Indifference Analysis

Utility
Benefits consumers obtain from goods & services they consume is utility A utility function shows an individuals perception of the utility level attained from consuming each conceivable bundle of goods

Theory of Consumer Behavior

Assume consumers have complete information about availability, prices, & utility levels of all goods & services All bundles of goods can be ranked based on their ability to provide utility for any pair of bundles A & B: Prefer bundle A to bundle B Prefer bundle B to bundle A Indifferent between the two bundles

Indifference Curves
Locus of points representing different bundles of goods, each of which yields the same level of total utility Negatively sloped & convex Marginal rate of substitution (MRS) Absolute value of the slope of the indifference curve Diminishes along the indifference curve as X increases & Y decreases

Typical Indifference Curve

(Figure 5.1)

Indifference analysis

Indifference curves

Indifference Curves: Definition

An indifference curve shows the various combinations of commodity X and commodity Y which yield equal utility or satisfaction to the consumer . A higher indifference curve shows a greater amount of satisfaction and a lower one , less satisfaction.

Constructing an indifference curve

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

Combinations of pears and oranges that Clive likes the same amount as 10 pears and 13 oranges

30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0

Constructing an indifference curve

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

Pears

10

12

14

16

18

20

22

Oranges

30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0

Constructing an indifference curve

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

Pears

10

12

14

16

18

20

22

Oranges

30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0

Constructing an indifference curve

a
Pears Oranges Point a b c d e f g

Pears

30 24 20 14 10 8 6

6 7 8 10 13 15 20

10

12

14

16

18

20

22

Oranges

30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 0

Constructing an indifference curve

a
Pears Oranges Point a b c d e f g

b c

Pears

30 24 20 14 10 8 6

6 7 8 10 13 15 20

f g

10

12

14

16

18

20

22

Oranges

Deriving the marginal rate of substitution (MRS)

30

a Y = 4 MRS = 4 b

26

X = 1 Units of good Y
20

MRS = Y/ X

10

0 0
67

10

20

Units of good X

Marginal Utility

Addition to total utility attributable to the addition of one unit of a good to the current rate of consumption, holding constant the amounts of all other goods consumed

MU = U X

Marginal Rate of Substitution

MRS shows the rate at which one good can be substituted for another while keeping utility constant Negative of the slope of the indifference curve Ratio of the marginal utilities of the goods

Y MU X MRS = X MUY

Deriving the marginal rate of substitution (MRS)

30

a Y = 4 MRS = 4 b

26

X = 1 Units of good Y
20

MRS = Y/ X

10 9

Y = 1 X = 1

MRS = 1 d

0 0
67

10

13 14

20

Units of good X

MRS : Definition

The MRS of X for Y ( MRS x y) refers to the amount of Y that a consumer willing to give up in order to gain one additional unit of X ( and still remain on the same indifference curves). As the individual moves down on indifference curve, the MRS x y diminishes.

30

An indifference map

Units of good Y

20

10

I5 I2
20

I3

I4

0 0 10

I1 Units of good X

The impossibility of two indifference curves crossing

30

Units of good Y

20

a
10

b I1
0 10 20

Units of good X

The impossibility of two indifference curves crossing

30

Units of good Y

20

a
10

I2 I1

0 0 10 20

Units of good X

Properties
1. 2. 3.

Negatively Sloped. Convex to the origin. They cannot intersect.

The impossibility of two indifference curves crossing

30

Units of good Y

20

a
10

c b I2 I1
0 10 20

Units of good X

Indifference analysis

Budget lines

A budget line
Units of good X Units of good Y 30 20 10 0

A budget constraint line shows all the different combinations of the two commodities that a consumer can Purchase , given his or her money income And the prices of the two commodities

0 5 10 15

Assumptions PX = Rs.2 PY = Rs.1 Budget = Rs.30

30 a

A budget line
Units of good X Units of Point on good Y budget line 30 20 10 0 a

Units of good Y

20

0 5 10 15

10

Assumptions PX = Rs.2 PY = Rs.1 Budget = Rs.30

0 0 5 10 15 20

Units of good X

Consumers Budget Line

Shows all possible commodity bundles that can be purchased at given prices with a fixed money income

M = PX X +PY Y
or

M PX Y = X PY PY

30

A budget line
Units of good X Units of Point on good Y budget line 30 20 10 0 a b

Units of good Y

20

0 5 10 15

10

Assumptions PX = Rs.2 PY = Rs.1 Budget = Rs.30

0 0 5 10 15 20

Units of good X

30

A budget line
Units of good X Units of Point on good Y budget line 30 20 10 0 a b c

Units of good Y

20

0 5 10 15

10

Assumptions PX = Rs.2 PY = Rs.1 Budget = Rs.30

0 0 5 10 15 20

Units of good X

30

A budget line
Units of good X Units of Point on good Y budget line 30 20 10 0 a b c d

