Indifference Analysis

Indifference analysis

Indifference curves
Constructing an indifference curve

Pears Oranges Point

30 6 a
24 7 b
20 8 c
14 10 d
10 13 e
8 15 f
6 20 g

Combinations of pears and

oranges that Clive likes
the same amount as
10 pears and 13 oranges
 Constructing an indifference curve
30
28
Pears Oranges Point
26
24 30 6 a
24 7 b
22 c
20 8
20 14 10 d
18 10 13 e
Pears

8 15 f
16
6 20 g
14
12
10
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Oranges
 Constructing an indifference curve
30 a
28
Pears Oranges Point
26
24 30 6 a
24 7 b
22 c
20 8
20 14 10 d
18 10 13 e
Pears

8 15 f
16
6 20 g
14
12
10
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Oranges
 Constructing an indifference curve
30 a
28
Pears Oranges Point
26
b 30 6 a
24
24 7 b
22 c
20 8
20 14 10 d
18 10 13 e
Pears

8 15 f
16
6 20 g
14
12
10
8
6
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Oranges
 Constructing an indifference curve
30 a
28
Pears Oranges Point
26
b 30 6 a
24
24 7 b
22 c
20 8
20 c d
14 10
18 10 13 e
Pears

8 15 f
16
d 6 20 g
14
12
e
10
f
8
6 g
4
2
0
0 2 4 6 8 10 12 14 16 18 20 22
Oranges
 Deriving the marginal rate of substitution (MRS)
30 a
∆Y = 4 MRS = 4
26 b

∆X = 1 MRS = ∆Y/∆X
Units of good Y

20

10

0
0 67 10 20
Units of good X
 Deriving the marginal rate of substitution (MRS)
30 a
∆Y = 4 MRS = 4
26 b

∆X = 1 MRS = ∆Y/∆X
Units of good Y

20

MRS = 1
10
c
∆Y = 1 d
9
∆X = 1

0
0 67 10 13 14 20
Units of good X
 An indifference map
30
Units of good Y

20

10

I5
I4
I3
I2
0 I1
0 10 20
Units of good X
 The impossibility of two indifference curves crossing
30
Units of good Y

20

10

I1
0
0 10 20
Units of good X
 The impossibility of two indifference curves crossing
30
Units of good Y

20

10

b I2

I1
0
0 10 20
Units of good X
 The impossibility of two indifference curves crossing
30
Units of good Y

20

10
c

b I2

I1
0
0 10 20
Units of good X
Indifference analysis

Budget lines
A budget line

Units of Units of
good X good Y

0 30
5 20
10 10
15 0

Assumptions

PX = £2
PY = £1
Budget = £30
 A budget line
30 a

Units of Units of Point on

good X good Y budget line

0 30 a
Units of good Y

20 5 20
10 10
15 0

10 Assumptions

PX = £2
PY = £1
Budget = £30

0
0 5 10 15 20
Units of good X
 A budget line
30 a

Units of Units of Point on

good X good Y budget line

0 30 a
b
Units of good Y

20 5 20 b
10 10
15 0

10 Assumptions

PX = £2
PY = £1
Budget = £30

0
0 5 10 15 20
Units of good X
 A budget line
30 a

Units of Units of Point on

good X good Y budget line

0 30 a
b
Units of good Y

20 5 20 b
10 10 c
15 0

c Assumptions
10

PX = £2
PY = £1
Budget = £30

0
0 5 10 15 20
Units of good X
 A budget line
30 a

Units of Units of Point on

good X good Y budget line

0 30 a
b
Units of good Y

20 5 20 b
10 10 c
15 0 d

c Assumptions
10

PX = £2
PY = £1
Budget = £30

0 d
0 5 10 15 20
Units of good X
 Effect of an increase in income on the budget line
40

30
Units of good Y

20

Assumptions

10 PX = £2
PY = £1
Budget = £30

0
0 5 10 15 20
Units of good X
 Effect of an increase in income on the budget line
40

