Chapter 4.3 Indifference Analysis and Discussion Chapter 4.3 Indifference Analysis and Discussion

Recall we were examining the effect of a change in income The income–consumption curveThe income–consumption curve –Tracks the effect of changes in income on our optimum choices of x and y.

I2I2 Units of good Y O Units of good X B1B1 B2B2 B3B3 B4B4 I1I1 I3I3 I4I4 Income–consumption curve Effect on consumption of a change in income

Slope of the Income Consumption Curve Thus far, when income rises the demand for both x and y rose. Is this always the case ?Thus far, when income rises the demand for both x and y rose. Is this always the case ? No. There is something called an inferior good with the property that if income rises demand for that good will fall. A tomato and cheese pizza is a good example ! It is inferior to a meat feast pizza.No. There is something called an inferior good with the property that if income rises demand for that good will fall. A tomato and cheese pizza is a good example ! It is inferior to a meat feast pizza. If x is the inferior good how do we depict this in an indifference curve diagram ?If x is the inferior good how do we depict this in an indifference curve diagram ?

Effect of a rise in income on the demand for an inferior good Units of good Y (normal good) Units of good X (inferior good) O I1I1 B1B1 a

Effect of a rise in income on the demand for an inferior good Units of good Y (normal good) Units of good X (inferior good) O I2I2 I1I1 B1B1 B2B2 a b

Effect of a rise in income on the demand for an inferior good Units of good Y (normal good) Units of good X (inferior good) O Income–consumption curve I2I2 I1I1 B1B1 B2B2 a b Bends backwards for an inferior good

The Engel curve: Another way of looking at things is through THE ENGEL CURVEAnother way of looking at things is through THE ENGEL CURVE

Deriving an Engel curve from an income–consumption curve Bread B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 CDs

B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 Income-consumption curve CDs Bread Deriving an Engel curve from an income–consumption curve

B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 Income-consumption curve CDs Bread Income (£) Deriving an Engel curve from an income–consumption curve

B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 Income-consumption curve Bread Income (£) CDs Qb1Qb1 Q cd 1 a Deriving an Engel curve from an income–consumption curve

B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 Income-consumption curve Bread Income (£) CDs Qb1Qb1 I1I1 Q cd 1 a a Deriving an Engel curve from an income–consumption curve

B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 Income-consumption curve Bread Income (£) CDs Qb2Qb2 Qb1Qb1 I2I2 I1I1 Q cd 2 Q cd 1 Q cd 2 Q cd 1 a b a b Deriving an Engel curve from an income–consumption curve

B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 Income-consumption curve Bread Income (£) CDs Qb3Qb3 Qb2Qb2 Qb1Qb1 I3I3 I2I2 I1I1 Q cd 3 Q cd 2 Q cd 1 Q cd 3 Q cd 2 Q cd 1 a b c a b c Deriving an Engel curve from an income–consumption curve

B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 Income-consumption curve Bread Income (£) CDs Qb3Qb3 Qb2Qb2 Qb1Qb1 I3I3 I2I2 i1i1 Q cd 3 Q cd 2 Q cd 1 Q cd 3 Q cd 2 Q cd 1 Engel curve a b c a b c Deriving an Engel curve from an income–consumption curve

Shifts in the Demand Curve Consider next the effect of a change in income on the original demand curve we derived for good x.Consider next the effect of a change in income on the original demand curve we derived for good x.

B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 I4I4 B4B4 Units of Good Y Units of good X Price - consumption curve a Price of CD Units of good X a Demand P1P1 P2P2 P3P3 P4P4 Q1Q1 Q2Q2 Q3Q3 Q4Q4 Deriving a demand curve from a price–consumption curve

B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 Bread CDs Qb1Qb1 P1P1 Q cd 1 a a What happens now as income rises? Price of CD

B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 Bread CDs Qb1Qb1 P1P1 Q cd 1 a a What happens now as income rises? Price of CD At P 1 the demand for good x increases when income rises (if x is normal)

B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 Bread CDs Qb1Qb1 P1P1 Q cd 1 a a And the Demand Curve SHIFTS out Price of CD Q cd2

B1B1 B2B2 I3I3 I2I2 I1I1 Bread Price (£) CDs Qb3Qb3 P1P1 Q cd 1 a a What about the effect of a change in the price of y?

