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BRIAN ROPI A LEVEL INDIFFERENCE CURVE THEORY NOTES 2022

Ordinal Utility
It is the concept of utility which is based on the idea of preference ordering and ranking
rather than the concept of measurable utility. It is assumed that a consumer is capable of
comparing any 2 alternative bundles of goods and deciding whether he prefers one bundle to
the other or is indifferent between them. Several assumptions are made about the nature of
this preference ordering which lead to the conclusion that all possible bundles of goods can
be grouped into sets in such a way that the consumer is indifferent between all bundles in one
set and not indifferent between sets. These indifferent sets can be arranged in increasing order
of preference. It is often convenient though not necessary to assign numbers to these sets
adopting the convention that the higher a set is in order of preference the higher its number
should be.
The indifference curves (ordinal) Approach
An indifference curve is a curve that describes a combination of two goods that yield the
same level of satisfaction or utility to the consumer. It shows the various sets of goods that
make a consumer indifferent to the satisfaction derived from consuming them. Based on the
same utility derived from various baskets of goods, it becomes uneasy for a consumer to
choose a particular basket of goods because utilities derived from a series of combinations to
another are indifferent.
Assumptions of Indifference Curves
i. Rationality – the consumer always aims to maximize satisfaction from goods
consumed.
ii. Ordinal Utility (assumption of completeness) - It is axiomatically believed that the
consumer can rank his preferences in accordance with the utility derived from various
baskets of goods, utility measurements can only be handled using the ordinal method
and not the cardinal method. The total satisfaction derived by a consumer is a function
of the total quantity of commodities consumed i.e. 𝑻𝑼=𝑭(𝑸𝟏,𝑸𝟐,𝑸𝟑,𝑸𝟒,...𝑸𝟏)
iii. Non satiety - consumers always prefer more to less. They will never reach the point
of satiety that is the maximum level of satisfaction.
iv. Consistency and transitivity of choice - Since we assume that a consumer is
rational, his choice of goods has to be consistent. When he chooses a particular point
in time, he is not expected to choose B over A in another time A>B, then A must be
preferred to B. Similarly if A>B>C – A>C. Meaning that if a consumer preferred
bundle A to bundle B and bundle B to C, then bundle A must be preferred to bundle
C.
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BRIAN ROPI A LEVEL INDIFFERENCE CURVE THEORY NOTES 2022

 There must be two baskets of goods for the analysis to be complete. The indifference
curve analysis will not be complete if the bundles are used in isolation of the other
basket.

Properties/Characteristics of Indifference Curves

1. Negative Slope - An indifference curve slopes down from left to right. This means that the
consumption of the 2 goods along the indifference curve is negatively related to each other
that is if the quantity of one commodity (Y) consumed decreases the quantity of the other (X)
must increase in order to maintain the same level of satisfaction.

2. Non Intersection - Indifference curves must not intersect. If the 2 curves intersect, the
point at which the intersection occurs will represent 2 different levels of satisfaction, thereby
violating the consistency assumption.
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BRIAN ROPI A LEVEL INDIFFERENCE CURVE THEORY NOTES 2022

In the above diagram, two indifference curves are showing cutting each other at point B. The
combinations represented by points B and F given equal satisfaction to the consumer because
both lie on the same indifference curve IC2. Similarly the combinations shows by points B
and E on indifference curve IC1 give equal satisfaction top the consumer. If combination F is
equal to combination B in terms of satisfaction and combination E is equal to combination B
in satisfaction. It follows that the combination F will be equivalent to E in terms of
satisfaction. This conclusion looks quite funny because combination F on IC2 contains more
of good Y (wheat) than combination which gives more satisfaction to the consumer. We,
therefore, conclude that indifference curves cannot cut each other.
3. Convexity - The indifference curve is convex to the origin. This means that the curve is
inwardly curved from left downwards to the right signifying diminishing marginal rate of
substitution (DMRS).
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BRIAN ROPI A LEVEL INDIFFERENCE CURVE THEORY NOTES 2022

