BEHIND 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
Assumptions

 (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
 Indifference 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
 30
Constructing an indifference
28
26
a

Pears Oranges Point

curve
24
22
30 6 a
b 24 7
20 c
20 8
18 14 10 d
16 10 13 e
Pears

14 8 15 f
12 6 20 g
10
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22

fig
Oranges
Indifference curves

 Convex - diminishing marginal rate of

substitution

 Indifference map
 …preferences
 30

An indifference map
20
Units of good Y

10

I5
0
I4
0 10 20
I3
I2
I1

fig
Units of good X
 Budget 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)
 30 a

A budget line Units of Units of Point on

good X good Y budget line
20 0 30 a
Units of good Y

5 20
10 10
15 0

10

Assumptions

PX = £2
0 PY = £1
0 5 10 15 Budget
20 = £30

fig
Units of good X
 40
Effect of an increase in income
on the budget line
30
Units of good Y

20

10
Assumptions

PX = £2
0 PY = £1
0 5 10 15 Budget
20 = £30

fig
Units of good X
 Effect on the budget line of a fall
30

Assumptions
in the price of good X P = £2 X
PY = £1
20
Budget = £30
Units of good Y

10

0
0 5 10 15 20 25 30

fig
Units of good X
 Effect on the budget line of a fall
30

Assumptions
in the price of good X P = £1 X
PY = £1
20
Budget = £30
Units of good Y

10

0
0 5 10 15 20 25 30

fig
Units of good X
 Optimal consumption
 Where is utility maximised?
 Point of tangency
 MRSyx = Py\Px
 Finding the optimum
consumption
Units of good Y

Budget line

I5
I4
I3
I2
I1
O
Units of figgood X
 Derivation 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)
 Deriving a demand curve
from a price-consumption
curve
Expenditure on
all other goods
a b Price-consumption
c d
curve

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X

P1 a
Price of good X

P2 b
P3 c
P4 d
Demand
fig
Q1 Q2 Q 3 Q 4 Units of good X
 Income & 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
 A conceptual experiment
 `What happens to demand if, after the price of a
good rises, the consumer’s income is increased
so that real income is unchanged?’
 Compensating variation
 Utility is left unchanged
 See Figure 6
Units of good Y Income and substitution effects: normal good

f
I1
I2
I3
I4
I5
B1 I6
QX1
Units of Good X
 General rules
 Normal goods
 income & substitution effects move in the
same direction
 Inferior goods
 income & substitution effects move in
opposite directions