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Unformatted text preview: 1 7- 1 DEMAND ANALYSIS II: INDIFFERENCE THEORY Slides by Alex Stojanovic with additions by Winston Moore 7- 2 Learning Outcomes • A theory of demand can be built by focusing on bundles of goods between which the consumer is indifferent • Indifference curves show combinations of goods that give the same level of satisfaction • A budget constraint shows what the consumer could buy with a given income • A consumer optimises by trying to get to the highest indifference curve that is available with a given budget constraint • The response to a price change can be decomposed into an income and a substitution effect • For a good to have a negative sloped demand curve, it is necessary (but not sufficient) that it be an inferior good 7- 3 Advantages of Indifference Curve Analysis • First, it allows us to distinguish between the two effects of a change in price, called the income and the substitution effects. • Second, it allows us to understand the rare but interesting exception to the prediction that all demand curves are negatively sloped, which arises with a Giffen good. 7- 4 Utility versus Indifference Theory • Assume that a consumer has a bundle of goods – Bundle one has 6 apples, 3 oranges, and 5 lemons – Bundle two has 8 apples, 2 oranges, and 4 lemons – Bundle three has 7 apples, 4 oranges, and 2 lemons 7- 5 Utility versus Indifference Theory • In utility theory all consumers are assumed to be able to say whether or not they are better off when they switch consumption from bundle 1 to bundle 2 or bundle 3. • In other words, the consumer is able to attach a numerical value to each bundle – cardinally measurable. • Can you attach numerical values to each of these bundles? 7- 6 Utility versus Indifference Theory • Indifference theory uses a much weaker assumption. • Consumers are assumed to able to rank the bundles, say I prefer bundle 1 to bundle 2. • Utility is said to be ordinally measurable. • This approach was developed by an Italian economist Vilfredo Pareto, and introduce to the English-speaking world by John Hicks and R.G.D. Allen. 2 7- 7 Assumptions 1. Consumers can make rational choices between different bundles of goods, and decide which bundles give him or her more or less satisfaction. 2. Ceteris paribus, the consumer always prefers more of any one product to less of that same product. 3. The less of one product that is presently being used by a consumer, the smaller the amount of it that the consumer will be willing to forgo in order to increase consumption of a second product. 4. Consumers seek to maximise total satisfaction, which means reaching the highest possible indifference curve. 7- 8 A Single Indifference Curve • Assume that a consumer has 18 units of clothing (C) and 10 units of food (F)....
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This note was uploaded on 11/12/2011 for the course ECON 2009 taught by Professor Mr.norvill during the Spring '11 term at University of the West Indies at Mona.

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