1. INDIFFERENCE ANALYSISINDIFFERENCE ANALYSIS
• Indifference curvesIndifference curves
– constructing an indifference curveconstructing an indifference curve
– the shape of an indifference curvethe shape of an indifference curve
– diminishing marginal rate of substitutiondiminishing marginal rate of substitution
– an indifference mapan indifference map
• The budget lineThe budget line
– constructing a budget lineconstructing a budget line
– effect of a change in incomeeffect of a change in income
– effect of a change in priceeffect of a change in price

2. 0
2
4
6
8
10
12
14
16
18
20
22
24
26
28
30
0 2 4 6 8 10 12 14 16 18 20 22
a
Pears
Oranges
Pears
30
24
20
14
10
8
6
Oranges
6
7
8
10
13
15
20
Point
a
b
c
d
e
f
g
Constructing an indifference curveConstructing an indifference curve

3. 0
10
20
30
0 10 20
Deriving the marginal rate of substitution (Deriving the marginal rate of substitution (MRSMRS))
a
b
UnitsofgoodY
Units of good X
26
6 7

4. 0
10
20
30
0 10 20
a
b
UnitsofgoodY
Units of good X
26
6 7
∆Y = 4
∆X = 1
MRS = 4
Deriving the marginal rate of substitution (Deriving the marginal rate of substitution (MRSMRS))

5. 0
10
20
30
0 10 20
a
b
UnitsofgoodY
Units of good X
26
6 7
c
d
∆Y = 4
∆X = 1
∆Y = 1
∆X = 1
MRS = 1
MRS = 4
13 14
9
Deriving the marginal rate of substitution (Deriving the marginal rate of substitution (MRSMRS))

6. 0
10
20
30
0 10 20
UnitsofgoodY
Units of good X
I1
I2
I3
I4
I5
An indifference mapAn indifference map

7. UnitsofgoodY
Units of good X
a
b
Units of
good X
0
5
10
15
Units of
good Y
30
20
10
0
Point on
budget line
a
b
Assumptions
PX = £2
PY = £1
Budget = £30
0
10
20
30
0 5 10 15 20
A budget lineA budget line

8. 0
10
20
30
40
0 5 10 15 20
UnitsofgoodY
Units of good X
Assumptions
PX = £2
PY = £1
Budget = £40
16
7
m
n
Budget
= £40
Budget
= £30
Effect of an increase in income on the budget lineEffect of an increase in income on the budget line

9. 0
10
20
30
0 5 10 15 20 25 30
Effect on the budget line of a fall in the price of good XEffect on the budget line of a fall in the price of good XUnitsofgoodY
Units of good X
Assumptions
PX = £1
PY = £1
Budget = £30
B1
B2
a
b c

10. INDIFFERENCE ANALYSISINDIFFERENCE ANALYSIS
• The optimum consumption pointThe optimum consumption point
– equating the marginal rate of substitution withequating the marginal rate of substitution with
the price ratiothe price ratio
• The effect of a change in incomeThe effect of a change in income
– the income–consumption curvethe income–consumption curve
– the Engel curvethe Engel curve
– income elasticity of demand and the income–income elasticity of demand and the income–
consumption curveconsumption curve
– the effect of a rise in income on the demand forthe effect of a rise in income on the demand for
an inferior goodan inferior good

11. I1
I2
I3
I4
I5
UnitsofgoodY
O
Units of good X
Budget line
Finding the optimum consumptionFinding the optimum consumption

12. I1
I2
I3
I4
I5
UnitsofgoodY
O
Units of good X
r
s
t
Y1
X1
v
u
Same slope atSame slope at tt of indifference curve and budget lineof indifference curve and budget line

13. UnitsofgoodY
O
Units of good X
B1
Effect on consumption of a change in incomeEffect on consumption of a change in income
I1

14. I2
UnitsofgoodY
O
Units of good X
B1
B2 I1
Effect on consumption of a change in incomeEffect on consumption of a change in income

15. I2
UnitsofgoodY
O
Units of good X
B1
B2 B3 B4 I1
I3
I4
Effect on consumption of a change in incomeEffect on consumption of a change in income

