Background To Demand
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Background to Demand
Background to Demand
Marginal Utility Theory
MARGINAL UTILITY THEORY ■
Total and marginal utility ✜
meaning of total utility
✜
marginal utility: ∆TU/∆Q ✦ diminishing
✜
marginal utility
total and marginal utility curves
Darren’s utility from consuming crisps (daily) 16 14
Utility (utils)
12 10 8 6 4
Packets of crisps
TU in utils
0 1 2 3 4 5 6
0 7 11 13 14 14 13
2 0 -2
0
1
2
3
4
Packets of crisps consumed (per day)
5
6
Darren’s utility from consuming crisps (daily) 16
TU
14
Utility (utils)
12 10 8 6 4
Packets of crisps
TU in utils
0 1 2 3 4 5 6
0 7 11 13 14 14 13
2 0 0
1
2
3
4
-2
Packets of crisps consumed (per day)
5
6
Darren’s utility from consuming crisps (daily) 16
TU
14
Utility (utils)
12
MU Packets TU of crisps in utils in utils
10
0 1 2 3 4 5 6
8 6 4
7 4 2 1 0 -1
0 7 11 13 14 14 13
2 0 0
1
2
3
4
-2
Packets of crisps consumed (per day)
5
6
Darren’s utility from consuming crisps (daily) 16
TU
14
Utility (utils)
12
MU Packets TU of crisps in utils in utils
10
0 1 2 3 4 5 6
8 6 4
7 4 2 1 0 -1
0 7 11 13 14 14 13
2 0 0
1
2
3
4
-2
Packets of crisps consumed (per day)
5
MU
6
Darren’s utility from consuming crisps (daily) 16
TU
14
∆TU = 2
Utility (utils)
12
∆Q = 1
10 8
MU = ∆TU / ∆Q
6 4 2 0 0
1
2
3
4
-2
Packets of crisps consumed (per day)
5
MU
6
Darren’s utility from consuming crisps (daily) 16
TU
14
∆TU = 2
Utility (utils)
12
∆Q = 1
10 8
MU = ∆TU / ∆Q = 2/1 = 2
6 4 2 0 0
1
2
3
4
-2
Packets of crisps consumed (per day)
5
MU
6
MARGINAL UTILITY THEORY ■
The optimum level of consumption: the one-commodity version ✜
consumer surplus (total and marginal) ✦ marginal ✦ total
consumer surplus: MU – P
consumer surplus: TU – TE
Consumer surplus MU, P
P1
MU
O
Q1
Q
Consumer surplus MU, P
P1
Total consumer expenditure O
MU
Q1
Q
Consumer surplus MU, P
P1
Total consumer surplus
Total consumer expenditure O
MU
Q1
Q
MARGINAL UTILITY THEORY ■
The optimum level of consumption: the one-commodity version ✜
consumer surplus (total and marginal) ✦ marginal ✦ total
✜
■
consumer surplus: MU – P
consumer surplus: TU – TE
maximising consumer surplus: P = MU
Marginal utility and the demand curve
Deriving an individual person’s demand curve MU, P
P1
a
Consumption at Q1 where P1 = MU
MU = D
O
Q1
Q
Deriving an individual person’s demand curve MU, P
P1
a
Consumption at Q2 where P2 = MU
b
P2
MU = D
O
Q1
Q2
Q
Deriving an individual person’s demand curve MU, P
P1
a
Consumption at Q3 where P3 = MU
b
P2
c
P3
MU = D
O
Q1
Q2
Q3
Q
MARGINAL UTILITY THEORY ■
■
Limitations of the one-commodity version ✜
marginal utility affected by consumption of other goods
✜
marginal utility of money not constant
Optimum combination of goods ✜
the equi-marginal principle MUA/MUB = PA/PB
✜
deriving a demand curve
Background to Demand
Risk, Uncertainty and Insurance
RISK, UNCERTAINTY AND INSURANCE ■
■
Demand under conditions of risk and uncertainty ✜
defining risk and uncertainty
✜
types of odds
✜
risk attitudes
Diminishing marginal utility of income and attitudes towards risk taking
Total utility of income
Total utility
TU
a
U1
0
5000
10 000
Income (£)
15 000
Total utility of income TU b
Total utility
U2
a
U1
0
5000
10 000
Income (£)
15 000
Total utility of income c
U3
b
U2 Total utility
TU
a
U1
0
5000
10 000
Income (£)
15 000
Total utility of income c
U3
b
U2 U4 Total utility
TU
d a
U1
0
5000
8000 10 000
Income (£)
15 000
RISK, UNCERTAINTY AND INSURANCE ■
Insurance: a way of removing risks
■
How insurers spread risks
■
✜
the law of large numbers
✜
importance of the independence of risks
Problems for insurers ✜
adverse selection
✜
moral hazard
Background to Demand
Indifference Analysis
INDIFFERENCE ANALYSIS ■
Indifference curves ✜
constructing an indifference curve
Constructing an indifference curve Pears Oranges 30 24 20 14 10 8 6
6 7 8 10 13 15 20
Point a b c d e f g
Combinations of pears and oranges that Clive likes the same amount as 10 pears and 13 oranges
Constructing an indifference curve
Pears
30 28 26
Pears Oranges 30 24 20 14 10 8 6
24 22 20 18 16 14 12 10 8 6
Point a b c d e f g
6 7 8 10 13 15 20
4 2 0 0
2
4
6
8
10
12
Oranges
14
16
18
20
22
Constructing an indifference curve
Pears
30 28 26
a Pears Oranges 30 24 20 14 10 8 6