B1B1 B2B2 I3I3 I2I2 I1I1 Bread Price (£) CDs Qb3Qb3 Qb2Qb2 P1P1 Q cd 2 Q cd 1 Q cd 2 Q cd 1 a a As P y rises the Budget Constraint swings down Where will the new optimum be?

B1B1 B2B2 I3I3 I2I2 I1I1 Bread Price (£) CDs Qb3Qb3 Qb2Qb2 P1P1 Q cd 2 Q cd 1 Q cd 2 Q cd 1 a a.

B1B1 B2B2 I3I3 I2I2 I1I1 Bread CDs Qb3Qb3 Qb2Qb2 P1P1 Q cd 2 Q cd 1 Q cd 2 Q cd 1 a a b And the demand curve shifts out Price (£)

INDIFFERENCE ANALYSIS The effect of changes in priceThe effect of changes in price –the price–consumption curve –the individual's demand curve

INDIFFERENCE ANALYSIS If income increases and this leads to an increase in demand for the good, the good is called:If income increases and this leads to an increase in demand for the good, the good is called: –a normal good

INDIFFERENCE ANALYSIS If income increases and this leads to a decreasing in demand for the good, the good is called:If income increases and this leads to a decreasing in demand for the good, the good is called: –an inferior good

Indifference Analysis If the price of a good increases, we would surely expect that the demand for the good decreases.If the price of a good increases, we would surely expect that the demand for the good decreases. However, it is possible – though quite rare - that a price increase actually makes the consumer demand more of the good. Such a good is called a Giffen good.However, it is possible – though quite rare - that a price increase actually makes the consumer demand more of the good. Such a good is called a Giffen good.

IMPORTANT ! Later on you will see how one can dive further into the details of indifference analysis in order to properly understand the concept of normal, inferior, and Giffen goods. This is suggested reading (income and substitution effects). It is not something you will be held accoutable for at the exam here, however.Later on you will see how one can dive further into the details of indifference analysis in order to properly understand the concept of normal, inferior, and Giffen goods. This is suggested reading (income and substitution effects). It is not something you will be held accoutable for at the exam here, however.

Discussion of INDIFFERENCE ANALYSIS Sloman’s discussion of indifference analysis is, as far as your present lecturer is concerned, not terribly relevant. It is, of course, true that not every real world situation fits into this framework. Fine. One should never postulate that a simple theory can explain everything. But it may explain something – and that’s good enough.

Discussion of INDIFFERENCE ANALYSIS The truly crucial assumption is that indifference curves are taken as given. WE DO NOT MODEL HOW THESE ACTUALLY COME ABOUT. ”They are just there”. Therefore, indifference analysis is open to a (quite justified) critique along psychological or sociological lines.

Discussion of INDIFFERENCE ANALYSIS Moreover, we assume that consumers behave in a consistent / rational manner. Again, one is entitled to the viewpoint that people are actually irrational and unsystematic in their behavior. Fine. Only then you are not going to explain anything. If people are irrational, but systematically so, this can be modeled (and this has indeed been done).

Discussion of INDIFFERENCE ANALYSIS If indifference curves in fact depend on such things as the market price (utility from a high price), what you have seen so far also runs into problems. So one can then look at ”price dependent preferences”. This has indeed been done.

Discussion of INDIFFERENCE ANALYSIS The usefulness of indifference analysis is that it allows us to rationalize behavior. We do not need any ordinal measure of utility to construct a person’s indifference map. Indifference analysis and utility theory are the tools – or language if you like – economists use.