In the above diagram, as the consumer moves from A to B to C to D, the willingness to

substitute good X for good Y diminishes. The slope of IC is negative. In the above diagram,
diminishing MRSxy is depicted as the consumer is giving AP>BQ>CR units of Y for
PB=QC=RD units of X. Thus indifference curve is steeper towards the Y axis and gradual
towards the X axis. It is convex to the origin. If the indifference curve is concave, MRSxy
increases. It violets the fundamental feature of consumer behaviour. If commodities are
almost perfect substitutes then MRSxy remains constant. In such cases the indifference curve
is a straight line at an angle of 45 degree with either axis. If two commodities are perfect
complements, the indifference curve will have a right angle. In reality, commodities are not
perfect substitutes or perfect complements to each other. Therefore MRSxy usually
diminishes.
4. Higher Indifference Curve Represents Higher Level of Satisfaction- Indifference curve
that lies above and to the right of another indifference curve represents a higher level of
satisfaction. The combination of goods which lies on a higher indifference curve will be
preferred by a consumer to the combination which lies on a lower indifference curve.
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The Indifference Map is a conglomeration of indifference curves. A higher curve than

another one signifies a higher level of satisfaction. The indifference map shows various
indifference curves that stand for different levels of satisfaction. It should be noted that
bundles or basket of goods found on the same indifference curve produce the same level of
satisfaction. An indifference map ranks the preferences of the consumer. The higher the
indifference curve or the farther away from the origin it is, the more preferable it is to a
rational consumer. On the other hand, the lower the indifference curve, or the closer the curve
is to the origin, the less preferable it is.

From the diagram IC3 > IC2 and IC2 > IC1.Though the level of satisfaction might not be
determined, the utility associated with I1 is less than that attached to IC2 and satisfaction
attached to I2 is less than that of IC3. Given that consumers are rational most purchases of
goods and services will like to consume along the highest indifference curve i.e. IC3.

5. Diminishing Marginal Rate of Substitution (DMRS) - The technical term for the
negative slope of an indifference curve is marginal rate of substitution (MRS). The MRS is
the amount of one good a consumer is ready to sacrifice in order to obtain an additional unit
of another good. The act of increasing and decreasing the commodities eg good X and Y i.e.
the willingness to give up one good for the other along the indifference curve is called
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Diminishing Marginal Rate of Substitution. The slope of the indifference curve = MRS =
MUx/ MUy
The Budget Constraint / Budget Line
A budget line shows combinations of two products which can be purchased with a given level
of income. The budget line slope shows the relative prices of the two goods that is Px/ Py. A
consumer‘s ability to purchase goods and services is limited by his level of income and the
prices of goods and services. A budget constraint/budget line or consumption possibilities
curve measures the relative scarcity between two goods. The line shows the combination of
goods a consumer can purchase given his/her income at market prices. It also classifies
attainable and unattainable regions.
The budget constraint in the case of two goods x and y is formulated as follows:
𝑰= 𝑷x𝑸x+ 𝑷y𝑸y
Where: 𝑰 is the consumer‘s income
𝑷x is the price of the good x
𝑸x is the quantity of the good x
𝑷y is the price of the good y
𝑸y is the quantity of the good y
For Example - A budget of $100 and prices for y of $2 per unit and for x of $5 per unit.
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The consumer can attain or consume any combination along the budget line for example at
point C that is the consumer consumes all his income. Inside the budget line for example at
point U, the consumer does not exhaust all the income. Points along the budget line are
attainable and points outside the budget line are unattainable for example point W is not
attainable that is it is beyond the consumer‘s income. A budget line measures Marginal Rate
of Transformation (MRT).

Shifts in the Budget Line

An increase or decrease in the level of the consumer’s income will result in an outward shift
of the budget line. Changes in prices affect the level of real income, if prices decreases real
income increases and the budget line shifts outwards. The reverse is true for increase in
prices.eg if prices decrease by 50%, the effect will be as follows.
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A Changes in price of only one good results in the slide of the budget line showing that any
combination less or more of a product will be purchased. For example if price of Good X
decrease by 50% the effect will be as follows:
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BRIAN ROPI A LEVEL INDIFFERENCE CURVE THEORY NOTES 2022

If the price of the good increases or decreases the budget line will not shift. It will pivot
inwards or outwards depending on the circumstances.
The Consumer Equilibrium under Indifference Curves Analysis
Given the consumer income and the prices of goods or supplies in the market, the consumer
maximizes satisfaction at the point of equilibrium. Graphically it is the point where the
budget line is tangential to the highest possible indifference curve.
Conditions of consumer’s equilibrium
The conditions of consumer equilibrium where he would maximize his satisfaction is as
follows:
 At equilibrium point budget line or price line should be tangent to indifferent curve.
 At equilibrium point slope of the indifference curve must be equal to the slope of
budget line.
 At equilibrium point = (𝑷x𝑸x) + (𝑷y𝑸y) = 𝑰𝒏𝒄𝒐𝒎𝒆
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BRIAN ROPI A LEVEL INDIFFERENCE CURVE THEORY NOTES 2022

