indifference analysis
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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
02468
1012141618202224262830
0 2 4 6 8 10 12 14 16 18 20 22
aP
ears
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
Uni
ts o
f goo
d Y
Units of good X
26
6 7
0
10
20
30
0 10 20
a
b
Uni
ts 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
Uni
ts 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
Uni
ts o
f goo
d Y
Units of good X
I1I2
I3
I4
I5
An indifference mapAn indifference map
Uni
ts 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
Uni
ts 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
I1I2
I3
I4
I5
Uni
ts o
f goo
d Y
OUnits of good X
Budget line
Finding the optimum consumptionFinding the optimum consumption
I1I2
I3
I4
I5
Uni
ts o
f goo
d Y
OUnits 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
Uni
ts o
f goo
d Y
OUnits of good X
B1
Effect on consumption of a change in incomeEffect on consumption of a change in income
I1
I2
Uni
ts o
f goo
d Y
OUnits of good X
B1 B2 I1
Effect on consumption of a change in incomeEffect on consumption of a change in income
I2
Uni
ts o
f goo
d Y
OUnits of good X
B1 B2 B3 B4 I1
I3I4
Effect on consumption of a change in incomeEffect on consumption of a change in income
I2
Uni
ts o
f goo
d Y
OUnits of good X
B1 B2 B3 B4 I1
I3I4
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
Qb3Qb2Qb1
Y3
Y2
Y1
Qcd3Qcd2Qcd1
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
Qb3Qb2Qb1
Y3
Y2
Y1
Qcd3Qcd2Qcd1
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
Uni
ts 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
Uni
ts 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
P3P4
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
P3P4
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
Uni
ts o
f goo
d Y
I1I2I3I4I5I6
f
B1
Income and substitution effects: normal goodIncome and substitution effects: normal good
QX1
Units of Good XUnits of Good X
Uni
ts o
f goo
d Y
I1I2I3I4I5I6
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
Uni
ts o
f goo
d Y
I1I2I3I4I5I6
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
Uni
ts o
f goo
d Y
I1I2I3I4I5I6
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
Uni
ts 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
Uni
ts 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
Uni
ts 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
Uni
ts 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
Uni
ts 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
Uni
ts 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
Uni
ts 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
Uni
ts 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
QX2Substitution effect
Income 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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