Assumptions

PX = £2
30 PY = £1
Budget = £40
Units of good Y

n
20

16
m

10 Budget
= £40
Budget
= £30
0
0 5 7 10 15 20
Units of good X
 Effect on the budget line of a fall in the price of good X
30
Assumptions

PX = £2
PY = £1
Budget = £30
Units of good Y

20

10

0
0 5 10 15 20 25 30
Units of good X
 Effect on the budget line of a fall in the price of good X
30
Assumptions

PX = £2
PY = £1
Budget = £30
Units of good Y

20

10

0
0 5 10 15 20 25 30
Units of good X
 Effect on the budget line of a fall in the price of good X
30
Assumptions

PX = £1
PY = £1
Budget = £30
Units of good Y

20

10

0
0 5 10 15 20 25 30
Units of good X
 Effect on the budget line of a fall in the price of good X
30 a
Assumptions

PX = £1
PY = £1
Budget = £30
Units of good Y

20

10

B1 B2

b c
0
0 5 10 15 20 25 30
Units of good X
 Indifference analysis

The optimal level

of consumption
 Finding the optimum consumption
Units of good Y

O
Units of good X
 Finding the optimum consumption
Units of good Y

I5
I4
I3
I2
I1
O
Units of good X
 Finding the optimum consumption
Units of good Y

Budget line

I5
I4
I3
I2
I1
O
Units of good X
 Finding the optimum consumption

r
s
Units of good Y

Y1 t

u I5
I4
v I3
I2
I1
O X1
Units of good X
 Indifference analysis

Effects of a
change in income
 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
B1 B2 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

I4
I3
I2
B1 B2 B3 B4 I1
O
Units of good X
 Effect on consumption of a change in income
Units of good Y

Income-consumption curve

I4
I3
I2
B1 B2 B3 B4 I1
O
Units of good X
Deriving an Engel curve from an income-consumption curve

Bread

I3
I2
I1
B1 B2 B3
CDs
Deriving an Engel curve from an income-consumption curve

Bread Income-consumption
curve

I3
I2
I1
B1 B2 B3
CDs
Deriving an Engel curve from an income-consumption curve

Bread Income-consumption
curve

I3
I2
I1
B1 B2 B3
CDs
Income (£)
Deriving an Engel curve from an income-consumption curve

Bread Income-consumption
curve
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd1 CDs
Income (£)
Deriving an Engel curve from an income-consumption curve

Bread Income-consumption
curve
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd1 CDs
Income (£)

Y1 a

Qcd1
Deriving an Engel curve from an income-consumption curve

Bread Income-consumption
Qb2 curve
b
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd1 Qcd2 CDs
Income (£)

Y2 b
Y1 a

Qcd1 Qcd2
Deriving an Engel curve from an income-consumption curve

Bread Qb3
c
Income-consumption
Qb2 curve
b
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd1 Qcd2 Qcd3 CDs
Income (£)

Y3
c
Y2 b
Y1 a

Qcd1 Qcd2 Qcd3

Deriving an Engel curve from an income-consumption curve

Bread Qb3
c
Income-consumption
Qb2 curve
b
Qb1 a
I3
I2
I1
B1 B2 B3
Qcd1 Qcd2 Qcd3 CDs
Income (£)

Engel curve
Y3
c
Y2 b
Y1 a

Qcd1 Qcd2 Qcd3

 Effect of a rise in income on the demand for an inferior good
Units of good Y
(normal good)

B1 I1

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

B1 I1 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

B1 I1 B2
O Units of good X
(inferior good)
 Indifference analysis

Effects of a
change in price
 Effect of a fall in the price of good X
30
Assumptions

PX = £2
PY = £1
Budget = £30
Units of good Y

20

10

0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30
Assumptions

PX = £2
PY = £1
Budget = £30
Units of good Y

20

10

B1 I1
0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30
Assumptions

PX = £1
PY = £1
Budget = £30
Units of good Y

20

10

B1 I1
0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30 a
Assumptions

PX = £1
PY = £1
Budget = £30
Units of good Y

20
k
j

10 I2

B1 I1 B2
0
0 5 10 15 20 25 30
Units of good X
 Effect of a fall in the price of good X
30 a

