Indifference Curve Analysis. lesson 3.pptx
- 2. Indifference Curve Analysis Indifference curve analysis does not attempt to measure satisfaction in cardinal numbers . Instead , it is based on ranking consumer satisfaction in order of preferences using ordinal numbers.
- 3. Indifference Curve (IC) ● Graphical representation showing different combinations of commodities which yield to the consumer the same level of satisfaction.
- 4. Indifference curve ● Thus , under indifference curve analysis, the consumer considers all possible combination of goods and service which he /she can afford and subsequently chooses the combination which is the most preferred. ● This choice framework is represented by indifference curves and the consumer budget line.
- 6. Explanation of the curve ● On the curve , point ABCD represent the combination or consumption bundles. ● Point A bundle comprise of ,4 units of good X and 20 units of good Y. By definition, this combination would yield the identical level of satisfaction represented by B which comprises 8 units of goods x and 10 units of good y. Thus, the consumer would have the same preference for either combination A or B. ● The same thing applies to all the other consumption bundles along this curve such as C and D.
- 7. Basic Assumptions of the IC 1. There are two goods X and Y. 2. The consumer acts rationally so as to maximise satisfaction 3. Any combination of both goods yield the same level of satisfaction. 4. The consumer’s tastes, habits and income remain the same. 5. The rate of exchange between both goods is called the marginal rate of substitution
- 8. Indifference map ● A graph showing a whole set of indifference curves. The further away a particular curve is from the origin the higher the level of satisfaction it represents.
- 9. Indifference Map IC5 represent the highest level of welfare and IC 1 represent the lowest level of welfare. Ic5 > ic4 > ic3>ic2>ic1 Where > represent the preferred level of welfare . Any point along the same indifference curve give the same level of satisfaction.
- 10. Indifference set ●A table showing the same information as indifference curve.
- 11. Characteristics of Indifference curves 1.All points on the same indifference curve give the same level of satisfaction; therefore the consumer is indifferent at any point along the IC. 1.Points to the right represent a higher level of satisfaction than all points along a given IC points to the left represent a lower level of satisfaction.
- 12. Characteristics Cont’d 3. They are an infinite number of indifference curves in welfare space ; collectively these are called indifference map. 4.They are downward sloping which means you have to give up more of a commodity to obtain more of another commodity. The slope measures the rate at which the customer is willing to substitute good x for good y so as to leave satisfaction unchanged .This is called the marginal rate of substitution
- 13. Characteristics 5 .They are convex to the origin (showing the diminishing marginal rate of substitution) i.e. MRS = change in ’Y’/ change in ’X’. 6. They never cross / They do not intersect. A point of intersection would exist only if two or more curve have a common point.
- 14. Indifference curves Indifference curves are plotted on what is called an indifference map. A consumer is indifferent or impartial between the combinations indicated by any two points on an indifference curve.
- 15. Activity ● There are two goods : pear and oranges. A consumers indifference set would be as follows: Bundles Pear Y Oranges X A 50 10 B 40 20 C 35 30 D 30 40 E 25 50 Calculate MRS for A-B B-C= C-D D-F =
- 17. Indifference curve analysis ● Indifference curve analysis ranks utility according to the combination of goods the consumer prefers, therefore the consumer can say whether he prefers patty to bun but unable to say by how much. ● Indifference curve analysis aims at analyzing consumers without having to measure utility (ordinalist approach).
- 18. IC is used to show: • Changes in consumer income ● A change in the price of one good or both goods ● It involves the use of IC and budget lines to show when consumer is maximizing his her utility. ● It can also be use to analyze the income and substitution effect of a price change.
- 19. (LESSON 2Budget Line) Objective:At The End Of This LesSon Explain the meaning of budget line Draw A budget lINE
- 20. The Budget Line ● The budget line is used to demonstrate the idea of the budget constraints .It shows that all consumers are constrained in what they are able to buy because of their income and the prices of the goods they wish to buy.
- 21. Budget line ● This shows the various combination of two goods which can be purchased with a given income and the going price of the good.
- 22. Budget line
- 23. Affordable Consumption Bundles Insert combination x 20 and y 10 . Label it G.
- 24. ● Good X cost $100 ● Good Y cost $200 ● Income $5 000 ● Draw a diagram (budget line ) to represent the data above .
