Transcript Indifference Curve Analysis

INDIFFERENCE
CURVE
ANALYSIS
ASSUMPTION OF INDIFFERENCE CURVE
ANALYSIS.
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1. A consumer is assumed to buy any two goods in
combinations.
2. A consumer can rank the alternative combinations
and compare their level of satisfaction, and he prefers
a combination providing a higher level of satisfaction.
3. Consumer is rational and his choices are transitive.
4.The consumer behaviour is assumed to be constant,
throughout the analysis.
5. Indifference curve analysis
marginal rate of substitution.
assumes
diminishing
INDIFFERENCE CURVE
Indifference curve :
A curve that shows combinations of goods
among which an individual is indifferent.
 The slope of the indifference curve is the ratio
of marginal utilities of the two goods.
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INDIFFERENCE CURVE
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An indifference curve is a graph showing different
bundles of goods, each measured as to quantity,
between which a consumer is indifferent.
That is, at each point on the curve, the consumer has
no preference for one bundle over another. In other
words, they are all equally preferred. One can
equivalently refer to each point on the indifference
curve
as
rendering
the
same
level
of utility(satisfaction) for the consumer.
Utility is then a device to
represent preferences rather than
something from which preferences come.
The main use of indifference curves is in
the representation of potentially
observable demand patterns for individual
consumers over commodity bundles.
INDIFFERENCE CURVE.
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An indiffererence curve represents satisfaction of
a consumer from two commodities.
For all the possible points ( or combinations of
the two commodities ) on an indifference curve
, the total satisfaction ( or Utility) remains the
same.
Therefore a consumer is indifferent as to the
combinations lying on an indifference curve. It is
also called Iso-utility Curve.
INDIFFERENCE SCHEDULE
Combinations
Biscuits (Y)
Tea ( X)
1
12
1
2
8
2
3
5
3
4
3
4
5
2
5
In the above schedule the consumer obtains as much Total Satisfaction from 8
Biscuits and 2 cups of tea, and same from all other combinations.
INDIFFERENCE MAP
•A set of indifference Curves is
called Indifference map.
•An indifference map is a set of
indifference curves , Satisfaction
level is higher the farthest
indifference curve from the
origin.
•We cannot say how much utility
the higher indifference curve
represents , meaning Aggregate
Utilities
are
rankable
not
measurable.
MARGINAL RATE OF SUBSTITUTION
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Whenever we move from one combination to
another combination of the goods, we are
basically substituting some units of one
commodity with another.
The marginal rate of substitution shows how
much of one commodity is substituted for how
much of another or at what rate a consumer
is willing to substitute one commodity for
another in his/her consumption pattern.
M.R.S
Combinations
Biscuits (Y)
Tea ( X)
MRSX Y = Δy/Δx
1
12
1
-
2
8
2
4:1
3
5
3
3:1
4
3
4
2:1
5
2
5
1:1
MRS can be defined as the amount of Biscuits that is sacrificed for
obtaining one Cup of Tea or as the amount of Biscuits that may be
given to the consumer for the loss of one cup of Tea so that he
may remain at the same level of satisfaction.
M.R.S CURVE
A X1 / X1B > BX2 / X2C
> CX3 / X3D > DX4 X4E
When the consumer has just one cup of tea, he is willing to give up 4 biscuits for an
additional cup of tea.
Now, as the number of cups of tea increases, he is prepared to sacrifice fewer and
fewer number of biscuits to get each additional cup of tea.
This is due to the reason that more of one good and the less of another a consumer
has, the units of the second become more important to consumer relative to the units of
the first.
PROPERTIES OF INDIFFERENCE CURVE
The indifference curves possess certain
characteristics which are also called as
properties.
The important properties are:
1. Downward Sloping to the right.
 2. Non-Intersecting.
 3. Convex to the Origin.
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DOWNWARD SLOPING TO THE RIGHT
OR
NEGATIVELY SLOPED
When
the
consumer
decides to have more
units of one of the two
goods, he/she will have
to reduce the number of
the units of the other
good, if he/she is to
remain at the same level
of satisfaction.