Price-consumption curve
Units of good Y

20
k
j

10 I2

B1 I1 B2
0
0 5 10 15 20 25 30
Units of good X
Deriving a demand curve from a price-consumption curve

Expenditure on
all other goods
a

I1
B1

Units of good X
Deriving a demand curve from a price-consumption curve

Fall in the

Expenditure on
all other goods
price of X
a b

I2
I1
B1 B2

Units of good X
Deriving a demand curve from a price-consumption curve

Further falls in

Expenditure on
all other goods
the price of X
a b

I2
I1
B1 B2

Units of good X
Deriving a demand curve from a price-consumption curve

Further falls in

Expenditure on
all other goods
the price of X
a b
c d

I4
I3
I
I1 2
B1 B2 B3 B4

Units of good X
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
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

Q1 Units of good X
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

Q1 Q2 Q3 Q4 Units of good X
 Indifference analysis

Income and
substitution effects of
a change in price:
(a) normal good
Units of good Y Income and substitution effects: normal good

f
I1
I2
I3
I4
I5
B1 I6
QX1
Units of Good X
 Income and substitution effects: normal good

Rise in the price

of good X
Units of good Y

f
I1
I2
I3
I4
I5
B2 B1 I6
QX3 QX1
Units of Good X
 Income and substitution effects: normal good

Substitution effect
of the price rise
Units of good Y

g
h

f
I1
I2
I3
I4
I5
B2 B1a B1 I6
QX3 QX2 QX1
Substitution Units of Good X
effect
 Income and substitution effects: normal good

Income effect of
the price rise
Units of good Y

g
h

f
I1
I2
I3
I4
I5
B2 B1a B1 I6
QX3 QX2 QX1
Incom Substitution Units of Good X
e effect
 Indifference analysis

Income and
substitution effects of
a change in price:
(b) inferior good
 Income and substitution effects: Inferior (non-Giffen) good
Units of good Y

I1

I2 B1

QX1
Units of Good X
 Income and substitution effects: Inferior (non-Giffen) good

Rise in the price

of good X
Units of good Y

f
h

I1

B2 I2 B1

QX3 QX1
Units of Good X
 Income and substitution effects: Inferior (non-Giffen) good

Substitution effect
of the price rise
g
Units of good Y

f
h

I1

B2 B1a I2 B1

QX2 QX1
Substitution effect Units of Good X
 Income and substitution effects: Inferior (non-Giffen) good

Income effect of
the price rise
g
Units of good Y

f
h

I1

B2 B1a I2 B1

QX2 QX3 QX1

Substitution effect Units of Good X
Income effect
 Indifference analysis

Income and
substitution effects of
a change in price:
(c) Giffen good
Units of good Y Income and substitution effects: Giffen good

I1

I2 B1
QX1
Units of Good X
 Income and substitution effects: Giffen good

Rise in the price

of good X
Units of good Y

I1
h

B2 I2 B1
QX1QX3
Units of Good X
 Income and substitution effects: Giffen good

Substitution effect
g of the price rise
Units of good Y

I1
h

B1a
B2 I2 B1
QX2 QX1QX3
Substitution effect Units of Good X
 Income and substitution effects: Giffen good

Income effect of
g the price rise
Units of good Y

I1
h

B1a
B2 I2 B1
QX2 QX1QX3
Substitution effect Units of Good X
Income effect
 Indifference analysis

Characteristics theory
 Choice between brands: characteristics approach
Brand 1
Brand 2 Quantities of any one of
three brands that can be
purchased for a given
Quantity of characteristic A

budget at current prices:

x1 Brand 1 is chosen
QA1

Brand 3

x2

x3 I5
I4
I3
I2
I1
QB1

Quantity of characteristic B
 Choice between brands: characteristics approach
Brand 1
Brand 2

Effect of reductions in the

Quantity of characteristic A

price of Brand 2:
x1 Brand 2 is now chosen

Brand 3
QA5 x5
x4
x2

x3 I5
I4
I3
I2
I1
QB5

Quantity of characteristic B