Indifference Analysis PDF

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INDIFFERENCE ANALYSIS CONSTRUCTING AN INDIFFERENCE CURVE

DERIVING THE MARGINAL RATE OF SUBSTITUTION (MRS)

An indifference map

The impossibility of two indifference curves crossing

a Budget line

Effects of an increase in income on the budget line

effect on the budget line of a fall in the price of good x

Finding the optimum consumption

•The optimum consumption point - !equating the marginal rate of -

substitution with the price ratio MRS = MUA/MUB = PA/PB

effect on consumption of a change in income

deriving an engel curve from an income-consumption curve

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

effect of a fall in the price of good x

deriving a demand curve from a price-consumption

income and substitution effects: normal good

Income and substitution effects: inferior (non-giffen) good

Income and substitution effects: giffen good

analysing a change in price: hicks income and substitution effects When a good’s price increases, consumers decrease their consumption of that good (‘the law of demand’) for two reasons:

- !The substitution effect: the good is now more expensive relative to other goods. ! Consumers substitute other goods for the more expensive good

- !The income effect: consumers cannot afford as much of it as before, because !! their money income is fixed Money income and real income are two different things:

• If your money income stays the same, but prices increase, your real income falls. Real income refers to how much you can buy; your ‘purchasing power’

• The income effect of a price change is due to changes in real income, so to look at the •

substitution effect, we need to hold real income constant Hicks suggested that real income, practically, is constant if the consumer’s level of satisfaction is constant, that is the consumer stays on the indifference curve that they were on before the price change - If they can get the same utility as before

Normal, inferior and Giffen goods The substitution effect is always negative (P increases, Q decreases and vice versa) and… If the income effect is

Then the good is

Negative

Normal

Positive

Inferior

Positive and outweighs substitution effect

Giffen...