Title: BEHIND THE DEMAND CURVE II
1BEHIND THE DEMAND CURVE II III
- Indifference Analysis
- 1. Assumptions
- 2. Indifference curves the budget constraint
- 3. Derivation of the demand curve
- 4. Income substitution effects
2Assumptions
- (i) Consumers rank preferences
- (ii) Preferences are transitive
- A to B, B to C then A to C
- (iii) Non-satiation
- Ordinal approach - ranking
- Assumptions ? Indifference curve
3Indifference curve
- Definition
- joins together all the different combinations of
two goods which yield the same utility... - Construction
- Slope Marginal Rate of Substitution (MRS)
- MRS?Y\ ?X or MUy \ MUx
- Give up Y for X - same utility
4Constructing an indifference curve
Pears
Point
Oranges
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
Combinations of pears and oranges that Clive
likes the same amount as 10 pears and 13 oranges
5Constructing an indifference curve
Pears
Point
Oranges
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
Pears
Oranges
6Constructing an indifference curve
a
Pears
Point
Oranges
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
Pears
Oranges
7Constructing an indifference curve
a
Pears
Point
Oranges
b
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
Pears
Oranges
8Constructing an indifference curve
a
Pears
Point
Oranges
b
a b c d e f g
30 24 20 14 10 8 6
6 7 8 10 13 15 20
c
Pears
d
e
f
g
Oranges
9Deriving the marginal rate of substitution (MRS)
MRS 4
DY 4
MRS ?Y/?X
Units of good Y
Units of good X
10Deriving the marginal rate of substitution (MRS)
a
MRS 4
DY 4
b
26
MRS ?Y/?X
DX 1
Units of good Y
MRS 1
d
DY 1
6
7
Units of good X
11Indifference curves
- Convex - diminishing marginal rate of
substitution -
- Indifference map
- preferences
12An indifference map
Units of good Y
Units of good X
13Budget constraint
- Actual choice is based on income prices
- Budget constraint
- Definition
- Shows all combinations of the two goods the
consumer is able to buy, given prices and income - Exhaust income
- Prices and income fixed
- What if a price changes? (figure 3)
- What if income changes? (figure 4)
14A budget line
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
Assumptions PX 2 PY 1 Budget 30
15A budget line
a
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
Units of good Y
Assumptions PX 2 PY 1 Budget 30
Units of good X
16A budget line
a
Point on budget line a b
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
b
Units of good Y
Assumptions PX 2 PY 1 Budget 30
Units of good X
17A budget line
a
Point on budget line a b c
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
b
Units of good Y
c
Assumptions PX 2 PY 1 Budget 30
Units of good X
18A budget line
a
Point on budget line a b c d
Units of good X 0 5 10 15
Units of good Y 30 20 10 0
b
Units of good Y
c
Assumptions PX 2 PY 1 Budget 30
d
Units of good X
19Effect of an increase in income on the budget line
Units of good Y
Units of good X
20Effect of an increase in income on the budget line
Units of good Y
Budget 40
Budget 30
Units of good X
21Effect on the budget line of a fall in the price
of good X
Assumptions PX 2 PY 1 Budget 30
Units of good Y
Units of good X
22Effect on the budget line of a fall in the price
of good X
Assumptions PX 2 PY 1 Budget 30
Units of good Y
Units of good X
23Effect on the budget line of a fall in the price
of good X
Assumptions PX 1 PY 1 Budget 30
Units of good Y
Units of good X
24Effect on the budget line of a fall in the price
of good X
a
Assumptions PX 1 PY 1 Budget 30
Units of good Y
B2
B1
c
b
Units of good X
25Optimal consumption
- Where is utility maximised?
- Point of tangency
- MRSyx Py\Px
26Finding the optimum consumption
Units of good Y
O
Units of good X
27Finding the optimum consumption
Units of good Y
I5
I4
I3
I2
I1
O
Units of good X
28Finding the optimum consumption
Units of good Y
I5
I4
I3
I2
I1
O
Units of good X
29Finding the optimum consumption
Units of good Y
I5
I4
I3
I2
I1
O
Units of good X
30Derivation of the demand schedule
- Step 1 Price falls - B pivots right
- Step 2 Optimal point of consumption changes
- join optima price consumption curve
- Step 3 Map optima into price-quantity space
- Step 4 Demand curve (figure 5)
31Deriving a demand curve from a price-consumption
curve
Expenditure on all other goods
B1
Units of good X
32Deriving a demand curve from a price-consumption
curve
Fall in the price of X
a
Expenditure on all other goods
I1
B1
Units of good X
33Deriving a demand curve from a price-consumption
curve
a
Expenditure on all other goods
I1
B1
Units of good X
34Deriving a demand curve from a price-consumption
curve
a
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
35Deriving a demand curve from a price-consumption
curve
a
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
36Deriving a demand curve from a price-consumption
curve
a
Price-consumption curve
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
Price of good X
Q1
Units of good X
37Deriving a demand curve from a price-consumption
curve
a
Price-consumption curve
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
a
P1
Price of good X
Q1
Q2
Units of good X
38Income substitution effects
- A price change
- (i) Income effect
- i.e. the change in demand due to a change in
real income.. - (ii) Substitution effect
- i.e. the change in demand due to a change in
relative prices - Identifying the two effects
39A conceptual experiment
- What happens to demand if, after the price of a
good rises, the consumers income is increased so
that real income is unchanged? - Compensating variation
- Utility is left unchanged
- See Figure 6
40Income and substitution effects normal good
Units of good Y
I1
I2
I3
I4
I5
I6
QX1
Units of Good X
41Income and substitution effects normal good
Rise in the price of good X
Units of good Y
f
I1
I2
I3
I4
I5
B1
I6
QX3
QX1
Units of Good X
42Income and substitution effects normal good
h
Units of good Y
f
I1
I2
I3
I4
I5
B2
B1
I6
QX3
QX1
QX2
Units of Good X
43Income and substitution effects normal good
g
h
Units of good Y
f
I1
I2
I3
I4
I5
B2
B1a
B1
I6
QX3
QX1
QX2
Units of Good X
Substitution effect
44General rules
- Normal goods
- income substitution effects move in the same
direction - Inferior goods
- income substitution effects move in opposite
directions