Chapter 4.3
Indifference Analysis
and Discussion
Recall we were examining 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.
Units of good Y
Effect on consumption of a change in income
Income–consumption curve
I4
I3
B1
B2
B3
O
Units of good X
B4
I2
I1
Slope of the Income Consumption Curve
• 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.
• If x is the inferior good how do we depict
this in an indifference curve diagram ?
Units of good Y
(normal good)
Effect of a rise in income on the demand for an inferior good
a
B
O
1
Units of good X
(inferior good)
I1
Units of good Y
(normal good)
Effect of a rise in income on the demand for an inferior good
b
I2
a
B
O
1
Units of good X
(inferior good)
I1
B
2
Effect of a rise in income on the demand for an inferior good
Units of good Y
(normal good)
Income–consumption curve
b
Bends backwards
for an inferior
good
I2
a
B
O
1
Units of good X
(inferior good)
I1
B
2
The Engel curve:
• Another way of looking at things is through
THE ENGEL CURVE
Bread
Deriving an Engel curve from an income–consumption curve
I3
B1
B2
I1
I2
B3
CDs
Bread
Deriving an Engel curve from an income–consumption curve
Income-consumption
curve
I3
B1
B2
I1
I2
B3
CDs
Bread
Deriving an Engel curve from an income–consumption curve
Income-consumption
curve
I3
B1
B2
I1
I2
B3
Income (£)
CDs
Bread
Deriving an Engel curve from an income–consumption curve
Income-consumption
curve
a
Qb1
I3
B1
Income (£)
Qcd1
B2
I1
I2
B3
CDs
Bread
Deriving an Engel curve from an income–consumption curve
Income-consumption
curve
a
Qb1
I3
B1
Income (£)
Qcd1
I1
I2
B3
CDs
a
Qcd1
B2
I1
Bread
Deriving an Engel curve from an income–consumption curve
Qb2
Qb1
a
b
Income-consumption
curve
I3
B1
Income (£)
Qcd1Qcd2
I2
I1
b
a
Qcd1Qcd2
B2
I1
I2
B3
CDs
Bread
Deriving an Engel curve from an income–consumption curve
Qb3
Qb2
Qb1
a
b
Income-consumption
c
curve
I3
B1
Income (£)
Qcd1Qcd2 Qcd3
I3
I2
I1
c
b
a
Qcd1Qcd2Qcd3
B2
I1
I2
B3
CDs
Bread
Deriving an Engel curve from an income–consumption curve
Qb3
Qb2
Qb1
a
b
Income-consumption
c
curve
I3
B1
B2
I1
I2
B3
Income (£)
Qcd1Qcd2 Qcd3
CDs
Engel curve
I3
I2
i1
c
b
a
Qcd1Qcd2Qcd3
Shifts in the Demand Curve
• Consider next the effect of a change in
income on the original demand curve we
derived for good x.
Units of Good Y
Deriving a demand curve from a price–consumption curve
Price-consumption
curve
a
B1
B2
B3
I2
I1
B4
I3
I4
Units of good X
Price of CD
P1
P2
a
P3
P4
Demand
Q1 Q2 Q3 Q4
Units of good X
Bread
What happens now as income rises?
a
Qb1
I3
B1
Price of CD
Qcd1
P1
I2
B3
CDs
a
Qcd1
B2
I1
What happens now as income rises?
Bread
At P1 the demand for good
x increases when income
rises (if x is normal)
a
Qb1
I3
B1
Price of CD
Qcd1
P1
I2
B3
CDs
a
Qcd1
B2
I1
Bread
And the Demand Curve SHIFTS out
a
Qb1
I3
B1
Price of CD
Qcd1
P1
Qcd2
a
Qcd1 Qcd2
B2
I1
I2
B3
CDs
What about the effect of a change in the price of y?
Bread
B1
Qb3
a
I3
B2
I1
Price (£)
Qcd1
P1
a
Qcd1
I2
CDs
As Py rises the Budget Constraint swings
down
B
Bread
1
Qb3
Qb2
Where will the
new optimum
be?
a
I3
B2
I1
Price (£)
Qcd1 Qcd2
P1
a
Qcd1
Qcd2
I2
CDs
.
Bread
B1
Qb3
Qb2
a
I3
B2
I1
Price (£)
Qcd1 Qcd2
P1
a
Qcd1
Qcd2
I2
CDs
And the demand curve shifts out
Bread
B1
Qb3
Qb2
a
I3
B2
I1
Price (£)
Qcd1 Qcd2
P1
a
Qcd1
b
Qcd2
I2
CDs
INDIFFERENCE ANALYSIS
• The 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:
– a normal good
INDIFFERENCE ANALYSIS
• 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.
• 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.
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.