INDIFFERENCE CURVE THEORY

Utility refers to the degree of satisfaction that an individual receives from an economic act.
People purchase goods and services to get some benefit or satisfaction. This allows them to
fulfil a need or want when they consume it. This phenomenon is called economic utility.
Cardinal Utility is a utility that determines the satisfaction of a commodity used by an
individual and can be measured by numeric values.
Ordinal Utility defines that satisfaction of goods and can be ranked in order of preference.
Cardinal numbers tell 'how many' of something, they show quantity.
Ordinal numbers tell the order of how things are set, they show the position or the rank of
something.
Marginal utility is the incremental increase in utility that results from the consumption of one
additional unit.

• The law of diminishing marginal utility says that the marginal utility from each
additional unit declines as consumption increases.
• The marginal utility can decline into negative utility, as it may become entirely
unfavourable to consume another unit of any product.
• The marginal utility may decrease into negative utility, as it may become entirely
unfavourable to consume another unit of any product.

The law of diminishing marginal utility states that all else equal, as consumption increases,
the marginal utility derived from each additional unit declines.
The law of equi-marginal utility explains the behaviour of a consumer when he consumers
more than one commodity. Wants are unlimited but the income which is available to the
consumers to satisfy all his wants is limited. This law explains how the consumer spends his
limited income on various commodities to get maximum satisfaction. The law of equi-marginal
utility is also known as the law of substitution or the law of maximum satisfaction or the
principle of proportionality between prices and marginal utility.
Assumptions
1. The consumer is rational so he wants to get maximum satisfaction.
2. The utility of each commodity is measurable.
3. The marginal utility of money remains constant.
4. The income of the consumer is given.
5. The prices of the commodities are given.
6. The law is based on the law of diminishing marginal utility.
Explanation of the law

Suppose there are two goods X and Y on which a consumer must spend a given income. The
consumer being rational, he will try to spend his limited income on goods X and Y to maximise
his total utility or satisfaction. Only at that point the consumer will be in equilibrium.
According to the law of equi-marginal utility, the consumer will be in equilibrium at the point
where the utility derived from the last rupee spent on each is equal.
 Every rational human being wants to get maximum satisfaction with his limited means.
The consumer arranges his expenditure in such a way that, M U x/Px = M U y/Py = M Uz/ P
z so that he will get maximum satisfaction.
Indifference Curve:
An indifference curve is a graphical representation of a combined products that gives similar
kind of satisfaction to a consumer thereby making them indifferent. Every point on the
indifference curve shows that an individual or a consumer is indifferent between the two
products as it gives him the same kind of utility.
In other words,
An indifference curve is the locus of all those combinations of two goods that yields the same
level of utility (satisfaction) to the consumer so that the consumer is indifferent to purchase the
particular combination s/he selects.

Such a situation arises because a consumer consumes a large number of goods and services.
Often, he finds that one commodity serves as a substitute for another. This allows him to
substitute one commodity for another. In this case, he can make various combinations of two
goods that give him the same level of satisfaction.
When a consumer faces such combinations of goods, he/she would be indifferent between the
combinations. When such combinations are plotted graphically, it gives a curve. This curve is
known as the indifference curve. It is also called the iso-utility curve or equal utility curve.

Indifference Schedule:

A table that shows the various combinations of two goods that yield the same level of
satisfaction to the consumer is called indifference schedule. The table below is an example of
an indifference schedule that shows 5 different combinations A, B, C, D, and E of two goods
X and Y. All these combinations yield the same level of satisfaction to the consumer. Therefore,
the consumer is indifferent between them.
Indifference schedule:
Combinations Commodity-X Commodity-Y
A 1 14
B 2 10
C 3 7
D 4 5
E 5 4
Indifference Curve/ Diagram/ Graph:

All the combinations of X and Y showed in the table above, give the same level of satisfaction
to the consumer. The indifference schedule, when plotted on a graph, gives an indifference
curve as shown in the figure below:

In the above figure, commodity X is measured on X-axis and commodity Y is measured on Y-

axis. IC represents an indifference curve. Points A, B, C, D, and E show combinations of X
and Y commodities that give the same level of satisfaction to the consumer. If we join these
points, we get a smooth, convex, and continuous negative sloped curve which is called the
indifference curve.
Indifference Map

An indifference map is a set of indifference curves plotted on a single plane. An

indifference map shows different indifference curves which rank the preference of the
consumer. Combinations that lie on an indifference curve give the same level of satisfaction to
the consumer. However, a higher indifference curve represents a higher level of satisfaction
than a lower indifference curve.
In the above figure, commodity X is measured on X-axis and Y commodity on Y-axis. The
indifference curve shows those combinations of two goods that yield the same satisfaction
level. IC3 yields higher satisfaction than IC2. IC1 yields the lowest level of satisfaction. This
is because higher IC contains more units of at least one commodity.

Properties or Characteristics of Indifference Curve

• Indifference curve has a negative slope

• Indifference Curve is Convex to the origin

• Indifference curves neither intersect nor become tangent to one another

• Higher indifference curve represents a higher level of satisfaction than the lower ones

• Indifference curves are not necessarily parallel

• Indifference curve does not touch either of the axes

• An indifference curve may not necessarily be a straight line

• Combinations that lie on an indifference curve give the same level of satisfaction

Budget:
Budget line (or, price line) is a graphical representation of all possible combinations of two
goods which can be purchased with given income and prices, such that the cost of each of these
combinations is equal to the money income of the consumer.
A budget line shows the combination of goods that can be afforded with your current income.
A budget line shows combinations of two goods a consumer can consume, given a budget
constraint. An indifference curve shows combinations of two goods that yield equal
satisfaction. To maximize utility, a consumer chooses a combination of two goods at which an
indifference curve is tangent to the budget line.
An indifference curve depicts all the combinations of two goods that provide the consumer
with equal satisfaction. When the Budget line is tangent to the indifference curve, a consumer
will be in equilibrium, according to the indifference curve approach.
 •Given a budget line of B1, the consumer will maximise utility where the
highest indifference curve is tangential to the budget line (20 apples, 10
bananas)
• Given current income – IC2 is unobtainable.
• IC3 is obtainable but gives less utility than the higher IC1
• The optimal choice of goods can also be shown with the Equi-marginal
principle
Income Consumption Curve (ICC):

Consumer’s Equilibrium:
A consumer is in equilibrium when he derives maximum satisfaction from the goods and is in
no position to rearrange his purchases.
Assumptions:
• There is a defined indifference map showing the consumer’s scale of preferences
across different combinations of two goods X and Y.
• The consumer has a fixed money income and wants to spend it completely on the
goods X and Y.
• The prices of the goods X and Y are fixed for the consumer.
 • The goods are homogenous and divisible.
• The consumer acts rationally and maximizes his satisfaction.
Equilibrium:

In the above figure, the combinations R, S, Q, T, and H cost the same to the consumer. In order
to maximize his level of satisfaction, the consumer will try to reach the highest indifference
curve. Since we have assumed a budget constraint, he will be forced to remain on the budget
line.
This is the best choice since Q lies on his budget line and pts puts him on the highest possible
indifference curve, IC3. While there are higher curves, IC4 and IC5, they are beyond his
budget. Therefore, he reaches the equilibrium at point Q on curve IC3.

Notice that at this point, the budget line PL is tangential to the indifference curve IC3. Also, in
this position, the consumer buys OM quantity of X and ON quantity of Y.

Since point Q is the tangent point, the slopes of line PL and curve IC3 are equal at this point.
Further, the slope of the indifference curve shows a marginal rate of substitution of X for Y
(MRSxy) equal to MUx / MUy. Also, the slope of the price line (PL) indicates the ratio between
the prices of X and Y and is equal to Px / Py.
Hence, at the equilibrium point, slope of budget line is equal to the slope of Indifference curve.
In other words, at the equilibrium, MRS xy = MUx / MUy = Px / Py.

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