24 22 20 18 16 14 12 10 8 6
Point a b c d e f g
6 7 8 10 13 15 20
4 2 0 0
2
4
6
8
10
12
Oranges
14
16
18
20
22
Constructing an indifference curve
Pears
30 28 26
a Pears Oranges
b
24 22 20 18 16 14 12 10 8 6
30 24 20 14 10 8 6
Point a b c d e f g
6 7 8 10 13 15 20
4 2 0 0
2
4
6
8
10
12
Oranges
14
16
18
20
22
Constructing an indifference curve
Pears
30 28 26
a Pears Oranges
b
24 22 20 18 16 14 12 10 8 6
30 24 20 14 10 8 6
c
d
e
Point a b c d e f g
6 7 8 10 13 15 20
f g
4 2 0 0
2
4
6
8
10
12
Oranges
14
16
18
20
22
INDIFFERENCE ANALYSIS ■
Indifference curves ✜
constructing an indifference curve
✜
the shape of an indifference curve
✜
diminishing marginal rate of substitution
Deriving the marginal rate of substitution (MRS) 30
a MRS = 4 b
∆Y = 4 26
Units of good Y
∆X = 1
MRS = ∆Y/∆X
20
10
0 0
67
10
Units of good X
20
Deriving the marginal rate of substitution (MRS) 30
a MRS = 4 b
∆Y = 4 26
Units of good Y
∆X = 1
MRS = ∆Y/∆X
20
10 9
∆Y = 1
c
MRS = 1 d
∆X = 1
0 0
67
10
13 14
Units of good X
20
INDIFFERENCE ANALYSIS ■
Indifference curves ✜
constructing an indifference curve
✜
the shape of an indifference curve
✜
diminishing marginal rate of substitution
✜
an indifference map
An indifference map
Units of good Y
30
20
10
I5 I2
I1
0 0
10
Units of good X
20
I3
I4
INDIFFERENCE ANALYSIS ■
■
Indifference curves ✜
constructing an indifference curve
✜
the shape of an indifference curve
✜
diminishing marginal rate of substitution
✜
an indifference map
The budget line ✜
constructing a budget line
A budget line Units of good X
Units of good Y
0 5 10 15
30 20 10 0
Assumptions PX = £2 PY = £1 Budget = £30
A budget line a
30
Units of good Y
Units of good X
Units of Point on good Y budget line
0 5 10 15
20
30 20 10 0
a
Assumptions
10
PX = £2 PY = £1 Budget = £30
0 0
5
10
Units of good X
15
20
A budget line a
30
Units of good Y
Units of good X 0 5 10 15
b
20
Units of Point on good Y budget line 30 20 10 0
a b
Assumptions
10
PX = £2 PY = £1 Budget = £30
0 0
5
10
Units of good X
15
20
A budget line a
30
Units of good Y
Units of good X 0 5 10 15
b
20
Units of Point on good Y budget line 30 20 10 0
c
10
a b c
Assumptions PX = £2 PY = £1 Budget = £30
0 0
5
10
Units of good X
15
20
A budget line a
30
Units of good Y
Units of good X 0 5 10 15
b
20
Units of Point on good Y budget line 30 20 10 0
c
10
a b c d
Assumptions PX = £2 PY = £1 Budget = £30
d
0 0
5
10
Units of good X
15
20
INDIFFERENCE ANALYSIS ■
■
Indifference curves ✜
constructing an indifference curve
✜
the shape of an indifference curve
✜
diminishing marginal rate of substitution
✜
an indifference map
The budget line ✜
constructing a budget line
✜
effect of a change in income
Effect of an increase in income on the budget line 40
Units of good Y
30
20 Assumptions
10
PX = £2 PY = £1 Budget = £30
0 0
5
10
Units of good X
15
20
Effect of an increase in income on the budget line 40 Assumptions PX = £2 PY = £1 Budget = £40
Units of good Y
30
n
20
m
16
10
Budget = £40 Budget = £30
0 0
5
7
10
Units of good X
15
20
INDIFFERENCE ANALYSIS ■
■
Indifference curves ✜
constructing an indifference curve
✜
the shape of an indifference curve
✜
diminishing marginal rate of substitution
✜
an indifference map
The budget line ✜
constructing a budget line
✜
effect of a change in income
✜
effect of a change in price
Effect on the budget line of a fall in the price of good X 30
Units of good Y
Assumptions PX = £2 PY = £1 Budget = £30
20
10
0 0
5
10
15
20
Units of good X
25
30
Effect on the budget line of a fall in the price of good X 30
Units of good Y
Assumptions PX = £2 PY = £1 Budget = £30
20
10
0 0
5
10
15
20
Units of good X
25
30
Effect on the budget line of a fall in the price of good X 30
Units of good Y
Assumptions PX = £1 PY = £1 Budget = £30
20
10
0 0
5
10
15
20
Units of good X
25
30
Effect on the budget line of a fall in the price of good X
a
30
Units of good Y
Assumptions PX = £1 PY = £1 Budget = £30
20
10
B2
B1
c
b
0 0
5
10
15
20
Units of good X
25
30
INDIFFERENCE ANALYSIS ■
The optimum consumption point
Units of good Y
Finding the optimum consumption
O Units of good X
Units of good Y
Finding the optimum consumption
I5
I1
O Units of good X
I2
I3
I4
Units of good Y
Finding the optimum consumption
Budget line
I5
I1
O Units of good X
I2
I3
I4
Finding the optimum consumption r
