INDIFFERENCE ANALYSIS Indifference curves constructing an indifference curve

INDIFFERENCE ANALYSIS • Indifference curves – constructing an indifference curve – the shape of an indifference curve – diminishing marginal rate of substitution – an indifference map • The budget line – constructing a budget line – effect of a change in income – effect of a change in price

Constructing an indifference curve a Pears Oranges Pears 30 24 20 14 10 8 6 Oranges 6 7 8 10 13 15 20 Point a b c d e f g

Deriving the marginal rate of substitution (MRS) a b Units of good Y 26 67 Units of good X

Deriving the marginal rate of substitution (MRS) a MRS = 4 b DY = 4 26 Units of good Y DX = 1 67 Units of good X

Deriving the marginal rate of substitution (MRS) a MRS = 4 b DY = 4 26 Units of good Y DX = 1 DY = 1 9 c MRS = 1 d DX = 1 67 13 14 Units of good X

Units of good Y An indifference map I 5 I 4 I 1 Units of good X I 2 I 3

A budget line a Units of good Y Units of good X b 0 5 10 15 Units of Point on good Y budget line 30 20 10 0 a b Assumptions PX = £ 2 PY = £ 1 Budget = £ 30 Units of good X

Effect of an increase in income on the budget line Units of good Y Assumptions PX = £ 2 PY = £ 1 Budget = £ 40 n m 16 Budget = £ 40 Budget = £ 30 7 Units of good X

Effect on the budget line of a fall in the price of good X a Assumptions Units of good Y PX = £ 1 PY = £ 1 Budget = £ 30 B 2 B 1 b Units of good X c

INDIFFERENCE ANALYSIS • The optimum consumption point – equating the marginal rate of substitution with the price ratio • The effect of a change in income – the income–consumption curve – the Engel curve – income elasticity of demand the income– consumption curve – the effect of a rise in income on the demand for an inferior good

Units of good Y Finding the optimum consumption Budget line I 5 I 4 I 1 O Units of good X I 2 I 3

Same slope at t of indifference curve and budget line r Units of good Y s Y 1 t u I 5 I 4 v O I 1 X 1 Units of good X I 2 I 3

Units of good Y Effect on consumption of a change in income B 1 O Units of good X I 1

Units of good Y Effect on consumption of a change in income B 1 B 2 O Units of good X I 2 I 1

Units of good Y Effect on consumption of a change in income I 3 B 1 B 2 B 3 O Units of good X B 4 I 2 I 1 I 4

Units of good Y Effect on consumption of a change in income Income–consumption curve I 3 B 1 B 2 B 3 O Units of good X B 4 I 2 I 1 I 4

Bread Deriving an Engel curve from an income–consumption curve Q b 3 Q b 2 Q b 1 a b Income-consumption c curve B 1 Income (£) Qcd 1 Qcd 2 Qcd 3 Y 2 Y 1 b c a Qcd 1 Qcd 2 Qcd 3 B 2 I 1 I 2 I 3 B 3 CDs

Bread Deriving an Engel curve from an income–consumption curve Q b 3 Q b 2 Q b 1 a b Income-consumption c curve B 1 B 2 I 1 I 2 B 3 Income (£) Qcd 1 Qcd 2 Qcd 3 Y 2 Y 1 CDs Engel curve b c a Qcd 1 Qcd 2 Qcd 3 I 3

Units of good Y (normal good) Effect of a rise in income on the demand for an inferior good a B 1 O Units of good X (inferior good) I 1

Effect of a rise in income on the demand for an inferior good Units of good Y (normal good) b I 2 a B 1 O Units of good X (inferior good) I 1 B 2

Effect of a rise in income on the demand for an inferior good Income–consumption curve Units of good Y (normal good) b I 2 a B 1 O Units of good X (inferior good) I 1 B 2

Effect of a fall in the price of good X Units of good Y Assumptions PX = £ 2 PY = £ 1 Budget = £ 30 j B 1 Units of good X I 1

Effect of a fall in the price of good X a Units of good Y Assumptions PX = £ 1 PY = £ 1 Budget = £ 30 k j I 2 B 1 Units of good X I 1 B 2

Effect of a fall in the price of good X a Units of good Y Price–consumption curve k j I 2 B 1 Units of good X I 1 B 2