- 25. Draw the diagram to represent this data. ● The slope of the line gives the ratio of prices of two goods which depicts the rate at which the consumer is able to substitute X for Y. ● Slope : ● Change in Y / Change in X = ● C and D ● 5/10 = ½ OR 0.5 ● The ratio of price of 0.5 implies that the price of good x is half the price of good Y. This
- 26. Notes on the graph 1. Any points along the budget line represents a consumption bundle which can be afforded by the consumer. 1. Any point within the budget line would represent consumption bundles which are also affordable but would not exhaust the consumer’s entire income.
- 27. Introductory activity ● What do you see ?
- 30. Changes in budget line ● Since the budget line represents the consumer’s income level and the combination of good x and y obtainable with the income at given prices, then a change in any of these variables would lead to a change in the budget line.
- 31. Question ● What do you think could be the two main changes that can affect the budget line? 1.Changes in income 2.Changes in Prices
- 32. Dayna Changes in the Budget Line ● Changes in price – cause the budget line to pivot ● Changes in income – cause the budget line to shift
- 33. Changes in Income ❖ A change in income cause the BL to shift (holding price remains constant). ❖ An increase in income cause the curve to shift to the right (outwards).This means more of both goods are affordable. ❖ A decrease in income cause the curve to shift to the left (inwards) so fewer of both goods will be affordable.
- 34. Changes in income and budget line
- 35. Changes in price ● As the price of good x or good y changes , the quantity which the consumer is able to afford would vary. These changes in the purchasing power of consumer’s income would therefore result in a change in the budget line.
- 36. Changes in price Prices fall so more goods become available. Hence ,more can be bought, but if prices increases, goods become more expensive so less is bought.
- 37. Price changes in the budget line
- 38. Class work ● Plot the budget lines when income is assumed to be $10 and also when income increases to $20. ● Assume also that the price of food is $2 per unit and $1 per unit for clothes. ● Hint :Prepare the Budget set , then plot ● Plot on same graph and label properly………….
- 40. What point consumer equilibrium is achieved?
- 42. IC and Consumer Equilibrium I1 to I4 represents a consumer indifference map. In order to determine which of the affordable consumption bundles represented by the budget line yields the highest level of satisfaction, a budget line is superimposed unto the indifference map.
- 43. Explanation ● Point E represents consumer equilibrium since this is where the budget line is tangential to (or just touches) an indifference curve. The point E represents the consumption bundle which is the most preferred among the affordable combinations of good x and y.
- 44. ExplanatioN ● Any other points along the budget line which represents other affordable consumption bundles lie on lower indifference curves and would therefore yield a lower level of satisfaction.
- 45. Explanation ● According to Indifference Curve Analysis , the consumer obtains equilibrium where the slope of the BL is equal to the marginal rate of substitution ( the rate at which the consumer is willing to substitute good x for good y.
- 46. Deriving the demand curve using Indifference Curve Analysis/Using Ordinalist approach to derive the demand curve
- 47. Deriving the demand curve using Indifference Curve Analysis/Using ordinalist approach to derive demand curve ● Let us try doing this step by step … ● You need this …. ● Let's go… listen for the steps
- 49. Explanation of Graph ● As the price of good x falls the budget line will pivots from BL1 to BL2. ● As this happens, the consumer moves from consuming x1 to x2 , i.e. ,(he consumes more of x (due to the income effect).
- 50. Explanation for Ordinalist approach to derive the demand curve ● As his consumption of x increases , he moves to a higher indifference curve illustrating greater satisfaction. At the same time , consumption of y falls from y1 to y2 (the substitution effect).
- 51. Explanation continues ● As the price of x falls further , the budget line pivots again to BL3 and the consumer moves to indifference curve 3. ● Hence, consumer equilibrium moves from E1 to E2 to E3.
- 52. Deriving the demand curve ● If good y on the y axis is substituted with price and the equilibrium quantities of good x are plotted against the corresponding prices , then the consumer demand curve is obtained.