Units of good Y
s
Y1
t
u
I5 v
O
I1 X1 Units of good X
I2
I3
I4
INDIFFERENCE ANALYSIS ■
The optimum consumption point ✜
equating the marginal rate of substitution with the price ratio MRS = MUA/MUB = PA/PB
Finding the optimum consumption r
Units of good Y
s
Y1
t
u
I5 v
O
I1 X1 Units of good X
I2
I3
I4
INDIFFERENCE ANALYSIS ■
The optimum consumption point ✜
equating the marginal rate of substitution with the price ratio MRS = MUA/MUB = PA/PB
■
The effect of a change in income
INDIFFERENCE ANALYSIS ■
The optimum consumption point ✜
equating the marginal rate of substitution with the price ratio MRS = MUA/MUB = PA/PB
■
The effect of a change in income ✜
the income–consumption curve
Units of good Y
Effect on consumption of a change in income
a
B1 O Units of good X
I1
Units of good Y
Effect on consumption of a change in income
B1
B2
O Units of good X
I1
I2
Units of good Y
Effect on consumption of a change in income
I3
B1
B2
B3
O Units of good X
B4
I1
I2
I4
Units of good Y
Effect on consumption of a change in income
Income-consumption curve
I3
B1
B2
B3
O Units of good X
B4
I1
I2
I4
INDIFFERENCE ANALYSIS ■
The optimum consumption point ✜
equating the marginal rate of substitution with the price ratio MRS = MUA/MUB = PA/PB
■
The effect of a change in income ✜
the income–consumption curve
✜
the Engel curve
Bread
Deriving an Engel curve from an income-consumption curve
B1
B2
I1
I2
I3
B3
CDs
Bread
Deriving an Engel curve from an income-consumption curve
Income-consumption curve
B1
B2
I1
I2
I3
B3
CDs
Bread
Deriving an Engel curve from an income-consumption curve
Income-consumption curve
B1
B2
I1
I2
I3
B3
Income (£)
CDs
Bread
Deriving an Engel curve from an income-consumption curve
Income-consumption curve
a
Qb1
B1
Income (£)
Qcd1
B2
I1
I2
I3
B3
CDs
Bread
Deriving an Engel curve from an income-consumption curve
Income-consumption curve
a
Qb1
B1
Income (£)
Qcd1
Y1
I2 B3
CDs
a
Qcd1
B2
I1
I3
Bread
Deriving an Engel curve from an income-consumption curve
Qb2 Qb1
a
b
Income-consumption curve
B1
Income (£)
Qcd1 Qcd2
Y2 Y1
b a
Qcd1 Qcd2
B2
I1
I2
I3
B3
CDs
Bread
Deriving an Engel curve from an income-consumption curve
Qb3 Qb2 Qb1
a
b
Income-consumption c curve
B1
Income (£)
Qcd1 Qcd2 Qcd3
Y3 Y2 Y1
b
c
a
Qcd1 Qcd2 Qcd3
B2
I1
I2
I3
B3
CDs
Bread
Deriving an Engel curve from an income-consumption curve
Qb3 Qb2 Qb1
a
b
Income-consumption c curve
B1
B2
I1
I2 B3
Income (£)
Qcd1 Qcd2 Qcd3
Y3 Y2 Y1
CDs Engel curve
b
c
a
Qcd1 Qcd2 Qcd3
I3
INDIFFERENCE ANALYSIS ■
The optimum consumption point ✜
equating the marginal rate of substitution with the price ratio MRS = MUA/MUB = PA/PB
■
The effect of a change in income ✜
the income–consumption curve
✜
the Engel curve
✜
income elasticity of demand and the income–consumption curve
Bread
Deriving an Engel curve from an income-consumption curve
Qb3 Qb2 Qb1
a
b
Income-consumption c curve
B1
B2
I1
I2 B3
Income (£)
Qcd1 Qcd2 Qcd3
Y3 Y2 Y1
CDs Engel curve
b
c
a
Qcd1 Qcd2 Qcd3
I3
INDIFFERENCE ANALYSIS ■
The optimum consumption point ✜
equating the marginal rate of substitution with the price ratio MRS = MUA/MUB = PA/PB
■
The effect of a change in income ✜
the income–consumption curve
✜
the Engel curve
✜
income elasticity of demand and the income–consumption curve
✜
the effect of a rise in income on the demand for an inferior good
Units of good Y (normal good)
Effect of a rise in income on the demand for an inferior good
a B1 O
Units of good X (inferior good)
I1
Effect of a rise in income on the demand for an inferior good
Units of good Y (normal good)
b
I2
a B1 O
Units of good X (inferior good)
I1
B2
Effect of a rise in income on the demand for an inferior good
Income-consumption curve Units of good Y (normal good)
b
I2
a B1 O
Units of good X (inferior good)
I1
B2
INDIFFERENCE ANALYSIS ■
The effect of changes in price ✜
the price–consumption curve
Effect of a fall in the price of good X 30
Units of good Y
Assumptions PX = £2 PY = £1 Budget = £30
20
10
0 0
5
10
15
20
Units of good X
25
30
Effect of a fall in the price of good X 30
Units of good Y
Assumptions PX = £2 PY = £1 Budget = £30
20
j 10
I1
B1
0 0
5
10
15
20
Units of good X
25
30
Effect of a fall in the price of good X 30
Units of good Y
Assumptions PX = £1 PY = £1 Budget = £30
20
j 10
I1
B1
0 0
5
10