Expenditure on all other goods Deriving a demand curve from a price–consumption curve Further falls in the price of X a b c B 1 d B 2 B 3 I 2 I 1 B 4 I 3 I 4 Units of good X

Expenditure on all other goods Deriving a demand curve from a price–consumption curve a b c B 1 d Price-consumption curve B 2 B 3 I 2 I 1 B 4 I 3 I 4 Units of good X

Expenditure on all other goods Deriving a demand curve from a price–consumption curve a b c B 1 d Price-consumption curve B 2 B 3 I 2 I 1 B 4 I 3 I 4 Price of good X Units of good X P 1 a b P 2 Q 1 Q 2 Units of good X

Expenditure on all other goods Deriving a demand curve from a price–consumption curve a b c d B 1 Price-consumption curve B 2 B 3 I 2 I 1 B 4 I 3 I 4 Price of good X Units of good X P 1 P 2 P 3 P 4 a b c d Q 1 Q 2 Q 3 Q 4 Units of good X

Expenditure on all other goods Deriving a demand curve from a price–consumption curve a b c d B 1 Price-consumption curve B 2 B 3 I 2 I 1 B 4 I 3 I 4 Price of good X Units of good X P 1 P 2 P 3 P 4 a b c d Q 1 Q 2 Q 3 Q 4 Demand Units of good X

INDIFFERENCE ANALYSIS • The effect of changes in price – the price–consumption curve – deriving the individual's demand curve • Income and substitution effects of a price change – a normal good – an inferior good – a Giffen good (a special type of inferior good)

Units of good Y Income and substitution effects: normal good f I 1 I 2 B 1 I 3 I 4 I 5 I 6 QX 1 Units X Units of Good X

Income and substitution effects: normal good Units of good Y Rise in the price of good X h f I 1 I 2 B 2 QX 3 B 1 I 3 I 4 I 5 I 6 QX 1 Units X Units of Good X

Income and substitution effects: normal good Units of good Y Substitution effect of the price rise g h f I 1 I 2 B 2 QX 2 B 1 a B 1 I 3 I 4 I 5 I 6 QX 1 Substitution effect Units X Units of Good X

Income and substitution effects: normal good Units of good Y Income effect of the price rise g h f I 1 I 2 B 2 QX 3 QX 2 Income effect B 1 a B 1 I 3 I 4 I 5 I 6 QX 1 Substitution effect Units X Units of Good X

Income and substitution effects: Inferior (non-Giffen) good Units of good Y Units of Good Y f I 1 I 2 B 1 QX 1 Units X Units of Good X

Income and substitution effects: Inferior (non-Giffen) good Units of Good Y Units of good Y Rise in the price of good X f h I 1 B 2 QX 3 I 2 B 1 QX 1 Units X Units of Good X

Income and substitution effects: Inferior (non-Giffen) good Units of good Y Units of Good Y Substitution effect of the price rise g f h I 1 B 2 QX 2 B 1 a I 2 B 1 QX 1 Substitution effect Units X Units of Good X

Income and substitution effects: Inferior (non-Giffen) good Units of Good Y Income effect of the price rise Units of good Y g f h I 1 B 2 QX 3 Income effect B 1 a I 2 B 1 QX 1 Substitution effect Units X Units of Good X

Income and substitution effects: Giffen good Units of good Y Units of Good Y f I 1 I 2 B 1 QX 1 Units X Units of Good X

Income and substitution effects: Giffen good Units of Good Y Units of good Y Rise in the price of good X f I 1 h B 2 I 2 B 1 QX 1 QX 3 Units X Units of Good X

Income and substitution effects: Giffen good Units of Good Y Substitution effect of the price rise Units of good Y g f I 1 h B 2 B 1 a I 2 B 1 QX 2 QX 1 QX 3 Substitution effect Units X Units of Good X

Income and substitution effects: Giffen good Units of Good Y Income effect of the price rise Units of good Y g f I 1 h B 2 B 1 a I 2 B 1 QX 2 QX 1 QX 3 Income effect Substitution effect Units X Units of Good X

INDIFFERENCE ANALYSIS • The effect of a change in price on the demand for other goods • The usefulness of indifference analysis – superiority of using ordinal measures – limitations of indifference analysis