indifference analysis

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


• 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


I2

Uni

ts o

f goo

d Y

OUnits of good X

B1 B2 B3 B4 I1

I3I4


I2

Uni

ts o

f goo

d Y

OUnits of good X

B1 B2 B3 B4 I1

I3I4

Income–consumption curve


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


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

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


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

P3P4

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

P3P4

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

Uni

ts o

f goo

d Y

I1I2I3I4I5I6

f

B1

Income and substitution effects: normal goodIncome and substitution effects: normal good

QX1


Uni

ts o

f goo

d Y

I1I2I3I4I5I6

f

B1


QX1

h

B2

QX3

Rise in the price of good X


Uni

ts o

f goo

d Y

I1I2I3I4I5I6

f

B1


QX1

h

B2

Substitutioneffect

g

QX2

B1a

Substitution effectof the price rise


Uni

ts o

f goo

d Y

I1I2I3I4I5I6

f

B1


QX1

h

B2

QX3Substitution

effect

g

QX2

B1a

Income effectof the price rise

Income

effect

Units of Good Y


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


Uni

ts o

f goo

d Y

f

B1


QX1

B2

h

QX3

I1

I2


Units of Good Y


Uni

ts o

f goo

d Y

f

B1


QX1

B2

g

h

QX2

I1

I2

Substitution effect

B1a


Units of Good Y


Uni

ts 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


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


Uni

ts o

f goo

d Y

f

B1


QX1

B2

h

QX3

I1

I2


Units of Good Y


Uni

ts o

f goo

d Y

f

B1


QX1

B2

h

QX3

I1

I2

g

QX2

B1a

Substitution effect


Units of Good Y


Uni

ts o

f goo

d Y

f

B1


QX1

B2

h

QX3

I1

I2

g

QX2Substitution effect

Income 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

indifference analysis

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