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Indifference Analysis- The Demand Curve
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In this section we want to investigate the effect of changing prices and income on our optimum consumption decisions. First we will look at the effect of these changes on the budget constraint and then consider their effect on our consumption choices.
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Effect on the budget line of a fall in the price of good X
Assumptions PX = £2 PY = £1 Budget = £30 Units of good Y Remember the maximum X we can consume is I/Px= 30/Px Units of good X
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Effect on the budget line of a fall in the price of good X
Assumptions PX = £2 PY = £1 Budget = £30 Units of good Y What will happen to this point if PX falls to 1? Units of good X
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Effect on the budget line of a fall in the price of good X
Assumptions PX = £2 PY = £1 Budget = £30 Units of good Y I/Px now rises to 30 and the budget constraint swings out Units of good X
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Effect on the budget line of a fall in the price of good X
Assumptions PX = £1 PY = £1 Budget = £30 Units of good Y I/Px now rises to 30 and the budget constraint swings out B2 B1 b c Units of good X
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INDIFFERENCE ANALYSIS
What would be the effect of a rise in the price of Y? 7
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Effect on the budget line of a rise in the price of good Y
Assumptions PX = £2 PY = £1 Budget = £30 Units of good Y Remember the maximum Y we can consume is I/PY= 30/PY Units of good X
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Effect on the budget line of a fall in the price of good X
Assumptions PX = £2 PY = £1 Budget = £30 Units of good Y What will happen to this point if PY rises to 2? Units of good X
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Effect on the budget line of a fall in the price of good X
Assumptions PX = £2 PY = £2 Budget = £30 Units of good Y I/PY now falls to 15 and the budget constraint swings in Units of good X
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So price down => Budget Constraint Swings out
Price Up => Budget Constraint Swings in
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Effect of an increase in income on the budget line
Units of good Y Assumptions PX = £2 PY = £1 Budget = £30 Units of good X
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Effect of an increase in income on the budget line
Assumptions PX = £2 PY = £1 Budget = £40 Units of good Y Budget = £40 Budget = £30 Units of good X
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What would be the effect of a 50% rise in the price of x and price of y
Assumptions PX = £3 PY = £1.50 Budget = £30 Budget = £30 Units of good Y Units of good X
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Effect of an increase in both prices on the budget line
Assumptions PX = £3 PY = £1.50 Budget = £30 Units of good Y Budget = £30 Units of good X
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What would be the effect of a 50% rise in the price of x and price of y and income
Assumptions PX = £3 PY = £1.50 Budget = £45 Budget = £30 Units of good Y Units of good X
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Assumptions PX = £3 PY = £1.50 Budget = £45 So generalised inflation in prices and income has no effect on the budget constraint Units of good Y Units of good X
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INDIFFERENCE ANALYSIS
We are now ready to combine our analysis of changes in the budget line with the Indifference curve map. So now we want to study the: effect of a change in price effect of a change in income on our equilibrium choices. 6
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INDIFFERENCE ANALYSIS
The effect of changes in price the price–consumption curve 8
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Effect of a fall in the price of good X
Assumptions PX = £1 PY = £1 Budget = £30 Units of good Y j B1 I1 B2 Units of good X
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Effect of a fall in the price of good X
Assumptions PX = £1 PY = £1 Budget = £30 k Units of good Y j I2 B1 I1 B2 Units of good X
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Effect of a rise in the price of good X
Assumptions PX = £3 PY = £1 Budget = £30 k Units of good Y j I2 B1 I1 B2 Units of good X
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Price–consumption curve
a Price–consumption curve k Units of good Y j I2 B1 I1 B2 Units of good X
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INDIFFERENCE ANALYSIS
The effect of changes in price the price–consumption curve deriving the individual's demand curve 8
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Deriving a demand curve from a price–consumption curve
Expenditure on all other goods I1 B1 Units of good X
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Deriving a demand curve from a price–consumption curve
Fall in the price of X a b Expenditure on all other goods I2 I1 B1 B2 Units of good X
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Deriving a demand curve from a price–consumption curve
Further falls in the price of X a b Expenditure on all other goods c d I4 I3 I2 I1 B1 B2 B3 B4 Units of good X
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Deriving a demand curve from a price–consumption curve
b Price-consumption curve Expenditure on all other goods c d I4 I3 I2 I1 B1 B2 B3 B4 Units of good X
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Deriving a demand curve from a price–consumption curve
b Price-consumption curve Expenditure on all other goods c d I4 I3 I2 I1 B1 B2 B3 B4 Units of good X a P1 Price of good X Q1 Units of good X
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Deriving a demand curve from a price–consumption curve
b Price-consumption curve Expenditure on all other goods c d I4 I3 I2 I1 B1 B2 B3 B4 Units of good X a P1 Price of good X P2 b Q1 Q2 Units of good X
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Deriving a demand curve from a price–consumption curve
b Price-consumption curve Expenditure on all other goods c d I4 I3 I2 I1 B1 B2 B3 B4 Units of good X a P1 Price of good X P2 b P3 c Q1 Q2 Q3 Units of good X
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Deriving a demand curve from a price–consumption curve
b Price-consumption curve Expenditure on all other goods c d I4 I3 I2 I1 B1 B2 B3 B4 Units of good X a P1 Price of good X P2 b P3 c P4 d Q1 Q2 Q3 Q4 Units of good X
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Deriving a demand curve from a price–consumption curve
b Price-consumption curve Expenditure on all other goods c d I4 I3 I2 I1 B1 B2 B3 B4 Units of good X a P1 Price of good X P2 b P3 c P4 d Demand Q1 Q2 Q3 Q4 Units of good X
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What about a change in Income?
What happens to the pattern of expenditure as income rises? How does that effect the optimum choice of x and y and how does it effect the demand curve for x.
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Effect on consumption of a change in income
Units of good Y B1 I1 O Units of good X
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Effect on consumption of a change in income
Units of good Y I2 B1 B2 I1 O Units of good X
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Effect on consumption of a change in income
Units of good Y I4 I3 I2 B1 B2 B3 B4 I1 O Units of good X
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Effect on consumption of a change in income
Income–consumption curve Units of good Y I4 I3 I2 B1 B2 B3 B4 I1 O Units of good X
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The effect of a change in income
The 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 desirability of x and y as income rises 7
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