Units of good Y

20

0 5 10 15

10

Assumptions PX = Rs.2 PY = Rs.1 Budget = Rs.30

0 0 5 10

d
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 = Rs2 PY = Rs.1 Budget = Rs.30

0 0 5 10 15 20

Units of good X

Effect of an increase in income on the budget line

40
Assumptions

30

Units of good Y

PX = Rs.2 PY = Rs.1 Budget = Rs.40

20
16

n m Budget = 40 Budget = 30
0 5
7

10

0 10

15

20

Units of good X

Effect on the budget line of a fall in the price of good X

30
Assumptions PX = Rs.2 PY = Rs.1 Budget = Rs.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 = Rs.2 PY = Rs.1 Budget = Rs.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 = Rs.1 PY = Rs.1 Budget = Rs.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 = Rs.1 PY = Rs.1 Budget = 30

Units of good Y

20

10

B1
0 0 5 10

B2 b c
20 25 30

15

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 I2 I3 I4

O Units of good X

I1

Finding the optimum consumption

Units of good Y

Budget line

I5 I2 I3 I4

O Units of good X

I1

Finding the optimum consumption

r s Units of good Y

Y1

u v O I1 X1 Units of good X I2 I3

I5 I4

Consumer Equilibrium

A consumer is in equilibrium when, given personal income and price constraints , the consumer maximises the total utility or satisfaction from his or her expenditures . In other words, a consumer equilibrium when, given his or her budget line , the person reaches the highest possible indifference curves

Utility Maximization

Utility maximization subject to a limited money income occurs at the combination of goods for which the indifference curve is just tangent to the budget line

Y MU X PX MRS = = = X MUY PY

Utility Maximization

Consumer allocates income so that the marginal utility per dollar spent on each good is the same for all commodities purchased

MU X MUY = PX PY

Constrained Utility Maximization

(Figure 5.7)

50 45 40

B
R

D
E IV III

30

s azz i p f o yti t nau Q

20 15 10

10 20 30 40 50 60

II T I

70

80

90

100

Quantity of burgers

Indifference analysis

Effects of a change in income

Effect on consumption of a change in income

Units of good Y

B1 O Units of good X

I1

Effect on consumption of a change in income

Units of good Y

B1 O

B2

I1

I2

Units of good X

Effect on consumption of a change in income

Units of good Y

B1 O

B2

B3

B4

I1

I2

I3

I4

Units of good X

Effect on consumption of a change in income

Units of good Y

Income-consumption curve

B1 O

B2

B3

B4

I1

I2

I3

I4

Units of good X

Deriving an Engel curve from an income-consumption curve

Bread

B1

B2

I1

I2 B3

I3

CDs

Deriving an Engel curve from an income-consumption curve

Bread

Income-consumption curve I3

B1

B2

I1

I2 B3

CDs

Deriving an Engel curve from an income-consumption curve

Bread

Income-consumption curve I3

B1

B2

I1

I2 B3

CDs Income ()

Deriving an Engel curve from an income-consumption curve

Bread

Income-consumption curve Qb1

a
B1 Qcd1 B2 I1 I2 B3

I3

CDs

Income ()

Deriving an Engel curve from an income-consumption curve

Bread

Income-consumption curve Qb1

a
B1 Qcd1 B2 I1 I2 B3

I3

CDs

Income ()

Y1

Qcd1

Deriving an Engel curve from an income-consumption curve

Bread

Qb2 Qb1

Income-consumption curve I3

B1 Qcd1 Qcd2

B2

I1

I2 B3

CDs

Income ()

Y2 Y1

b a

Qcd1 Qcd2

Deriving an Engel curve from an income-consumption curve

Bread

Qb3 Qb2 Qb1

Income-consumption c curve I3

B1 Qcd1 Qcd2 Qcd3

B2

I1

I2 B3

CDs

Income ()

Y3 Y2 Y1

b a

Qcd1 Qcd2 Qcd3

Deriving an Engel curve from an income-consumption curve

Bread

Qb3 Qb2 Qb1

Income-consumption c curve I3

B1 Qcd1 Qcd2 Qcd3

B2

I1

I2 B3

CDs
Engel curve

Income ()

Y3 Y2 Y1

b a

Qcd1 Qcd2 Qcd3

The Income- Consumption Curve and the Engel Curve

The income consumption curve is the locus of points of consumer equilibrium resulting when only the consumers income is varied . The Engel curve shows the amount of a commodity that the consumer would purchase per unit of time at various levels of total income

Effect of a rise in income on the demand for an inferior good

Units of good Y (normal good)

a B1 O Units of good X (inferior good) I1

Effect of a rise in income on the demand for an inferior good

Units of good Y (normal good)

