Indifference Curve Analysis

Introduction
•.

•This approach was propounded by Hicks &

Allen.
• It measures utility ordinally.
•It explains consumer behaviour in terms of his
preferences or rankings for different
combinations of two goods, say X and Y.
•An indifference Curve is drawn on the from
the indifferent schedule of the consumer.
 Indifference schedule
An Combination Good x Good y

indifference L 1 18
schedule is a
list of M 2 13

combinations N 3 9
of two
commodities O 4 6

that yields Q 5 4
equal
satisfaction. R 6 3
 Indifference Curve
•Indifference Curve is
a Diagrammatic
Representation of
Indifference Schedule.
• It is an Indifference
curve.
•It is a line that shows
all possible combinations
of Two Goods between
which a person is
Indifferent
•It slopes from left to
right
- Indifference curves are convex to the origin.
- The marginal rate of substitution. As noted
On the indifference curve the consumer requires more of X in
return for Y (or vice versa) as the consumer moves along the
indifference curve. In other words the rate of exchange of X
for Y changes along the whole length of the curve.
The rate at which a consumer is willing to exchange one unit
of one product for units of another is termed the marginal rate
of substitution. It is given by the slope of the indifference
curve.
An indifference map. Any movement of the indifference curve to the
right is a movement to greater total utility.
Indifference curves never cross
An infinite number of curves. Given a consumer’s
scale of preferences, it is possible to
construct any number of indifference curves
on the indifference map
 Indifference Map

•An Indifference Map is

a Group of Indifference
Curves each of which
represents a given level
of Satisfaction.
•If an Indifference curve
Shifts to Right, the Level
of Satisfaction goes on
Increasing.
•From the Point of View
of Satisfaction I1<I2<I3
 Assumptions of Indifference Curve
1. Consumer acts rationally so as to maximise satisfaction.
2. There are two goods X and Y.
3. Utility is measured ordinally.
4. It is based on the axim of diminishing marginal rate of
substitution.
5. The consumer is consistent in his choice, that is, if in one
time he chooses bundle A over B, he will not choose B
over A in another time if both bundles are available to
him. If A>B , then B> A
6. Consumer’s choices are characterized by Transitivity . It
means that if a Consumer prefers A to B & B to C, he
must prefer A to C.
 Marginal Rate of Substitution (MRS)
The marginal rate of Combin Good Good MRS of X
substitution is the rate of ation x y forY
exchange between some
units of goods X and Y L 1 18 -
which are equally
preferred. The marginal M 2 13 5:1
rate of substitution of X
for Y (MRS)xy is the N 3 9 4:1
amount of Y that will be
given up for obtaining O 4 6 3:1
each additional unit of
X. This rate is explained
P 5 4 2:1
below in the following
indifference schedule.
Q 6 3 1:1
To have the combination M and yet to be at the same level of
satisfaction, the consumer is prepared to forgo 5 units of Y for
obtaining an extra unit of X. The marginal rate of substitution of X
for Y is 5:1. The rate of substitution will then be the number of
units of Y for which one unit of X is a substitute. As the consumer
proceeds to have additional units of X, he is willing to give away
less and less units of Y so that the marginal rate of substitution falls
from 5:1 to 1:1 in the sixth combination (Col. 4). In Fig. 8.4 above
at point M on the indifference curve I1, the consumer is willing to
give up 5 units of Y to get an additional unit of X.As he moves
along the curve form M to R, the consumer acquires more of X and
less of Y. The amount of Y he is prepared to give up to get
additional units of X becomes smaller and smaller. This behaviour
of the consumer is known as the principle of diminishing marginal
rate of substitution.
 The marginal rate of
substitution is in fact the
slope of the curve at a
point on the indifference
curve. Thus, M.R.S. x y =
ΔY / Δ X, on any point
on the indifference curve.
MRS Keeps on
Declining since
Consumer has more &
more units of one Good,
he gives up Less Units of
Other Good
 Properties of Indifference Curve
1. An Indifference Curve has a negative slope. It
denotes that if the quantity of one commodity (y)
decreases, the quantity of the other (X)
increases, if the consumer is to stay on the same
level of satisfaction. If the quantity of good X is
increased in the combination, while the quantity
of good Y remains unchanged, the new
combination will be preferable to the original
one and the two combinations will not therefore
lie on the same indifference curve provided more
of a commodity gives more satisfaction.
2. A higher indifference
Curve to the right of
another represents a
higher level of
satisfaction. Here in the
fig, IC2gives more
level of satisfaction
than IC1
. This is because IC2
contains more units of
at least one commodity
3.Indifference curves do not
intersect. If they did, the point of
intersection would imply two
different level of satisfaction,
which is impossible. Suppose
two Ics intersects at point A, then
A=C (lies on the same IC2)
A=B (lies on the same IC1)
 B=C(because of transitivity
assumption). But it is impossible
because point C gives higher
level of satisfaction than point B.
4. Indifference Curves are
convex to the point of
Origin due to
diminishing the
marginal rate of
substitution of
commodities. This implies
that as the consumer gets
more and more of X he is
ready to sacrifice less and
less of Y.
5. An indifference curve
Y
cannot touch either axis. If
it touches-X axis as in Fig.
at M, the consumer will be
having OM quantity of L
good X and none of Y.
Similarly, if it touches Y
axis at L, the consumer
will have only OL of Y
good and none of X. This
M X
is against the assumption
of consumer consumes
combination of two goods
6. Indifference
curves are not
necessarily
parallel to each
other. This is because
MRS may differ for
different indifference
curves. If MRS differs
the slope of
indifference curves also
differs.
 Exceptional Indifference Curves
Exception:1 If Marginal
Rate of Substitution(MRS)
of X for Y or Y for X is
constant,theindifference
Curve will be a straight
line sloping downwards to
the right at 45°.
If MRS of X for Y or Y
for X is increases, instead
of diminishes, the
indifference curve will be a
concave curve.
Exception:2 Perfect Complementary Goods have L-shaped Indifference
Curves