8
7
6
5
4
3
2
1
0
4
3
Biscuits
Biscuits
HORIZONTAL /VERTICAL INDIFFERENCE CURVE
2
1
1
2
3
Tea Cups
4
0
2
4
Tea Cups
6
Biscuits
UPWARD SLOPING INDIFFERENCE CURVE
16
14
12
10
8
6
4
2
0
1
2
3
Tea Cups
Horizontal, Vertical, Upward Sloping Indifference Curve = Absurd
NON-INTERSECTING
No two indifference curves will cut
each other.
Suppose that the two indifference curves
did cross , Then because point A is on the
same indifference curve as point B, the
two would make consumer equally happy.
In addition, because point B is on the
same indifference curve as point C, these
two points would make the consumer
equally happy. But these conclusions imply
that points A & C would make the
consumer equally happy even though point
C has more of both goods.
This contradicts our assumption that
consumer prefers more of Goods than less
, thus two indifference curves cannot
cross.
CONVEX TO ORIGIN
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Indifference Curves are normally convex in
nature.
The Implication of this convexity rule is
that as we have more and more of Good
X and less of Y, the marginal rate of
substitution of X for Y goes on falling.
CONVEX INDIFFERENCE CURVE
CONCAVE & STRAIGHT LINE
INDIFFERENCE CURVE
Biscuits
16
14
12
10
8
6
4
2
0
1
2
3
4
Tea
Cups
Concave & Straight Line Indifference Curve = Absurd or Unrealistic.
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PRICE LINE OR BUDGET LINE OR
BUDGET CONSTRAINT.
Higher the IC Higher is the level
of satisfaction.
A rational consumer will try to
reach the highest possible IC in
order to obtain higher level of
satisfaction.
In this pursuit , our consumer
will be governed by the amount
of the money or income he has
to spend on goods and the prices
of the goods in the market.
CONSUMPTION POSSIBILITIES
The budget line
is a constraint on
your choices.
 You can afford
any point on
your budget line
or inside it.
 You cannot
afford any point
outside your
budget line.
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THE BUDGET CONSTRAINT- A CHANGE IN PRICES
A rise in the price
of the good on the
x-axis:
 Decreases the
affordable quantity
of that good.
 Causes the budget
line to rotate.
 Increases the slope
of the budget line.
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THE BUDGET CONSTRAINT- A CHANGE IN INCOME
CONSUMER’S EQUILLIBRIUM
OR MAXIMISING SATISFACTION OR OPTIMAL CHOICE.
The consumer’s best affordable point is:
1. On the budget line.
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2.On the highest attainable indifference
curve.
3.Has a marginal rate of substitution
between the two goods equal to the
relative price of the two goods.
OPTIMAL CHOICE
INCOME EFFECT
Effect on consumers equilibrium of a change
in consumers income, relative prices of
commodities remaining same, is called Income
Effect.
 Income effect is the effect on the quantity
demanded exclusively as a result of change in
money income, all prices remaining constant.
 As a result of change in income , his
satisfaction will either increase or diminish,
for he has now a larger or smaller income to
spend.
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ICC for Inferior Goods
Sometimes it also happens that
with the rise in income, the
consumer buys more of one
commodity and less of another.
For instance, he may buy less of
wheat and more of rice.
In diagram
the income
consumption curve bends back on
itself. With the rise in income, the
consumer buys more of rice and
less of wheat. The price effect for
rice is positive and for wheat is
negative. The good which is
purchased less with the increase
in income is called inferior good.
Income Effect When Rice is an
Inferior Good:
In the figure , it is shown that
with the rise in money income,
the purchase of wheat has
increased
from
M1
to
M4 indicating positive income
effect on the purchase of normal
good wheat. The income effect on
inferior good is negative. The
income consumption curve ICC is
starts
bending
towards
the
horizontal axis which shows that
wheat is a normal good and rice is
inferior good.
PRICE EFFECT : PCC
Price Effect on the Consumption of a Normal Good:
When there is change in the price of a good shown on
the two axes of an indifference map, there takes place a
change in demand in response to a change in price of a
commodity, other things remaining the same, is called
price effect.
PCC FOR NORMAL GOOD
AB is the initial budget line.
It is assumed that the price
of wheat has fallen and the
price of rice and the income
of the consumer remains
unchanged. The price line
takes a new position AC and
the equilibrium point shifts
from P to U.