15
20
Units of good X
25
30
Effect of a fall in the price of good X 30
a
Units of good Y
Assumptions PX = £1 PY = £1 Budget = £30
20
k j 10
I2
I1
B1
0 0
5
10
15
20
Units of good X
25
B2 30
Effect of a fall in the price of good X
Units of good Y
30
a
Price-consumption curve
20
k j 10
I2
I1
B1
0 0
5
10
15
20
Units of good X
25
B2 30
INDIFFERENCE ANALYSIS ■
The effect of changes in price ✜
the price–consumption curve
✜
deriving the individual's demand curve
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve
a
B1
I1
Units of good X
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve Fall in the price of X a
b
B1
B2
I1
I2
Units of good X
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve Further falls in the price of X a
b
B1
B2
I1
I2
Units of good X
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve Further falls in the price of X a
b
c
B1
d
B2
B3
I I1 2 B4
I3
I4
Units of good X
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve
a
b
c
B1
d
Price-consumption curve
B2
B3
I I1 2 B4
I3
I4
Units of good X
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve
a
b
c
B1
d
Price-consumption curve
B2
B3
I I1 2 B4
I3
I4
Price of good X
Units of good X P1
a
Q1
Units of good X
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve
a
b
c
d
B1
Price-consumption curve
B2
B3
I I1 2 B4
I3
I4
Price of good X
Units of good X P1
P2 P3 P4
a
b c
d
Q1 Q2 Q3 Q4
Demand Units of good X
INDIFFERENCE ANALYSIS ■
■
The effect of changes in price ✜
the price–consumption curve
✜
deriving the individual's demand curve
Income and substitution effects of a price change
INDIFFERENCE ANALYSIS ■
■
The effect of changes in price ✜
the price–consumption curve
✜
deriving the individual's demand curve
Income and substitution effects of a price change ✜
a normal good
Units of good Y
Income and substitution effects: normal good
f
I1 I2
B1 QX1
I3 I4 I5 I6
Units of Good X
Income and substitution effects: normal good
Units of good Y
Rise in the price of good X
h f
I1 I2
B2 QX3
QX1
B1
I3 I4 I5 I6
Units of Good X
Income and substitution effects: normal good
Units of good Y
Substitution effect of the price rise
g h f
I1 I2
B2 QX3
QX2
QX1
Substitution effect
B1a
B1
I3 I4 I5 I6
Units of Good X
Income and substitution effects: normal good
Units of good Y
Income effect of the price rise
g h f
I1 I2
B2 QX3
QX2
Incom e
QX1
Substitution effect
B1a
B1
I3 I4 I5 I6
Units of Good X
INDIFFERENCE ANALYSIS ■
■
The effect of changes in price ✜
the price–consumption curve
✜
deriving the individual's demand curve
Income and substitution effects of a price change ✜
a normal good
✜
an inferior good
Units of good Y
Income and substitution effects: Inferior (non-Giffen) good
f
I1 I2
B1
QX1 Units of Good X
Income and substitution effects: Inferior (non-Giffen) good
Units of good Y
Rise in the price of good X
f h
I1
B2 QX3
I2
B1
QX1 Units of Good X
Units of good Y
Income and substitution effects: Inferior (non-Giffen) good
Substitution effect of the price rise
g
f h
I1
B2 QX2
B1a
I2
B1
QX1
Substitution effect
Units of Good X
Income and substitution effects: Inferior (non-Giffen) good
Income effect of the price rise
Units of good Y
g
f h
I1
B2 QX2 QX3 Income effect
B1a
I2
B1
QX1
Substitution effect
Units of Good X
INDIFFERENCE ANALYSIS ■
■
The effect of changes in price ✜
the price–consumption curve
✜
deriving the individual's demand curve
Income and substitution effects of a price change ✜
a normal good
✜
an inferior good
✜
a Giffen good (a special type of inferior good)
Units of good Y
Income and substitution effects: Giffen good
f
I1
I2
B1
QX1 Units of Good X
Income and substitution effects: Giffen good
Units of good Y
Rise in the price of good X
f
I1 h
B2
I2
B1
QX1QX3 Units of Good X
Units of good Y
Income and substitution effects: Giffen good
Substitution effect of the price rise
g f
I1 h
B2
B1a
I2
B1
QX2 QX1QX3 Substitution effect
Units of Good X
Income and substitution effects: Giffen good
Income effect of the price rise
Units of good Y
g f
I1 h
B2
B1a
I2
B1
QX2 QX1QX3 Income effect
Substitution effect
Units of Good X
INDIFFERENCE ANALYSIS ■
The effect of a change in price on the demand for other goods
■
The usefulness of indifference analysis ✜
superiority of using ordinal measures
✜
limitations of indifference analysis