Indifference curve of perfect

complements, as shown in Fig. A is
L-shaped (Right Angle). Perfect
complementary goods are those which
are used simultaneously in the definite
ratio for instance, right shoe and left
shoe are perfect complement because
one is useless without the other. When
consumer has its minimum number
then there is no rate at which one shoe
be substituted for another. In case of
ordinary complementaries which have
a low rate of substitution on or near
the curvature of the curve as shown in
fig B
Exception 3: Horizontal
Indifference Curve – Goods that
give zero satisfaction: When any Y
product yields zero satisfaction
then the consumer will not want
to sacrifice even the last quantity
of the other product to get a
single unit of that product. For IC
instance, indifference curve of
cigarettes for a non-smoker, as
shown in Fig., will be a straight
line. Indifference curve of that
product which yields zero
satisfaction, will be parallel to O X
OX (at which product yielding
zero satisfaction is shown).
Exception 4: U-Shaped
Indifference Curve Goods y
that give Negative utility: If
consumption of any product
will result in negative utility
after a certain limit, then its Ic
indifference curve, as shown
in Fig. will be U shaped. For
instance, at point Q, the
consumer gets the quantity
of goods which are needed.
After point Q, slope of
o x
indifference curve becomes
positive.
 Budget Line
Abudget line is a line which shows all combinations of two goods that a
consumer can afford with a given income and prices of
commodities It is also known asprice line, consumption possibility
line, and line of attainable combinations.
Example of Budget Line
Suppose a consumer has an income of $50, and it will be used to buy
commodities X andY.To derive maximum utility from the said income,
only the following options are available.
If the price of X is $5 and price of Y is $2 a budget line
can be drawn with this information.
Y = $200

Good A $10 per unit

Good B $5 per unit

Combination Goods X ($ GoodsY Income (budget
10 each) ($ 5 each) allocation)

A 0 10 (10×0)+(5×10)=50

B 1 8 (10×1)+(5×8)=50

C 2 6 (10×2)+(5×6)=50

D 3 4 (10×3)+(5×4)=50

E 4 2 (10×4)+(5×2)=50

F 5 0 (10×5)+(5×0)=50
The required
budget line is
obtained by
plotting the
above budget
against the
following graph.
In the graph, the
X-axis represents
commodity X,
and Y-axis
represents
commodity Y.
 Features of Budget Line
⚫Negative slope: It has a negative slope.
⚫Straight line: It indicates a continuous
market rate of exchange in individual
combinations.
⚫Real income line: It denotes the income and
the spending amount of a customer.
.
 Consumer’s Equilibrium
Aconsumer is in equilibrium when he maximizes his satisfaction
with his given income and the market prices.Two conditions
must be fulfilled for the consumer to be in equilibrium.
1. MRSxy = Px/Py. It means MRS be equal to the ratio of
commodity prices.
This is a necessary but not sufficient condition for equilibrium.
2.The indifference curves be convex to the origin.This condition
is fulfilled by the axiom of diminishing MRSxy which states that
the slope of the indifference curve decreases as we move along the
curve from the downwards to the right.
Graphical Presentation
Given the indifference
map of the consumer
and his budget line, the
equilibrium is defined
by the point of
tangency of the
budget line with the
highest possible
indifference curve
(point E in the fig.)
At the point of tangency the slope of the budget line (Px/Py) and
MRSxy are equal Px/Py = MRSxy
At the point of equilibrium the consumer is
maximizing his satisfaction
Consumer Equilibrium Indifference
Consumer

At the of equilibrium the consumer is

maximizing his satisfaction.
Change in Price of ONE Good
As the price of one good change the budget line will
pivot. The curve that joins the points is called the price
consumption line.
 Price Consumption Line

As the price of X falls, the budget line

pivots from AF to AG to AH and the
consumer shifts from C to C1 and C2,
substituting X and Y. C-C1-C2 is the
price–consumption line in the
diagram above.
 Income Consumption Line
A rise in the consumer’s income shifts the budget line
outwards and equilibrium shifts from C to C1 to C2 as
more of both X and Y are consumed. Line C-C1-C2 is the
income–consumption line.
Separating income and
substitution effects
 Inferior Good

An inferior good is one

where demand actually
goes down as a result of an
increase in income.
 Giffen goods

Giffen goods are those

where a fall in the price of
the good causes a fall in the
demand.
Separating the substitution effect
from the Income Effect Giffen
Good
With a GIFFEN GOOD there is a positive substitution
effect but there is a larger negative income effect that
outweighs the substitution effect causing less of the
commodity to be demanded.
Inferior Good
https://www.youtube.com/watch?v=vQsDCo-
xVZY

The negative income effect outweighs the substitution effect causing

less of the commodity to be bought when the price decreases.