16. I2
UnitsofgoodY
O
Units of good X
B1
B2 B3 B4 I1
I3
I4
Income–consumption curve
Effect on consumption of a change in incomeEffect on consumption of a change in income

17. B1
B2 B3
I3
I2
I1
Income-consumption
curve
BreadIncome(£)
CDs
Qb3
Qb2
Qb1
Y3
Y2
Y1
Qcd3
Qcd2
Qcd1
Qcd3
Qcd2
Qcd1
a
b
c
a
b
c
Deriving an Engel curve from an income–consumption curveDeriving an Engel curve from an income–consumption curve

18. B1
B2 B3
I3
I2
I1
Income-consumption
curve
BreadIncome(£)
CDs
Qb3
Qb2
Qb1
Y3
Y2
Y1
Qcd3
Qcd2
Qcd1
Qcd3
Qcd2
Qcd1
Engel curve
a
b
c
a
b
c
Deriving an Engel curve from an income–consumption curveDeriving an Engel curve from an income–consumption curve

19. Effect of a rise in income on the demand for an inferior goodEffect of a rise in income on the demand for an inferior goodUnitsofgoodY
(normalgood)
Units of good X
(inferior good)
O
I1B1
a

20. Effect of a rise in income on the demand for an inferior goodEffect of a rise in income on the demand for an inferior goodUnitsofgoodY
(normalgood)
Units of good X
(inferior good)
O
I2
I1B1 B2
a
b

21. Effect of a rise in income on the demand for an inferior goodEffect of a rise in income on the demand for an inferior goodUnitsofgoodY
(normalgood)
Units of good X
(inferior good)
O
Income–consumption curve
I2
I1B1 B2
a
b

22. 0
10
20
30
0 5 10 15 20 25 30
Effect of a fall in the price of goodEffect of a fall in the price of good XXUnitsofgoodY
Units of good X
Assumptions
PX = £2
PY = £1
Budget = £30
B1
I1
j

23. 0
10
20
30
0 5 10 15 20 25 30
UnitsofgoodY
Units of good X
Assumptions
PX = £1
PY = £1
Budget = £30
B1
I1
j
I2
B2
k
Effect of a fall in the price of goodEffect of a fall in the price of good XX
a

24. 0
10
20
30
0 5 10 15 20 25 30
UnitsofgoodY
Units of good X
B1
I1
j
I2
B2
k
Price–consumption curve
Effect of a fall in the price of goodEffect of a fall in the price of good XX
a

25. B1 B2 B3
I3
I2
I1
I4
B4
Expenditureon
allothergoods
Units of good X
a b
c d
Further falls in
the price of X
Deriving a demand curve from a price–consumption curveDeriving a demand curve from a price–consumption curve

26. B1 B2 B3
I3
I2
I1
I4
B4
Expenditureon
allothergoods
Units of good X
a Price-consumption
curve
b
c d
Deriving a demand curve from a price–consumption curveDeriving a demand curve from a price–consumption curve

27. B1 B2 B3
I3
I2
I1
I4
B4
Expenditureon
allothergoods
Units of good X
a Price-consumption
curve
b
c d
PriceofgoodX
Units of good X
a
b
P1
P2
Q1 Q2
Deriving a demand curve from a price–consumption curveDeriving a demand curve from a price–consumption curve

28. B1 B2 B3
I3
I2
I1
I4
B4
Expenditureon
allothergoods
Units of good X
a Price-consumption
curve
b
c d
PriceofgoodX
Units of good X
a
b
c
d
P1
P2
P3
P4
Q1 Q2 Q3 Q4
Deriving a demand curve from a price–consumption curveDeriving a demand curve from a price–consumption curve

29. B1 B2 B3
I3
I2
I1
I4
B4
Expenditureon
allothergoods
Units of good X
a Price-consumption
curve
b
c d
PriceofgoodX
Units of good X
a
b
c
d
Demand
P1
P2
P3
P4
Q1 Q2 Q3 Q4
Deriving a demand curve from a price–consumption curveDeriving a demand curve from a price–consumption curve

