Sunday, 7 October 2012

Principles of Economics: Indifference Analysis (Microeconomics)

Indifference analysis is basically a solution to the issues that arise from using the marginal utility theory to derive demand. Utility cannot be measured absolutely, which is one of the problems with the marginal utility theory. In indifference analysis we rank combinations of goods in order of preference. This can get quite complex, but stick with it!

We start by looking at a simple indifference curve. An indifference curves, by definition, shows us all the combinations of two goods that give the same amount of satisfaction. All the combinations that will leave the consumer 'indifferent'. We first have to construct an indifference set like this:

At all combinations of these two goods above, the consumer in question is equally as satisfied. We then go on to map this data out onto a diagram.

Here we have an indifference curve for the data above. The curve will slope downwards and get flatter and flatter the further along it you go. We can work out the marginal rate of substitution for the two goods from here as well using the formula (Change in Y) / (Change in X). This will give us the rate at which we are prepared to exchange good Y for good X and still remain indifferent. The more we move down the slope the more MRS diminishes. There's two ways of looking at it, either way we say MRS decreases. If we follow the curve up and to the left, the value of MRS diminishes because it will always give a negative value. If we follow the curve to the right then the absolute value (ignoring the negative) will decrease. So, the principle is that as we move along an indifference curve MRS falls. 

We can go further on from this and generate an indifference map. This is different combinations of the two goods that give different amounts of satisfaction. It's modeled like this: 

You may see this referred to as a 'mountain' in some cases. But basically, the further up this 'mountain' you go the more satisfaction. Each of these indifference curves resembles a different combination of goods which give the same amount of satisfaction. L1 is the least satisfied combination whereas L4 is the most satisfied. Would the lines ever cross i hear you say? Well, no is the short answer to that. We can prove this via contradiction. Picture two indifference lines that cross in your head. Point A is the point they cross, point B is a point on one curve and point C is a point on the other curve. We can say that A is indifferent to B because they are on the same curve and we can also say that A is indifferent to C. By this, we should be able to say that B is indifferent to C, but this isn't the case because one of these points will offer a better combination of goods than the other and therefore give more satisfaction, making the two points not indifferent. By this logic the indifference curves cannot cross. 

Mhmm, that's an introduction to indifference curve. The next logical step from this will be too look at the budget line which I will do in the next few blog posts. So expect that at some point next week. Thanks for reading, please follow and share the blog if you found it useful! Any comments are much appreciated! Have a good night/day!


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