Background to Demand
Marginal Utility Theory
MARGINAL UTILITY THEORY ■
Total and marginal utility ✜
meaning of total utility
✜
marginal utility: ∆TU/∆Q ✦ diminishing
✜
marginal utility
total and marginal utility curves
Darren’s utility from consuming crisps (daily) 16 14
Utility (utils)
12 10 8 6 4
Packets of crisps
TU in utils
0 1 2 3 4 5 6
0 7 11 13 14 14 13
2 0 -2
0
1
2
3
4
Packets of crisps consumed (per day)
5
6
Darren’s utility from consuming crisps (daily) 16
TU
14
Utility (utils)
12 10 8 6 4
Packets of crisps
TU in utils
0 1 2 3 4 5 6
0 7 11 13 14 14 13
2 0 0
1
2
3
4
-2
Packets of crisps consumed (per day)
5
6
Darren’s utility from consuming crisps (daily) 16
TU
14
Utility (utils)
12
MU Packets TU of crisps in utils in utils
10
0 1 2 3 4 5 6
8 6 4
7 4 2 1 0 -1
0 7 11 13 14 14 13
2 0 0
1
2
3
4
-2
Packets of crisps consumed (per day)
5
6
Darren’s utility from consuming crisps (daily) 16
TU
14
Utility (utils)
12
MU Packets TU of crisps in utils in utils
10
0 1 2 3 4 5 6
8 6 4
7 4 2 1 0 -1
0 7 11 13 14 14 13
2 0 0
1
2
3
4
-2
Packets of crisps consumed (per day)
5
MU
6
Darren’s utility from consuming crisps (daily) 16
TU
14
∆TU = 2
Utility (utils)
12
∆Q = 1
10 8
MU = ∆TU / ∆Q
6 4 2 0 0
1
2
3
4
-2
Packets of crisps consumed (per day)
5
MU
6
Darren’s utility from consuming crisps (daily) 16
TU
14
∆TU = 2
Utility (utils)
12
∆Q = 1
10 8
MU = ∆TU / ∆Q = 2/1 = 2
6 4 2 0 0
1
2
3
4
-2
Packets of crisps consumed (per day)
5
MU
6
MARGINAL UTILITY THEORY ■
The optimum level of consumption: the one-commodity version ✜
consumer surplus (total and marginal) ✦ marginal ✦ total
consumer surplus: MU – P
consumer surplus: TU – TE
Consumer surplus MU, P
P1
MU
O
Q1
Q
Consumer surplus MU, P
P1
Total consumer expenditure O
MU
Q1
Q
Consumer surplus MU, P
P1
Total consumer surplus
Total consumer expenditure O
MU
Q1
Q
MARGINAL UTILITY THEORY ■
The optimum level of consumption: the one-commodity version ✜
consumer surplus (total and marginal) ✦ marginal ✦ total
✜
■
consumer surplus: MU – P
consumer surplus: TU – TE
maximising consumer surplus: P = MU
Marginal utility and the demand curve
Deriving an individual person’s demand curve MU, P
P1
a
Consumption at Q1 where P1 = MU
MU = D
O
Q1
Q
Deriving an individual person’s demand curve MU, P
P1
a
Consumption at Q2 where P2 = MU
b
P2
MU = D
O
Q1
Q2
Q
Deriving an individual person’s demand curve MU, P
P1
a
Consumption at Q3 where P3 = MU
b
P2
c
P3
MU = D
O
Q1
Q2
Q3
Q
MARGINAL UTILITY THEORY ■
■
Limitations of the one-commodity version ✜
marginal utility affected by consumption of other goods
✜
marginal utility of money not constant
Optimum combination of goods ✜
the equi-marginal principle MUA/MUB = PA/PB
✜
deriving a demand curve
Background to Demand
Risk, Uncertainty and Insurance
RISK, UNCERTAINTY AND INSURANCE ■
■
Demand under conditions of risk and uncertainty ✜
defining risk and uncertainty
✜
types of odds
✜
risk attitudes
Diminishing marginal utility of income and attitudes towards risk taking
Total utility of income
Total utility
TU
a
U1
0
5000
10 000
Income (£)
15 000
Total utility of income TU b
Total utility
U2
a
U1
0
5000
10 000
Income (£)
15 000
Total utility of income c
U3
b
U2 Total utility
TU
a
U1
0
5000
10 000
Income (£)
15 000
Total utility of income c
U3
b
U2 U4 Total utility
TU
d a
U1
0
5000
8000 10 000
Income (£)
15 000
RISK, UNCERTAINTY AND INSURANCE ■
Insurance: a way of removing risks
■
How insurers spread risks
■
✜
the law of large numbers
✜
importance of the independence of risks
Problems for insurers ✜
adverse selection
✜
moral hazard
Background to Demand
Indifference Analysis
INDIFFERENCE ANALYSIS ■
Indifference curves ✜
constructing an indifference curve
Constructing an indifference curve Pears Oranges 30 24 20 14 10 8 6
6 7 8 10 13 15 20
Point a b c d e f g
Combinations of pears and oranges that Clive likes the same amount as 10 pears and 13 oranges
Constructing an indifference curve
Pears
30 28 26
Pears Oranges 30 24 20 14 10 8 6
24 22 20 18 16 14 12 10 8 6
Point a b c d e f g
6 7 8 10 13 15 20
4 2 0 0
2
4
6
8
10
12
Oranges
14
16
18
20
22
Constructing an indifference curve
Pears
30 28 26
a Pears Oranges 30 24 20 14 10 8 6
24 22 20 18 16 14 12 10 8 6
Point a b c d e f g
6 7 8 10 13 15 20
4 2 0 0
2
4
6
8
10
12
Oranges
