its o

f goo

d Y

f

B1


QX1

B2

h

QX3

I1

I2


Units of Good Y


Un

its o

f goo

d Y

f

B1


QX1

B2

g

h

QX2

I1

I2

Substitution effect

B1a


Units of Good Y


Un

its o

f goo

d Y

f

B1


QX1

B2

g

h

QX2QX3

I1

I2

Substitution effectIncome effect

B1a

Income effect ofthe price rise

Units of Good Y


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


Un

its o

f goo

d Y

f

B1


QX1

B2

h

QX3

I1

I2


Units of Good Y


Un

its o

f goo

d Y

f

B1


QX1

B2

h

QX3

I1

I2

g

QX2

B1a

Substitution effect


Units of Good Y


Un

its o

f goo

d Y

f

B1


QX1

B2

h

QX3

I1

I2

g

QX2

Substitution effectIncome effect

Income effect ofthe price rise

B1a


• 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