Chapter 4.3 Indifference Analysis Income & Sub effects, etc. P Chapter 4.3 Indifference Analysis Income & Sub effects, etc. P

Last lecture we started to to investigate the effect of changing prices and income on our optimum consumption decisions.Last lecture we started to to investigate the effect of changing prices and income on our optimum consumption decisions. In this lecture we further explore changes in Income and the price of other goods. In addition we start to dissect the effects of a change in the price of a good to get a deeper understanding of the demand curve.In this lecture we further explore changes in Income and the price of other goods. In addition we start to dissect the effects of a change in the price of a good to get a deeper understanding of the demand curve.

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. Its shape tells us something about the relative desireability of x and y as income risesIts shape tells us something about the relative desireability of x and y as income rises.

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 here?Thus far, when income rises the demand for both x and y rose. Is this always the case here? Demand for an inferior good will fall.Demand for an inferior good will fall. If x is the inferior good how do we depict that on the indifference curve diagram.If x is the inferior good how do we depict that on the 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 back for an inferior good

The Engel curve: Another way of representing this information is:Another way of representing this information is: The Engel curve: this plots the relationship between Income and one good (here the good x). The Engel curve: this plots the relationship between Income and one good (here the good x). Both the shape of the ICC and the Engel Curve tells us something about desireability of x (and in the case of the ICC, y) as income rises.Both the shape of the ICC and the Engel Curve tells us something about desireability of x (and in the case of the ICC, y) as income rises.

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

B1B1 B2B2 B3B3 I3I3 I2I2 I1I1 I4I4 B4B4 Expenditure on all other goods 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 Y1Y1 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 equilibrium 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 In this example x and y are substitutes

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 –deriving the individual's demand curve Income and substitution effects of a price changeIncome and substitution effects of a price change –a normal good

Units of Good X Units of good Y I6I6 I5I5 I4I4 I3I3 I2I2 I1I1 f B1B1 Income and substitution effects: normal good QX1QX1

Units of Good X Units of good Y f B1B1 Income and substitution effects: normal good QX1QX1 h B2B2 QX3QX3 Rise in the price of good X I6I6 I5I5 I4I4 I3I3 I2I2 I1I1

Units of Good X Units of good Y f B1B1 Income and substitution effects: normal good QX1QX1 h B2B2 Restore Income so that can get same Utility level as before QX3QX3 I6I6 I5I5 I4I4 I3I3 I2I2 I1I1

Units of Good X Units of good Y f B1B1 Income and substitution effects: normal good QX1QX1 h B2B2 Restore Income so that can get same Utility level as before QX3QX3 I6I6 I5I5 I4I4 I3I3 I2I2 I1I1

Units of Good X Units of good Y f B1B1 Income and substitution effects: normal good QX1QX1 h B2B2 Restore Income so that can get same Utility level as before QX3QX3 I6I6 I5I5 I4I4 I3I3 I2I2 I1I1

Units of Good X Units of good Y f B1B1 Income and substitution effects: normal good QX1QX1 h B2B2 B 2a Restore Income so that can get same Utility level as before QX3QX3 I6I6 I5I5 I4I4 I3I3 I2I2 I1I1

Units of Good X Units of good Y f B1B1 Income and substitution effects: normal good QX1QX1 h B2B2 g QX2QX2 Substitution effect of the price rise QX3QX3 B 2a I6I6 I5I5 I4I4 I3I3 I2I2 I1I1

Units of Good X Units of good Y f B1B1 Income and substitution effects: normal good QX1QX1 h B2B2 Substitution effect g QX2QX2 Substitution effect of the price rise QX3QX3 B 2a I6I6 I5I5 I4I4 I3I3 I2I2 I1I1

Units of Good X Units of good Y f B1B1 Income and substitution effects: normal good QX1QX1 h B2B2 QX3QX3 Substitution effect g QX2QX2 Income effect of the price rise Income effect Overall? B 2a I6I6 I5I5 I4I4 I3I3 I2I2 I1I1

Units of Good X Units of good Y f B1B1 Income and substitution effects: normal good QX1QX1 h B2B2 QX3QX3 g QX2QX2 Income effect of the price rise Overall B 2a I6I6 I5I5 I4I4 I3I3 I2I2 I1I1

INDIFFERENCE ANALYSIS Income and substitution effects of a price changeIncome and substitution effects of a price change –a normal good –an inferior good

Units of Good Y Units of Good X Units of good Y f B1B1 Income and substitution effects: Inferior good QX1QX1 I2I2 I1I1

Units of Good Y Units of Good X Units of good Y f B1B1 Income and substitution effects: Inferior (non-Giffen) good QX1QX1 B2B2 h QX3QX3 I2I2 I1I1 Rise in the price of good X