14
16
18
20
22
Constructing an indifference curve
Pears
30 28 26
a Pears Oranges
b
24 22 20 18 16 14 12 10 8 6
30 24 20 14 10 8 6
Point a b c d e f g
6 7 8 10 13 15 20
4 2 0 0
2
4
6
8
10
12
Oranges
14
16
18
20
22
Constructing an indifference curve
Pears
30 28 26
a Pears Oranges
b
24 22 20 18 16 14 12 10 8 6
30 24 20 14 10 8 6
c
d
e
Point a b c d e f g
6 7 8 10 13 15 20
f g
4 2 0 0
2
4
6
8
10
12
Oranges
14
16
18
20
22
INDIFFERENCE ANALYSIS ■
Indifference curves ✜
constructing an indifference curve
✜
the shape of an indifference curve
✜
diminishing marginal rate of substitution
Deriving the marginal rate of substitution (MRS) 30
a MRS = 4 b
∆Y = 4 26
Units of good Y
∆X = 1
MRS = ∆Y/∆X
20
10
0 0
67
10
Units of good X
20
Deriving the marginal rate of substitution (MRS) 30
a MRS = 4 b
∆Y = 4 26
Units of good Y
∆X = 1
MRS = ∆Y/∆X
20
10 9
∆Y = 1
c
MRS = 1 d
∆X = 1
0 0
67
10
13 14
Units of good X
20
INDIFFERENCE ANALYSIS ■
Indifference curves ✜
constructing an indifference curve
✜
the shape of an indifference curve
✜
diminishing marginal rate of substitution
✜
an indifference map
An indifference map
Units of good Y
30
20
10
I5 I2
I1
0 0
10
Units of good X
20
I3
I4
INDIFFERENCE ANALYSIS ■
■
Indifference curves ✜
constructing an indifference curve
✜
the shape of an indifference curve
✜
diminishing marginal rate of substitution
✜
an indifference map
The budget line ✜
constructing a budget line
A budget line Units of good X
Units of good Y
0 5 10 15
30 20 10 0
Assumptions PX = £2 PY = £1 Budget = £30
A budget line a
30
Units of good Y
Units of good X
Units of Point on good Y budget line
0 5 10 15
20
30 20 10 0
a
Assumptions
10
PX = £2 PY = £1 Budget = £30
0 0
5
10
Units of good X
15
20
A budget line a
30
Units of good Y
Units of good X 0 5 10 15
b
20
Units of Point on good Y budget line 30 20 10 0
a b
Assumptions
10
PX = £2 PY = £1 Budget = £30
0 0
5
10
Units of good X
15
20
A budget line a
30
Units of good Y
Units of good X 0 5 10 15
b
20
Units of Point on good Y budget line 30 20 10 0
c
10
a b c
Assumptions PX = £2 PY = £1 Budget = £30
0 0
5
10
Units of good X
15
20
A budget line a
30
Units of good Y
Units of good X 0 5 10 15
b
20
Units of Point on good Y budget line 30 20 10 0
c
10
a b c d
Assumptions PX = £2 PY = £1 Budget = £30
d
0 0
5
10
Units of good X
15
20
INDIFFERENCE ANALYSIS ■
■
Indifference curves ✜
constructing an indifference curve
✜
the shape of an indifference curve
✜
diminishing marginal rate of substitution
✜
an indifference map
The budget line ✜
constructing a budget line
✜
effect of a change in income
Effect of an increase in income on the budget line 40
Units of good Y
30
20 Assumptions
10
PX = £2 PY = £1 Budget = £30
0 0
5
10
Units of good X
15
20
Effect of an increase in income on the budget line 40 Assumptions PX = £2 PY = £1 Budget = £40
Units of good Y
30
n
20
m
16
10
Budget = £40 Budget = £30
0 0
5
7
10
Units of good X
15
20
INDIFFERENCE ANALYSIS ■
■
Indifference curves ✜
constructing an indifference curve
✜
the shape of an indifference curve
✜
diminishing marginal rate of substitution
✜
an indifference map
The budget line ✜
constructing a budget line
✜
effect of a change in income
✜
effect of a change in price
Effect on the budget line of a fall in the price of good X 30
Units of good Y
Assumptions PX = £2 PY = £1 Budget = £30
20
10
0 0
5
10
15
20
Units of good X
25
30
Effect on the budget line of a fall in the price of good X 30
Units of good Y
Assumptions PX = £2 PY = £1 Budget = £30
20
10
0 0
5
10
15
20
Units of good X
25
30
Effect on the budget line of a fall in the price of good X 30
Units of good Y
Assumptions PX = £1 PY = £1 Budget = £30
20
10
0 0
5
10
15
20
Units of good X
25
30
Effect on the budget line of a fall in the price of good X
a
30
Units of good Y
Assumptions PX = £1 PY = £1 Budget = £30
20
10
B2
B1
c
b
0 0
5
10
15
20
Units of good X
25
30
INDIFFERENCE ANALYSIS ■
The optimum consumption point
Units of good Y
Finding the optimum consumption
O Units of good X
Units of good Y
Finding the optimum consumption
I5
I1
O Units of good X
I2
I3
I4
Units of good Y
Finding the optimum consumption
Budget line
I5
I1
O Units of good X
I2
I3
I4
Finding the optimum consumption r
Units of good Y
s
Y1
t
u
I5 v
O
I1 X1 Units of good X
I2
I3
I4
INDIFFERENCE ANALYSIS ■