- 53. Home work ● Explain what is meant by the : 1. Income Effect 2. Substitution Effect
- 54. The Income Consumption Curve/Line ● A line showing how a person’s optimal consumption of two goods change as income changes (assuming price is constant)
- 55. Graph
- 56. Price consumption curve/line ● The flatter the curve is the lower the price. Each curve represents an optimal consumption point. The lines that connect these is called the PCC. ● PCC is a line showing how a person’s optimum level of consumption of 2 goods changes as the price of one of them changes
- 57. Graph
- 58. Income and substitution effects of a price change
- 59. Income and substitution effects of a price change ● Using indifference curve analysis, further inferences could be made about the inverse relationship between price and quantity demanded of a good. Specifically two distinct reasons why a consumer increases consumption of a good as it price fall are revealed. These are : 1. The substitution effect 2. The income effect
- 60. Income and substitution effect ● The substitution effect refers to the change in consumption patterns where the consumer purchases more of the good which experiences a price cut and less of the other good. ● The income effect arises from the increase in purchasing power of the consumer’s disposable income as the price of one of the good has fallen. The increase in real income motivates the consumer to increase consumption of both goods.
- 61. ● Two approaches which utilizes indifference curve analysis to distinguish between the substitution effects . These are : 1. Hicksian income and substitution effect 2. Slutsky income and substitution effects
- 62. Change in consumer Equilibrium from a fall in price of good x
- 63. Activity ● Write your own explanation………….. ● For graph above….
- 64. Do together Steps for Isolating income and substitution effects 1. Draw a budget line , showing equilibrium EA…. Label good x and Y. Label indifference curve Ic 1 and the quantity of good x xA. What if the price of good Xfall , what will happen? 1. Show a fall in the price of good x and a new level equilibrium EB and indifference curve ic2 and where quantity of good demanded rises to XB.
- 65. Isolating the Substitution effect ● Insert an imaginary budget line parallel to the new indifference curve and tangent to the old indifference curve . ● Label it Ec, BL3 and the quantity xc.The movement from EA to Equilibrium Ec( increase in quantity from XA-XC IS solely in response to the fall in price of X. this is the substitution effect. As the consumer is simple substituting more of good x which is cheaper ,in place of less unit of good y so as to remain indifferent .
- 66. Isolating the income and substitution effects using the Hicksian Approach
- 67. Explanation of graph ● In the Hicksian approach, in order to distinguish between the income and substitution effects of the fall in price of good x , an imaginary budget line is inserted as shown by BL3 . ● This imaginary budget line BL3 is inserted on the basis of two conditions.
- 68. ● Firstly , it is drawn parallel to the new budget line BL2 in order to reflect the new ratio of prices after the fall in price of good x(remember the slope of the budget line gives the price ratio). ● Secondly , it is tangential to the indifference curve i1 which passes through the initial equilibrium at point A. The point of tangency between IC1 and the imaginary budget line BL3 is shown by point C.
- 69. ● Point C represents the combination the consumer would have chosen after the price of good X has fallen , if he or she wanted to keep the total level of satisfaction equivalent to that attained at point A. ● Thus ,moving from point A to C, the consumer is simple substituting more of good x, which is now cheaper , in place of less unit of good y so as to remain indifference. The substitution effect is therefore shown by the distance Xa to Xc.
- 70. ● The movement from point C, which is the imaginary equilibrium , to point B which is the final equilibrium , after the fall in the price of good x , is the income effect . ● This is because point B lies on the budget line to the right of the imaginary budget line through C. This means the shift from C to B represents a rise in income. This increase in income is the increase in purchasing power made possible by the fall in price of good x and the corresponding increase in consumption attributable to the income effect is the distance XC to XB.
- 71. Income and substitution effects of a price change Types of goods: 1.Normal goods 2.Inferior goods 3.Giffen goods
- 72. Normal Goods ● The demand for normal goods increases as income increases. There is a positive income effect.
- 73. Inferior Goods ● The demand for these goods decrease as income increases. They have a negative income effect
- 74. Giffen Goods ● This is an inferior good, demand increases as price increases. These goods are considered necessary.
- 76. Explanation ● Good Y is a normal good since the amount purchased increases from Y1 to Y2 as the budget constraint shifts from BC1 to the higher income BC2. Good X is an inferior good since the amount bought decreases from X1 to X2 as income increases.
- 78. Explanation of Graph ● As the price decreases the budget line pivots outwards, consumers will have less of the Giffen good and more of the normal goods.
- 79. Income and substitution effect of a price change: The Hicksian approach Decrease in the price of goods ….
