INDIFFERENCE ANALYSIS

1
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

2
Constructing 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
3
Deriving the marginal rate of substitution (MRS)
a
b
26
Units of good Y
6
7
Units of good X
4
Deriving the marginal rate of substitution (MRS)
a
MRS 4
DY 4
b
26
DX 1
Units of good Y
6
7
Units of good X
5
Deriving the marginal rate of substitution (MRS)
a
MRS 4
DY 4
b
26
DX 1
Units of good Y
MRS 1
c
d
DY 1
9
DX 1
6
7
13
14
Units of good X
6
An indifference map
Units of good Y
I5
I4
I3
I2
I1
Units of good X
7
A 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
8
Effect of an increase in income on the budget line
Assumptions PX 2 PY 1 Budget 40
Units of good Y
n
m
16
Budget 40
Budget 30
7
Units of good X
9
Effect 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
10
INDIFFERENCE ANALYSIS

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

11
Finding the optimum consumption
Units of good Y
Budget line
I5
I4
I3
I2
I1
O
Units of good X
12
Same slope at t of indifference curve and budget
line
r
s
Units of good Y
t
Y1
u
I5
I4
v
I3
I2
I1
O
X1
Units of good X
13
Effect on consumption of a change in income
Units of good Y
B1
I1
O
Units of good X
14
Effect on consumption of a change in income
Units of good Y
I2
B2
B1
I1
O
Units of good X
15
Effect on consumption of a change in income
Units of good Y
I4
I3
I2
B2
B3
B1
B4
I1
O
Units of good X
16
Effect on consumption of a change in income
Incomeconsumption curve
Units of good Y
I4
I3
I2
B2
B3
B1
B4
I1
O
Units of good X
17
Deriving an Engel curve from an
incomeconsumption curve
Bread
Income-consumption curve
Qb3
c
Qb2
b
a
Qb1
I3
I2
I1
B3
B2
B1
Qcd2
Qcd3
Qcd1
CDs
Y3
c
Income ()
Y2
b
Y1
a
Qcd3
Qcd2
Qcd1
CDs
18
Deriving an Engel curve from an
incomeconsumption curve
Bread
Income-consumption curve
Qb3
c
Qb2
b
a
Qb1
I3
I2
I1
B3
B2
B1
Qcd2
Qcd3
Qcd1
CDs
Engel curve
Y3
c
Income ()
Y2
b
Y1
a
Qcd3
Qcd2
Qcd1
CDs
19
Effect of a rise in income on the demand for an
inferior good
Units of good Y (normal good)
a
I1
B1
O
Units of good X (inferior good)
20
Effect of a rise in income on the demand for an
inferior good
b
Units of good Y (normal good)
I2
a
I1
B1
B2
O
Units of good X (inferior good)
21
Effect of a rise in income on the demand for an
inferior good
Incomeconsumption curve
b
Units of good Y (normal good)
I2
a
I1
B1
B2
O
Units of good X (inferior good)
22
Effect of a fall in the price of good X
Assumptions PX 2 PY 1 Budget 30
Units of good Y
j
I1
B1
Units of good X
23
Effect of a fall in the price of good X
a
Assumptions PX 1 PY 1 Budget 30
k
Units of good Y
j
I2
I1
B1
B2
Units of good X
24
Effect of a fall in the price of good X
a
Priceconsumption curve
k
Units of good Y
j
I2
I1
B1
B2
Units of good X
25
Deriving a demand curve from a priceconsumption
curve
Further falls in the price of X
a
b
Expenditure on all other goods
c
d
I4
I3
I2
I1
B4
B3
B1
B2
Units of good X
26
Deriving a demand curve from a priceconsumption
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
27
Deriving a demand curve from a priceconsumption
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
b
P2
Q1
Q2
Units of good X
28
Deriving a demand curve from a priceconsumption
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
b
P2
c
P3
d
P4
Q1
Q2
Q3
Q4
Units of good X
29
Deriving a demand curve from a priceconsumption
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
b
P2
c
P3
d
P4
Demand
Q1
Q2
Q3
Q4
Units of good X
30
INDIFFERENCE ANALYSIS

• The effect of changes in price
• the priceconsumption 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)

31
Income and substitution effects normal good
Units of good Y
f
I1
I2
I3
I4
I5
B1
I6
QX1
Units of Good X
Units of Good X
32
Income and substitution effects normal good
Rise in the price of good X
h
Units of good Y
f
I1
I2
I3
I4
I5
B2
B1
I6
QX3
QX1
Units of Good X
Units of Good X
33
Income and substitution effects normal good
Substitution effect of the price rise
g
h
Units of good Y
f
I1
I2
I3
I4
I5
B2
B1a
B1
I6
QX1
QX2
Substitution effect
Units of Good X
Units of Good X
34
Income and substitution effects normal good
Income effect of the price rise
g
h
Units of good Y
f
I1
I2
I3
I4
I5
B2
B1a
B1
I6
QX3
QX1
QX2
Substitution effect
Income effect
Units of Good X
Units of Good X
35
Income and substitution effects Inferior
(non-Giffen) good
Units of Good Y
Units of good Y
f
I1
I2
B1
QX1
Units of Good X
Units of Good X
36
Income and substitution effects Inferior
(non-Giffen) good
Units of Good Y
Rise in the price of good X
Units of good Y
f
h
I1
I2
B2
B1
QX3
QX1
Units of Good X
Units of Good X
37
Income and substitution effects Inferior
(non-Giffen) good
Units of Good Y
Substitution effect of the price rise
g
Units of good Y
f
h
I1
I2
B2
B1
B1a
QX1
QX2
Substitution effect
Units of Good X
Units of Good X
38
Income and substitution effects Inferior
(non-Giffen) good
Units of Good Y
Income effect of the price rise
g
Units of good Y
f
h
I1
I2
B2
B1
B1a
QX3
QX1
QX2
Substitution effect
Units of Good X
Units of Good X
Income effect
39
Income and substitution effects Giffen good
Units of Good Y
f
Units of good Y
I1
B1
I2
QX1
Units of Good X
Units of Good X
40
Income and substitution effects Giffen good
Units of Good Y
Rise in the price of good X
f
Units of good Y
I1
h
B2
B1
I2
QX3
QX1
Units of Good X
Units of Good X
41
Income and substitution effects Giffen good
Units of Good Y
Substitution effect of the price rise
g
f
Units of good Y
I1
h
B1a
B2
B1
I2
QX3
QX1
QX2
Units of Good X
Substitution effect
Units of Good X
42
Income and substitution effects Giffen good
Units of Good Y
Income effect of the price rise
g
f
Units of good Y
I1
h
B1a
B2
B1
I2
QX3
QX1
QX2
Units of Good X
Substitution effect
Units of Good X
Income effect
43
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