The optimum consumption point ✜
equating the marginal rate of substitution with the price ratio MRS = MUA/MUB = PA/PB
Finding the optimum consumption r
Units of good Y
s
Y1
t
u
I5 v
O
I1 X1 Units of good X
I2
I3
I4
INDIFFERENCE ANALYSIS ■
The optimum consumption point ✜
equating the marginal rate of substitution with the price ratio MRS = MUA/MUB = PA/PB
■
The effect of a change in income
INDIFFERENCE ANALYSIS ■
The optimum consumption point ✜
equating the marginal rate of substitution with the price ratio MRS = MUA/MUB = PA/PB
■
The effect of a change in income ✜
the income–consumption curve
Units of good Y
Effect on consumption of a change in income
a
B1 O Units of good X
I1
Units of good Y
Effect on consumption of a change in income
B1
B2
O Units of good X
I1
I2
Units of good Y
Effect on consumption of a change in income
I3
B1
B2
B3
O Units of good X
B4
I1
I2
I4
Units of good Y
Effect on consumption of a change in income
Income-consumption curve
I3
B1
B2
B3
O Units of good X
B4
I1
I2
I4
INDIFFERENCE ANALYSIS ■
The optimum consumption point ✜
equating the marginal rate of substitution with the price ratio MRS = MUA/MUB = PA/PB
■
The effect of a change in income ✜
the income–consumption curve
✜
the Engel curve
Bread
Deriving an Engel curve from an income-consumption curve
B1
B2
I1
I2
I3
B3
CDs
Bread
Deriving an Engel curve from an income-consumption curve
Income-consumption curve
B1
B2
I1
I2
I3
B3
CDs
Bread
Deriving an Engel curve from an income-consumption curve
Income-consumption curve
B1
B2
I1
I2
I3
B3
Income (£)
CDs
Bread
Deriving an Engel curve from an income-consumption curve
Income-consumption curve
a
Qb1
B1
Income (£)
Qcd1
B2
I1
I2
I3
B3
CDs
Bread
Deriving an Engel curve from an income-consumption curve
Income-consumption curve
a
Qb1
B1
Income (£)
Qcd1
Y1
I2 B3
CDs
a
Qcd1
B2
I1
I3
Bread
Deriving an Engel curve from an income-consumption curve
Qb2 Qb1
a
b
Income-consumption curve
B1
Income (£)
Qcd1 Qcd2
Y2 Y1
b a
Qcd1 Qcd2
B2
I1
I2
I3
B3
CDs
Bread
Deriving an Engel curve from an income-consumption curve
Qb3 Qb2 Qb1
a
b
Income-consumption c curve
B1
Income (£)
Qcd1 Qcd2 Qcd3
Y3 Y2 Y1
b
c
a
Qcd1 Qcd2 Qcd3
B2
I1
I2
I3
B3
CDs
Bread
Deriving an Engel curve from an income-consumption curve
Qb3 Qb2 Qb1
a
b
Income-consumption c curve
B1
B2
I1
I2 B3
Income (£)
Qcd1 Qcd2 Qcd3
Y3 Y2 Y1
CDs Engel curve
b
c
a
Qcd1 Qcd2 Qcd3
I3
INDIFFERENCE ANALYSIS ■
The optimum consumption point ✜
equating the marginal rate of substitution with the price ratio MRS = MUA/MUB = PA/PB
■
The effect of a change in income ✜
the income–consumption curve
✜
the Engel curve
✜
income elasticity of demand and the income–consumption curve
Bread
Deriving an Engel curve from an income-consumption curve
Qb3 Qb2 Qb1
a
b
Income-consumption c curve
B1
B2
I1
I2 B3
Income (£)
Qcd1 Qcd2 Qcd3
Y3 Y2 Y1
CDs Engel curve
b
c
a
Qcd1 Qcd2 Qcd3
I3
INDIFFERENCE ANALYSIS ■
The optimum consumption point ✜
equating the marginal rate of substitution with the price ratio MRS = MUA/MUB = PA/PB
■
The effect of a change in income ✜
the income–consumption curve
✜
the Engel curve
✜
income elasticity of demand and the income–consumption curve
✜
the effect of a rise in income on the demand for an inferior good
Units of good Y (normal good)
Effect of a rise in income on the demand for an inferior good
a B1 O
Units of good X (inferior good)
I1
Effect of a rise in income on the demand for an inferior good
Units of good Y (normal good)
b
I2
a B1 O
Units of good X (inferior good)
I1
B2
Effect of a rise in income on the demand for an inferior good
Income-consumption curve Units of good Y (normal good)
b
I2
a B1 O
Units of good X (inferior good)
I1
B2
INDIFFERENCE ANALYSIS ■
The effect of changes in price ✜
the price–consumption curve
Effect of a fall in the price of good X 30
Units of good Y
Assumptions PX = £2 PY = £1 Budget = £30
20
10
0 0
5
10
15
20
Units of good X
25
30
Effect of a fall in the price of good X 30
Units of good Y
Assumptions PX = £2 PY = £1 Budget = £30
20
j 10
I1
B1
0 0
5
10
15
20
Units of good X
25
30
Effect of a fall in the price of good X 30
Units of good Y
Assumptions PX = £1 PY = £1 Budget = £30
20
j 10
I1
B1
0 0
5
10
15
20
Units of good X
25
30
Effect of a fall in the price of good X 30
a
Units of good Y
