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## INDIFFERENCE ANALYSIS

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**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 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**Deriving the marginal rate of substitution (MRS)**a b 26 Units of good Y 6 7 Units of good X**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**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**An indifference map**Units of good Y I5 I4 I3 I2 I1 Units of good X**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**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**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**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 and the income–consumption curve • the effect of a rise in income on the demand for an inferior good**Finding the optimum consumption**Units of good Y Budget line I5 I4 I3 I2 I1 O Units of good X**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**Effect on consumption of a change in income**Units of good Y B1 I1 O Units of good X**Effect on consumption of a change in income**Units of good Y I2 B2 B1 I1 O Units of good X**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**Effect on consumption of a change in income**Income–consumption curve Units of good Y I4 I3 I2 B2 B3 B1 B4 I1 O Units of good X**Deriving an Engel curve from an income–consumption curve**Bread Income-consumption curve Qb3 c Qb2 b a Qb1 I3 I2 I1 B3 B2 B1 Qcd2 Qcd1 Qcd3 CDs Y3 c Income (£) Y2 b Y1 a Qcd1 Qcd2 Qcd3 CDs**Deriving an Engel curve from an income–consumption curve**Bread Income-consumption curve Qb3 c Qb2 b a Qb1 I3 I2 I1 B3 B2 B1 Qcd2 Qcd1 Qcd3 CDs Engel curve Y3 c Income (£) Y2 b Y1 a Qcd1 Qcd2 Qcd3 CDs**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)**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)**Effect of a rise in income on the demand for an inferior**good Income–consumption curve b Units of good Y (normal good) I2 a I1 B1 B2 O Units of good X (inferior good)**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**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**Effect of a fall in the price of good X**a Price–consumption curve k Units of good Y j I2 I1 B1 B2 Units of good X**Deriving a demand curve from a price–consumption 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**Deriving 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**Deriving 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 b P2 Q1 Q2 Units of good X**Deriving 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 b P2 c P3 d P4 Q1 Q3 Q4 Q2 Units of good X**Deriving 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 b P2 c P3 d P4 Demand Q1 Q3 Q4 Q2 Units of good X**INDIFFERENCEANALYSIS**• 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)**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**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**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**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**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**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**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 B1a B1 QX1 QX2 Substitution effect Units of Good X Units of Good X**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 B1a B1 QX3 QX1 QX2 Substitution effect Units of Good X Units of Good X Income effect**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**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**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 Substitution effect Units of Good X Units of Good X**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 Substitution effect Units of Good X Units of Good X Income effect**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