- 80. Recap definition for……eVERYONE…… ❑ The substitution effect is defined as the change in the combination of goods purchased due to a change in the relative prices. ❑ The income effect refers to the change in combinations of good due to a change in the level of real income, where real income is defined as the purchasing power of money.
- 81. Income and sub effects from a fall in price of normal , inferior and Giffen goods
- 82. Explanation ● The substitution and income effects work in the same direction when good X is a normal good. The final price effect is then positive. The consumer tends to increase consumption of Good X with fall in its price. ● When good X is an inferior good, then the substitution and income effects work in opposite directions. When price of good X (Px)falls, the consumer tends to increase consumption of good X as a result of substitution effect. However, income effect here is negative. The price effect then depends on relative magnitude of the two effects. The final price effect is positive for inferior goods, as change in the consumption of good X as a result of the substitution effect is greater than the income effect. ● When good X is a Giffen good then also substitution and income effects work in opposite directions. When price of good X (Px)falls, the consumer tends to increase consumption of good X as a result of substitution effect. However, income effect here is negative. Further, the magnitude of change in units of good X on account of the substitution effect is less than the income effect. The price effect, the final outcome, is therefore negative.
- 83. Normal goods- Price Decrease
- 84. Explanation ● Let us see what figure 2 depicts. The consumer’s original equilibrium is E1. At this point, the budget line M1N1 is tangent to the indifference curve IC1. Suppose the price of commodity X (normal goods) decreases and other things remain the same. The price decline shifts the budget line to M1N3. Consequently, the consumer moves to new equilibrium point E3. Consumer’s movement from E1 to E3 is the total price effect. Let us eliminate the income effect from the price effect by following Hicks’ version. To do so, we draw an imaginary budget line M2N2, which is tangent to IC1 at E2. E2 equilibrium point after the elimination of the income effect. ● Hence, total price effect = X1X3 ● Substitution effect = X1 -X2 ● Income effect =X2- X3
- 85. Normal Good - Price Increase ●If the price of good x increases the budget line will pivot inwards as people real income will decrease ●Draw a diagram showing a price increase in normal good
- 86. Inferior Goods - Price decrease Here, total price effect = X1-X2 Substitution effect = X1 -X3 income effect = = X3_x2
- 87. Explanation ● In figure 3, X-axis represents inferior goods (commodity X) and Y-axis denotes superior goods (commodity Y). The consumer’s original equilibrium point is E1. At this equilibrium point, the budget line M1N1 is tangent to indifference curve IC1. If price of commodity X is reduced, new budget line M1N2 is formed and the consumer moves to the new equilibrium point E2. At E2, the budget line M1N2 is tangent to indifference curve IC2. ● Here, consumer’s movement from equilibrium point E1 to equilibrium point E2 is the total price effect. We follow Hicks’ version to eliminate the income effect from the price effect. To accomplish this, an imaginary budget line M2N3 is drawn in such a way that it is parallel to budget line M1N2 and tangent to the original indifference curve IC1 at E3. Hence, E3 is the equilibrium point after the elimination of income effect.
- 88. Giffen Goods – Price decrease
- 89. Graph : Explanation ● In figure 1, the consumer’s initial equilibrium point is E1, where original budget line M1N1 is tangent to the indifference curve IC1 . X-axis represent Giffen goods (commodity X) and Y-axis denotes superior goods (commodity Y). ● Assume that price of Giffen goods decreases. This causes the budget line to shift outward and forms a new budget line M1N3. The consumer moves to the new equilibrium point E3. ● At this new equilibrium point the quantity demanded of commodity X decreases by X2X1. This movement represents the total price effect. Total price effect consists of income effect and substitution effect. By drawing a parallel budget line M2N2, we are eliminating the income effect. ● Hence, the consumer again moves to another equilibrium point E2. At E2, the quantity demanded of commodity X increases by X1X3.
- 90. Usefulness of ICAs ● It demonstrates the logics of rational consumer choice, the derivation of the individual indifference curve and the income and substitution effect without having to measure utility.
- 91. Limitation of its usefulness ● 1. Consumer choice may be influenced by advertisement. They may be disappointed or surprised by their choice. Therefore, the optimal consumption choice may not in practice give consumers maximum satisfaction. Consumers may not have perfect knowledge. ● 2. Consumers are not always rational
- 92. ● END OF PRESENTATION