Assumptions PX = £1 PY = £1 Budget = £30
20
k j 10
I2
I1
B1
0 0
5
10
15
20
Units of good X
25
B2 30
Effect of a fall in the price of good X
Units of good Y
30
a
Price-consumption curve
20
k j 10
I2
I1
B1
0 0
5
10
15
20
Units of good X
25
B2 30
INDIFFERENCE ANALYSIS ■
The effect of changes in price ✜
the price–consumption curve
✜
deriving the individual's demand curve
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve
a
B1
I1
Units of good X
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve Fall in the price of X a
b
B1
B2
I1
I2
Units of good X
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve Further falls in the price of X a
b
B1
B2
I1
I2
Units of good X
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve Further falls in the price of X a
b
c
B1
d
B2
B3
I I1 2 B4
I3
I4
Units of good X
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve
a
b
c
B1
d
Price-consumption curve
B2
B3
I I1 2 B4
I3
I4
Units of good X
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve
a
b
c
B1
d
Price-consumption curve
B2
B3
I I1 2 B4
I3
I4
Price of good X
Units of good X P1
a
Q1
Units of good X
Expenditure on all other goods
Deriving a demand curve from a price-consumption curve
a
b
c
d
B1
Price-consumption curve
B2
B3
I I1 2 B4
I3
I4
Price of good X
Units of good X P1
P2 P3 P4
a
b c
d
Q1 Q2 Q3 Q4
Demand Units of good X
INDIFFERENCE ANALYSIS ■
■
The effect of changes in price ✜
the price–consumption curve
✜
deriving the individual's demand curve
Income and substitution effects of a price change
INDIFFERENCE ANALYSIS ■
■
The effect of changes in price ✜
the price–consumption curve
✜
deriving the individual's demand curve
Income and substitution effects of a price change ✜
a normal good
Units of good Y
Income and substitution effects: normal good
f
I1 I2
B1 QX1
I3 I4 I5 I6
Units of Good X
Income and substitution effects: normal good
Units of good Y
Rise in the price of good X
h f
I1 I2
B2 QX3
QX1
B1
I3 I4 I5 I6
Units of Good X
Income and substitution effects: normal good
Units of good Y
Substitution effect of the price rise
g h f
I1 I2
B2 QX3
QX2
QX1
Substitution effect
B1a
B1
I3 I4 I5 I6
Units of Good X
Income and substitution effects: normal good
Units of good Y
Income effect of the price rise
g h f
I1 I2
B2 QX3
QX2
Incom e
QX1
Substitution effect
B1a
B1
I3 I4 I5 I6
Units of Good X
INDIFFERENCE ANALYSIS ■
■
The effect of changes in price ✜
the price–consumption curve
✜
deriving the individual's demand curve
Income and substitution effects of a price change ✜
a normal good
✜
an inferior good
Units of good Y
Income and substitution effects: Inferior (non-Giffen) good
f
I1 I2
B1
QX1 Units of Good X
Income and substitution effects: Inferior (non-Giffen) good
Units of good Y
Rise in the price of good X
f h
I1
B2 QX3
I2
B1
QX1 Units of Good X
Units of good Y
Income and substitution effects: Inferior (non-Giffen) good
Substitution effect of the price rise
g
f h
I1
B2 QX2
B1a
I2
B1
QX1
Substitution effect
Units of Good X
Income and substitution effects: Inferior (non-Giffen) good
Income effect of the price rise
Units of good Y
g
f h
I1
B2 QX2 QX3 Income effect
B1a
I2
B1
QX1
Substitution effect
Units of Good X
INDIFFERENCE ANALYSIS ■
■
The effect of changes in price ✜
the price–consumption curve
✜
deriving the individual's demand curve
Income and substitution effects of a price change ✜
a normal good
✜
an inferior good
✜
a Giffen good (a special type of inferior good)
Units of good Y
Income and substitution effects: Giffen good
f
I1
I2
B1
QX1 Units of Good X
Income and substitution effects: Giffen good
Units of good Y
Rise in the price of good X
f
I1 h
B2
I2
B1
QX1QX3 Units of Good X
Units of good Y
Income and substitution effects: Giffen good
Substitution effect of the price rise
g f
I1 h
B2
B1a
I2
B1
QX2 QX1QX3 Substitution effect
Units of Good X
Income and substitution effects: Giffen good
Income effect of the price rise
Units of good Y
g f
I1 h
B2
B1a
I2
B1
QX2 QX1QX3 Income effect
Substitution effect
Units of Good X
INDIFFERENCE ANALYSIS ■
The effect of a change in price on the demand for other goods
■
The usefulness of indifference analysis ✜
superiority of using ordinal measures
✜
limitations of indifference analysis
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