Units of Good Y Units of Good X Units of good Y f B1B1 Income and substitution effects: Inferior (non-Giffen) good QX1QX1 B2B2 g h QX2QX2 I2I2 I1I1 Substitution effect B 2b Substitution effect of the price rise

Units of Good Y Units of Good X Units of good Y f B1B1 Income and substitution effects: Inferior good QX1QX1 B2B2 g h QX2QX2 QX3QX3 I2I2 I1I1 Substitution effect Income effect Income effect of the price rise Inferior: But demand for the good still falls Overall? B 2b

Units of Good Y Units of Good X Units of good Y f B1B1 Income and substitution effects: Inferior good QX1QX1 B2B2 g h QX3QX3 I2I2 I1I1 Income effect of the price rise Overall B 2b

INDIFFERENCE ANALYSIS Income and substitution effects of a price changeIncome and substitution effects of a price change –a normal good –an inferior good –a Giffen good (a special type of inferior good)

Units of Good Y Units of Good X Units of good Y f B1B1 Income and substitution effects: Giffen good QX1QX1 I2I2 I1I1

Units of Good Y Units of Good X Units of good Y f B1B1 Income and substitution effects: Giffen good QX1QX1 B2B2 h QX3QX3 I2I2 I1I1 Rise in the price of good X

Units of Good Y Units of Good X Units of good Y f B1B1 Income and substitution effects: Giffen good QX1QX1 B2B2 h QX3QX3 I2I2 I1I1 A Giffen Good is a good whose demand rises when price rises, and v.v.

Units of Good Y Units of Good X Units of good Y f B1B1 Income and substitution effects: Giffen good QX1QX1 B2B2 h QX3QX3 I2I2 I1I1 g QX2QX2 B 2c Substitution effect of the price rise

Units of Good Y Units of Good X Units of good Y f B1B1 Income and substitution effects: Giffen good QX1QX1 B2B2 h QX3QX3 I2I2 I1I1 g QX2QX2 Substitution effect Income effect Income effect of the price rise Overall? B 2c

Units of Good Y Units of Good X Units of good Y f B1B1 Income and substitution effects: Giffen good QX1QX1 B2B2 h QX3QX3 I2I2 I1I1 g QX2QX2 Income effect of the price rise Overall? B 2c

Units of Good Y Units of Good X Units of good Y f B1B1 Income and substitution effects: Giffen good QX1QX1 B2B2 h QX3QX3 I2I2 I1I1 g QX2QX2 Overall Overall Q x UP B 2c

Income & Substitution Effects: Summary The Substitution effect is always NEGATIVE P up, Q DownThe Substitution effect is always NEGATIVE P up, Q Down The Income effect is normally positiveThe Income effect is normally positive P UpP Up Real Income DownReal Income Down Therefore Q downTherefore Q down So a rise in Price =>So a rise in Price => –Sub effect - Q down –Inc Effect - Q Down –Overall - Q Down

Income & Substitution Effects: Summary The Substitution effect is always NEGATIVE P up, Q DownThe Substitution effect is always NEGATIVE P up, Q Down BUT income effect can be NEGATIVEBUT income effect can be NEGATIVE Inferior GoodInferior Good P Up - Real Income DownP Up - Real Income Down But now Q UPBut now Q UP So a rise in Price =>So a rise in Price => –Sub effect - Q down –Inc effect - Q UP –Overall – Which effect is stronger?

Income & Substitution Effects: Summary The Substitution effect is always NEGATIVE P up, Q DownThe Substitution effect is always NEGATIVE P up, Q Down BUT income effect can be NEGATIVEBUT income effect can be NEGATIVE Inferior Good, P Up - Real Income Down Q UPInferior Good, P Up - Real Income Down Q UP So P upSo P up –Sub effect - D down –Inc Effect - Q UP –Overall – Which effect is stronger? –Sub effect > Inc Effect => Inferior good Q down –Inc effect > Sub Effect => Giffen good Q UP

Discussion of INDIFFERENCE ANALYSIS The usefulness of indifference analysis –superiority of using ordinal measures –All ‘as if’ – not using actual Utility Function –limitations of indifference analysis –Difficult to derive – rubbish - all ‘as if’ –Uncertainty about product – ex ante decision –Indifference curves not smooth (e.g. once off items) – not really big deal – services product provides

Discussion of INDIFFERENCE ANALYSIS The usefulness of indifference analysis Allows us to rationalise behaviour Using this analysis can develop useful predictions (will see next year) Predictions can be tested Tests allow us to check whether theory is false (True?)