Point E is the equilibrium point. The equilibrium quantities are QX and QY. The slope of the
budget line = Px/ Py (marginal rate of transformation for good x and y (MRT)) and the slope
of the indifference curve = MUx/ MUY (marginal rate of substitution for good x and y (MRS
xy)) are equal at their point of tangency. At this point marginal rate of substitution is equal to
marginal rate of transformation and satisfaction will be equal to income. At point A MRS >
MRT and at B MRS < MRT.
Applications of Indifference Curves Analysis/Changes in Consumer Equilibrium
1. Effects of Changes in Income- A rise in the level of the consumer‘s income shifts from C
to C1 to C2 as more of both x and y are consumed. The line C, C1, C2 is income
consumption line/curve (ICC/ICL) or the Engel curve (EC).
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BRIAN ROPI A LEVEL INDIFFERENCE CURVE THEORY NOTES 2022

An income consumption curve is the line that traces the different equilibrium points of the
consumer arising from changes in his income. If the increase in income leads to an increase
in the quantity demanded of a good then this is a normal good.

2. Effects of changes in prices

Changes in price of Good X, while that of Good Y remains fixed. As the price of Good X
falls, the budget line pivots outwards and the consumer equilibrium shifts from A to B to C.
TSR is the price consumption curve/line (PPC).
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BRIAN ROPI A LEVEL INDIFFERENCE CURVE THEORY NOTES 2022

A price consumption curve (PPC) is a line that traces or joins the new equilibrium points as a
result of continuous falling or increasing of the price of a commodity.
3. Derivation of the demand curve using the indifference curves approach.
Indifference curves can be used to show how an individual demand curve is derived. With
expenditure on all other goods plotted on the vertical axis and with income, tastes and the
price of all other goods held constant, we can now derive the demand curve for good X. This
is demonstrated in the diagram below;
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Distinguishing between income and substitution effects

Total Effect - Total price effect measures the impact on quantity of good as a result of
changes in the price of that commodity. The effect can be divided into two different
components of substitution and income effects.
Income and substitution effect for a normal good
A normal good is a good such that when the constraints income increases people buy more of
the good. On the diagram below B2 is the original budget line with the consumer in
equilibrium at point A with indifference curve IC1. If the price of product x falls this will
lead to a pivot in the budget line to B3, allowing the consumer to reach a higher indifference
curve (IC2) and a new equilibrium of point C. The result of this is that the quantity of product
x bought has risen from X1 to X3.
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Given a budget line of B2 and an indifference curve of IC1 a consumer is in equilibrium at

point A. The price of product X falls, hence the budget line pivots to B3. The substitution
effect involves a move from point A to B, where the relative prices of products x and y have
changed but real income has remained constant. The income effect involves a move from B
to C, where real income increases while relative prices remain unchanged.
Income and substitution effect for an inferior good
When people‘s incomes increase, they will buy less of inferior goods e.g. public transport,
second hand clothing, poor foodstuffs etc. since they will now be able to afford better quality
goods (and vice versa). On the diagram below, if the price of product x falls it leads to a
substitution effect towards the product, i.e. a movement from A to B, with more being
consumed (X1 to X2). However, the income effect is negative, unlike that for a normal good,
and this means a movement from B to C with less being consumed, X2 to X3.
Although the income effect is negative, in this case it is not sufficient to outweigh the
substitution effect, which means that overall there is still more of the product demanded as
the consumer has moved from X1 to X3. In other words, the demand curve for product x is
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still downward sloping. It is possible, however, for the negative income effect to be
sufficiently large to outweigh the substitution effect.

The figure relates to an inferior good with the income effect (represented by a move from B
to C) working in the opposite direction to the substitution effect (represented by a move from
A to B) following a fall in the price of product X. The substitution effect is greater than the
income effect and so the demand curve for the product is still downward sloping.
Critique of the Indifference Curves Approach
 In practice, it is virtually impossible to derive indifference curves since it would
involve the consumer having to imagine a whole series of different combinations of
goods and deciding in each case whether a given combination gave more, equal or
less satisfaction than other combinations.
 Consumers may not behave rationally and hence may not give careful consideration to
the satisfaction they believe they will gain from consuming goods. They may behave
impetuously (that is rushing or acting without considering) for example impulsive
buying.
 Consumers are not perfectly knowledgeable. Therefore the optimum consumption
point may not in practice give consumers maximum satisfaction for their money.
 The belief that consumers are rational may be influenced by advertising.
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 Indifference curves are based on the assumption that marginal increases in one good can
be traded off against marginal decreases in another. This will not be the case with
consumer durables for example cars, TVs, sofas and Houses since they are purchased
only now and again and then only one at a time.