I2

a B1 O Units of good X (inferior good) I1 B2

Effect of a rise in income on the demand for an inferior good

Income-consumption curve Units of good Y (normal good) b

I2

a B1 O Units of good X (inferior good) I1 B2

Indifference analysis

Effects of a change in price

Effect of a fall in the price of good X

30
Assumptions PX = Rs2 PY = Rs1 Budget = Rs30

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 = Rs2 PY = Rs1 Budget = Rs.30

Units of good Y

20

j
10

0 0 5 10

B1
15 20 25

I1
30

Units of good X

Effect of a fall in the price of good X

30
Assumptions PX = Rs1 PY = Rs1 Budget = Rs30

Units of good Y

20

j
10

0 0 5 10

B1
15 20 25

I1
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

0 0 5 10

B1
15 20 25

I1

B2
30

Units of good X

Effect of a fall in the price of good X

30

Units of good Y

20

Price-consumption curve

k j
10

I2

0 0 5 10

B1
15 20 25

I1

B2
30

Units of good X

Deriving a demand curve from a price-consumption curve

Expenditure on all other goods

B1

I1

Units of good X

Deriving a demand curve from a price-consumption curve

Fall in the price of X a b

Expenditure on all other goods

B1

B2

I1

I2

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

B1

B2

I1

I2

Units of good X

Deriving a demand curve from a price-consumption curve

Further falls in the price of X a b c d
I4

Expenditure on all other goods

B1

B2

B3

I I1 2 B4

I3

Units of good X

Deriving a demand curve from a price-consumption curve

Expenditure on all other goods

Price-consumption curve
I3 I4

B1

B2

B3

I I1 2 B4

Units of good X

Deriving a demand curve from a price-consumption curve

Expenditure on all other goods

Price-consumption curve
I3 I4

B1

B2

B3

I I1 2 B4

Units of good X Price of good X P1 a

Q1

Units of good X

Deriving a demand curve from a price-consumption curve

Expenditure on all other goods

Price-consumption curve
I3 I4

B1

B2

B3

I I1 2 B4

Units of good X Price of good X P1 a

P2 P3 P4

b c d

Demand Units of good X

Q1 Q2 Q 3 Q 4

The Price Consumption Curve and The Consumers Demand Curve

The price consumption curve for commodity X is the locus of points of consumer equilibrium resulting when only the price of X is varied The Consumers demand curve for commodity X shows the amount of X that the consumer would purchase at various prices of X, ceteris paribus

Indifference analysis

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

Price Effect

The Income Effect may be defined as the effect on the purchase of the consumer caused by changes in income, if prices of goods remain constant Substitution effect refers to the change in the consumption or demand of two goods as a result of their relative change in prices, real income remaining constant Price effect shows how much the satisfaction of the consumer varies due to change in the consumption of two goods as the price of one changes the price of other and money income changes

Income and substitution effects: normal good

Units of good Y

I1 I2 I3 I4 I5 I6

B1 QX1

Units of Good X

Income and substitution effects: normal good

Rise in the price of good X Units of good Y

h f

I1 I2 I3 I4 I5 I6

B2 QX3 QX1

B1

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 I6

B2 QX3 QX2
Substitution effect

B1a

B1

QX1

Units of Good X

Income and substitution effects: normal good

Income effect of the price rise Units of good Y

g h f

I1 I2 I3 I4 I5 I6

B2 QX3
Incom e

B1a

B1

QX2

Substitution effect

QX1

Units of Good X

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
QX1 Units of Good X B1

Income and substitution effects: Inferior (non-Giffen) good

Rise in the price of good X Units of good Y

f h

I1 I2
B1 Units of Good X

B2 QX3 QX1

Income and substitution effects: Inferior (non-Giffen) good

Units of good Y

Substitution effect of the price rise

f h

I1 I2
B1 Units of Good X

B2 QX2 QX1

B1a

Substitution effect

Income and substitution effects: Inferior (non-Giffen) good

Units of good Y

Income effect of the price rise

f h

I1 I2
B1 Units of Good X

B2 QX2 QX3
Income effect

B1a

QX1

Substitution effect

Indifference analysis

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

Income and substitution effects: Giffen good

Units of good Y

I1

I2
QX1

B1 Units of Good X

Income and substitution effects: Giffen good

Rise in the price of good X Units of good Y

I1
h

B2 QX1QX3

I2

B1 Units of Good X

Income and substitution effects: Giffen good

Units of good Y

g f

Substitution effect of the price rise

I1
h

B2 QX2 QX1QX3
Substitution effect

B1a

I2

B1 Units of Good X

Income and substitution effects: Giffen good

Units of good Y

g f

Income effect of the price rise

I1
h

B2 QX2 QX1QX3
Income effect Substitution effect

B1a

I2

B1 Units of Good X