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Indifference Analysis

Utility
Benefits consumers obtain from goods & services they consume is utility A utility function shows an individual’s 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

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 .Indifference Curves Locus of points representing different bundles of goods.

1) .Typical Indifference Curve (Figure 5.

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 2 4 6 8 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 2 4 6 8 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 Pears 30 24 20 14 10 8 6 6 7 8 10 13 15 20 2 4 6 8 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 d 30 24 20 14 10 8 6 6 7 8 10 13 15 20 e f g 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 b 26 ∆X = 1 Units of good Y 20 MRS = ∆ Y/∆ X 10 0 0 67 10 20 Units of good X .

holding constant the amounts of all other goods consumed MU = ∆U ∆X .Marginal Utility Addition to total utility attributable to the addition of one unit of a good to the current rate of consumption.

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 c 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). . the MRS x y diminishes. As the individual moves down on indifference curve.

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 0 Units of good X .

The impossibility of two indifference curves crossing 30 Units of good Y 20 a 10 b I2 I1 0 0 10 20 Units of good X .

They cannot intersect. Negatively Sloped. .Properties 1. Convex to the origin. 2. 3.

The impossibility of two indifference curves crossing 30 Units of good Y 20 a 10 c b I2 I1 0 10 20 0 Units of good X .

Indifference analysis Budget lines .

30 .1 Budget = Rs.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.

2 PY = Rs.1 Budget = Rs.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.30 0 0 5 10 15 20 Units of good X .

Consumer’s 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 .

2 PY = Rs.30 a 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 b 0 5 10 15 10 Assumptions PX = Rs.1 Budget = Rs.30 0 0 5 10 15 20 Units of good X .

30 0 0 5 10 15 20 Units of good X .1 Budget = Rs.2 PY = Rs.30 a 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 b 0 5 10 15 10 c Assumptions PX = Rs.

2 PY = Rs.30 a 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 b 0 5 10 15 10 c Assumptions PX = Rs.30 0 0 5 10 d 15 20 Units of good X .1 Budget = 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 30 Units of good Y 20 Assumptions 10 PX = Rs2 PY = Rs.

40 20 16 n m Budget = £40 Budget = £30 0 5 7 10 0 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.1 Budget = Rs.2 PY = Rs.

30 Units of good Y 20 10 0 0 5 10 15 20 25 30 Units of good X .2 PY = Rs.Effect on the budget line of a fall in the price of good X 30 Assumptions PX = Rs.1 Budget = Rs.

1 Budget = Rs.Effect on the budget line of a fall in the price of good X 30 Assumptions PX = Rs.2 PY = Rs.30 Units of good Y 20 10 0 0 5 10 15 20 25 30 Units of good X .

1 PY = Rs.1 Budget = Rs.Effect on the budget line of a fall in the price of good X 30 Assumptions PX = 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 Budget = 30 Units of good Y 20 10 B1 0 0 5 10 B2 b c 20 25 30 15 Units of good X .1 PY = Rs.

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 t u v O I1 X1 Units of good X I2 I3 I5 I4 .

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

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 •A •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 C II T I 0 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 a 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

a

Qcd1

Deriving an Engel curve from an income-consumption curve

Bread

Qb2 Qb1

a

b

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

a

b

Income-consumption c curve I3

B1 Qcd1 Qcd2 Qcd3

B2

I1

I2 B3

CDs

Income (£)

Y3 Y2 Y1

b a

c

Qcd1 Qcd2 Qcd3

Deriving an Engel curve from an income-consumption curve Bread Qb3 Qb2 Qb1 a b Income-consumption c curve I3 B1 Qcd1 Qcd2 Qcd3 B2 I1 I2 B3 CDs Engel curve Income (£) Y3 Y2 Y1 b a c Qcd1 Qcd2 Qcd3 .

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

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) b 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 .

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 = Rs2 PY = Rs1 Budget = Rs.

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 a 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 a 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 a b c d 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 a b c d 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 a b c d 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 Consumer’s 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 Consumer’s 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 f 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 f 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 g 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 g 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 f 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 f 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 .