30. INDIFFERENCEINDIFFERENCE ANALYSISANALYSIS
• The effect of changes in priceThe effect of changes in price
– the price–consumption curvethe price–consumption curve
– deriving the individual's demand curvederiving the individual's demand curve
• Income and substitution effects of a priceIncome and substitution effects of a price
changechange
– a normal gooda normal good
– an inferior goodan inferior good
– a Giffen good (a special type of inferior good)a Giffen good (a special type of inferior good)

31. Units of Good XUnits of Good X
UnitsofgoodY
I1
I2
I3
I4
I5
I6
f
B1
Income and substitution effects: normal goodIncome and substitution effects: normal good
QX1

32. Units of Good XUnits of Good X
UnitsofgoodY
I1
I2
I3
I4
I5
I6
f
B1
Income and substitution effects: normal goodIncome and substitution effects: normal good
QX1
h
B2
QX3
Rise in the price
of good X

33. Units of Good XUnits of Good X
UnitsofgoodY
I1
I2
I3
I4
I5
I6
f
B1
Income and substitution effects: normal goodIncome and substitution effects: normal good
QX1
h
B2
Substitution
effect
g
QX2
B1a
Substitution effect
of the price rise

34. Units of Good XUnits of Good X
UnitsofgoodY
I1
I2
I3
I4
I5
I6
f
B1
Income and substitution effects: normal goodIncome and substitution effects: normal good
QX1
h
B2
QX3
Substitution
effect
g
QX2
B1a
Income effect
of the price rise
Incom
e

35. Units of Good Y
Units of Good XUnits of Good X
UnitsofgoodY
f
B1
Income and substitution effects: Inferior (non-Giffen) goodIncome and substitution effects: Inferior (non-Giffen) good
QX1
I1
I2

36. Units of Good Y
Units of Good XUnits of Good X
UnitsofgoodY
f
B1
Income and substitution effects: Inferior (non-Giffen) goodIncome and substitution effects: Inferior (non-Giffen) good
QX1
B2
h
QX3
I1
I2
Rise in the price
of good X

37. Units of Good Y
Units of Good XUnits of Good X
UnitsofgoodY
f
B1
Income and substitution effects: Inferior (non-Giffen) goodIncome and substitution effects: Inferior (non-Giffen) good
QX1
B2
g
h
QX2
I1
I2
Substitution effect
B1a
Substitution effect
of the price rise

38. Units of Good Y
Units of Good XUnits of Good X
UnitsofgoodY
f
B1
Income and substitution effects: Inferior (non-Giffen) goodIncome and substitution effects: Inferior (non-Giffen) good
QX1
B2
g
h
QX2
QX3
I1
I2
Substitution effect
Income effect
B1a
Income effect of
the price rise

39. Units of Good Y
Units of Good XUnits of Good X
UnitsofgoodY
f
B1
Income and substitution effects: Giffen goodIncome and substitution effects: Giffen good
QX1
I1
I2

40. Units of Good Y
Units of Good XUnits of Good X
UnitsofgoodY
f
B1
Income and substitution effects: Giffen goodIncome and substitution effects: Giffen good
QX1
B2
h
QX3
I1
I2
Rise in the price
of good X

41. Units of Good Y
Units of Good XUnits of Good X
UnitsofgoodY
f
B1
Income and substitution effects: Giffen goodIncome and substitution effects: Giffen good
QX1
B2
h
QX3
I1
I2
g
QX2
B1a
Substitution effect
Substitution effect
of the price rise

42. Units of Good Y
Units of Good XUnits of Good X
UnitsofgoodY
f
B1
Income and substitution effects: Giffen goodIncome and substitution effects: Giffen good
QX1
B2
h
QX3
I1
I2
g
QX2
Substitution effect
Income effect
Income effect of
the price rise
B1a

43. INDIFFERENCE ANALYSISINDIFFERENCE ANALYSIS
• The effect of a change in price on theThe effect of a change in price on the
demand fordemand for otherother goodsgoods
• The usefulness of indifference analysisThe usefulness of indifference analysis
– superiority of using ordinal measuressuperiority of using ordinal measures
– limitations of indifference analysislimitations of indifference analysis