The
consumer
buys
now
OT
quantity of wheat (the amount
demanded rises from OE to OT)
and OZ quantity of rice. With
further fall in the price of wheat,
the consumer is in equilibrium at
point S, where the budget line AD
is tangent to a higher indifference
curve IC3. He buys now OF
quantity of wheat and OR quantity
of rice. The rise in amount
purchased of wheat (OE to OF) as
a result of a fall in its price is
called price effect. The price effect
on the consumption of a normal
good is Positive. If we join the
equilibrium points PUS, we get
price consumption curve (PCC) of
the consumer for the commodity
wheat.
PCC WHEN COMMODITY IS A GIFFEN GOOD
Giffen good is a particular type of inferior good.
When there is a decrease in the quantity demanded
of a good with a fall in its price, the good is called
Giffen good .
The consumer is in equilibrium at point E where the budget line
AB is tangent to the indifference curve IC1. The consumer
purchases OX1 quantity of Giffen good X and OY1 quantity of good
Y.
When there is a reduction in the price of good X but no change in
the price of good Y, the budget line AB/ will showing upward. The
consumer is in equilibrium at point E/where the budget line AB/ is
a tangent to the indifference curve IC2.
In the new equilibrium position, the consumer purchases only
OX2 units of Giffen good X and OY2 units of good Y. We find that
the decrease in the price of Giffen good X, its quantity purchased
has fallen from OX1 to OX2 and the quantity demanded of Y
commodity goes up from OY1 to OY2. The price effect on the
consumption of Giffen good is Negative. It is indicated by the
backward bending PCC in the case of X as a Giffen good.
PRICE CHANGE: INCOME & SUBSTITUTION EFFECTS
The decomposition of the price effect
into the income and substitution effect
can be done in several ways.
 There are two main methods:
(i) The Hicksian method; and
(ii) The Slutsky method.
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THE HICKSIAN METHOD
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Sir John R.Hicks (1904-1989)
Awarded the Nobel Laureate in
Economics (with Kenneth J. Arrrow)
in 1972 for work on general
equilibrium
theory
and
welfare
economics.
THE HICKSIAN METHOD
Optimal bundle is Ea, on
indifference curve I1.
X2
Ea
I1
xa
X1
THE HICKSIAN METHOD
A fall in the price of X1
X2
P
The budget line pivots out from P
*
Ea
I1
xa
X1
THE HICKSIAN METHOD
The new optimum is Eb on I2.
X2
The Total Price Effect is xa to xb
Ea
Eb
I2
I1
xa
xb
X1
THE HICKSIAN METHOD
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To isolate the substitution effect we ask….
“what would the consumer’s optimal bundle be
if s/he faced the new lower price for X1 but
experienced no change in real income?”
This amounts to returning the consumer to the
original indifference curve (I1).
THE HICKSIAN METHOD
The new optimum is Eb on I2.
X2
The Total Price Effect is xa to xb
Ea
Eb
I2
I1
xa
xb
X1
THE HICKSIAN METHOD
Draw a line parallel to the new
budget line and tangent to the old
indifference curve.
X2
Ea
Eb
I2
I1
xa
xb
X1
THE HICKSIAN METHOD
The new optimum on I1 is at Ec. The
movement from Ea to Ec (the increase in
quantity demanded from Xa to Xc) is
solely in response to a change in relative
prices.
X2
Eb
Ea
Ec
xa
xc
I2
I1
xb
X1
THE HICKSIAN METHOD
This is the substitution effect.
X2
Eb
Ea
I2
Ec
I1
Xa
Substitution Effect
Xc
X1
THE HICKSIAN METHOD
To isolate the income effect …
 Look at the remainder of the total price effect
 This is due to a change in real income.
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THE HICKSIAN METHOD
The remainder of the total effect is due to a
change in real income. The increase in real
income is evidenced by the movement from I1
to I2
X2
Eb
Ea
I2
Ec
I1
Xc
X1
Income Effect
Xb
THE HICKSIAN METHOD
X2
Eb
Ea
I2
Ec
I1
xa
xc
xb
Sub. Income
Effect
Effect
X1
NATURE OF PRICE EFFECT
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Positive price effect means with a decrease in the price the consumption
increases. This is same as the law of demand. The exception to the law of
demand is negative price effect.
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The price effect is positive for normal goods and inferior goods. There are
some inferior goods where the price effect is negative. These goods with
negative price effect are called Giffen’s goods.
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The price effect depends on the components - income and substitution effects.
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For normal goods the price effect is positive because the components income
and substitution effects are positive.