indifference curve analysis

Indifference Curve

Analysis

by:Manisha Joshi

Indifference Curve

Indifference Curve is a locus of all such points which shows different

combination of two commodities which

yield equal satisfaction to the consumer, so

that he is indifferent to the particular

combination he consumes.

Indifference Curve schedule

It refers to a schedule that indicates different combinations of two commodities which yield equal satisfaction.

Table 1. Indifference Curve schedule

Combination of

apple s and oranges

Apples Oranges

A 1 10

B 2 7

C 3 5

D 4 4

Indifference Map

Indifference Map refers to a

set of Indifference

Curve.

Assumptions of Indifference Curve Analysis:

a) Consumer is rational. b) Utility can be measured in Ordinal numbers. c) Marginal rate of substitution (MRS) diminishes. d) Consumer does not reach the level of satiety, he offers more quantity of a good to less quantity.

e) Consumer’s behavior is Consistent. E.g. if consumer prefers A combination > B combination at one time, then at another time he will not prefer more of B combination than A combination. f) Transitivity. E.g. if consumer prefers A combination to B combination and B combination to C combination, then he will definitely prefer A combination to C combination.

g) Consumer’s scale of Preference is Independent of his income and prices of goods in the market.

Properties of

Indifference Curve

1) An Indifference curve slopes downward.

An IC curve slopes downward from left to right or it has a negative

slope.

IC curve may be a

a) Vertical line

b) Horizontal line

c) Upward sloping curve

2) Convex to the point of Origin

It implies that IC slope tends to decrease as we move along it from left to right. Since,slope of IC is same as MRS, we can say that Convexity of IC implies diminishing

MRS.

This is possible in case of Normal goods only.

If an Indifference Curve is not Convex to point of Origin ‘O’ then it can be

o A straight line

It signifies that MRS of Apples for Oranges remains Constant. Such an Indifference Curve can be possible in case of Perfect Substitutes.

o Concave

It signifies that MRS of Apples for Oranges

is increasing. It means that as the

quantity of Apples is increasing its

importance is also increasing, but it

does not happen in real life.

3) Two Indifference Curve never cut each other.

Each IC represents different level of satisfaction, so

their intersection is ruled out.

From figure:

lC1 shows that satisfaction from = satisfaction from A combination B combinationlC2 shows that satisfaction from = satisfaction from A combination C combination ;It implies satisfaction from is equal to satisfaction from B combination C combination (3 oranges+ 2 apples) (2 oranges+2 apples) ,

but it is not possible as quantity of oranges in B combination is more than in C combination, though quantity of apples in both combinations are equal.

4) Higher Indifference Curve represents more satisfaction.

In Indifference Map, higher IC represents those combinations

which yield more satisfaction than the combinations on the

lower IC.

5) Indifference Curve touches neither X-axis nor Y-axis.

In IC analysis, it is assumed that a consumer buys combination of different quantities of two commodities. Hence, Indifference Curve touches neither X-axis nor Y-axis.

In case an indifference curve touches either X-axis or Y-axis, it means that consumer wants only one commodity and his demand for second commodity is zero.

An indifference curve may touch OY-axis, if it represents money instead of a commodity.

6) Indifference Curve need not to be parallel to each other.

Indifference Curves may or may not be parallel to each other. It all depends on the MRS of two curves.

Indifference Curves will be parallel to each other only when MRS of different points on two curves diminishes at constant rate, otherwise they will not be parallel.

7) Indifference Curve become complex in case of more than two commodities.

If consumer wants a combination of more than two commodities, say three commodities then such a combination cannot be expressed in the form of diagram.

Shape ofIndifference

Curve

1) Straight line indifference curve :

In case of Perfect Substitutes, IC may be a straight line with negative slope.e.g. Taj Mahal (X-commodity) and Brooke Bond tea (Y-commodity) are perfect substitute of each other.Here,

MRSxy = 1

2) Right-angled Indifference Curve :

In case of Perfectly Complementary goods, the shape of IC is right-Angle.e.g. a consumer will buy right and left shoes in a fixed ratio.Here,

MRSxy = 0

Budget Line or

Price Line

The Budget line shows all different combinations of the two commodities that a consumer can purchase given his money income and price of two commodities.

Slope of Price line = Px/Py

Here;Px= price of applesPy = price of oranges

Suppose ; a consumer has

Income = Rs. 4 to be spent on apples and oranges.Price of apple = Rs. 1.00Price of oranges = Rs. 0.50

the different combinations that a consumer can get of these goods are :

From Figure;Budget line = AB

If there is any point outside or to the right of price line AB, the consumer will not be able to buy that combination of two goods because of his limited income.

If there is any point inside or to the left of price line AB, then the consumer will be unable to spend all his income.

Shifting of the Price Line

Change in Income

Effect on Price Line

Rise Shift to Right

Fall Shift to Left

1) Due to change in Income:

Assumptions :o price of two goods

remain constant and o income of consumer

changes.

2) Due to change in the Price of one commodity:

Assumptions:

O Income of consumer remain unchanged.

O Price of one commodity is constant.

O Price of other commodity changes.

Consumer’s Equilibrium

– Indifference Curve Analysis

Consumer’s equilibrium refers to a situation in which a consumer with given income and given prices purchases such a combination of goods and services which gives him maximum satisfaction and he is not willing to make any change in it.

It is struck when“what he is willing to buy coincides with what he can buy”

Assumptions:

O Prices of goods are constant.O Consumer’s income is also constant.O Consumer knows the prices of all things.O Consumer can spend his income in

small quantities.O Consumer is rational.O Consumer is fully aware of Indifference

map.O Perfect competition in the market.

Conditions of Consumer’s Equilibrium

1) Price line should be tangent to Indifference Curve. or Slope of IC = Slope of Price line or MRSxy = Px/Py

2) Indifference Curve must be Convex to the Origin.

1) Price line should be tangent to Indifference Curve

When the consumer is in equilibrium, his highest attainable Indifference Curve is tangent to price line.

From Figure:At point ‘D’, slope of Indifference Curve and Price Line coincide. Therefore, first condition of consumer’s equilibrium is satisfied.

2) Indifference Curve must be Convex to the Origin

It means that MRS of Apples for Oranges should be diminishing.

If at the point of equilibrium, Indifference Curve is Concave and not Convex to the Origin, then it will not be a position of permanent equilibrium.

Therefore, a consumer will be in permanent equilibrium where both the conditions are satisfied.

Marginal Rate of Substitution

It is the rate at which the consumer is willing to give up commodity Y for one more unit of commodity X in order to maintain the same level of satisfaction.

Utility gained of Good X = Utility lost of Good Y

It is estimated asMRSxy = ΔY/ΔX

on any point on IC.

Law of Diminishing Marginal Rate of Substitution

According to this Law, “as a consumer gets more and more units of X, he will be willing to

give up less and less units of Y.”

In other words, the marginal rate of substitution of X for Y will go on diminishing

while the level of satisfaction of the consumer remains the same.

Combinations

Apples (X)

Oranges (Y)

MRS = Loss Y/Gain X

A 1 10 _

B 2 7 3/1

C 3 5 2/1

D 4 4 1/1

Table 2. Schedule

Table 2. indicates that the consumer will give up 3 oranges for getting the second

apple, 2 oranges for getting the third apple

and 1 orange for getting the fourth apple.

In other words, MRS of apples for oranges goes on diminishing.

Why Marginal rate of substitution diminishes ?

It diminishes ; As Law of Diminishing marginal rate of substitution is an

extensive form of Law of diminishing marginal utility. According to Law of Diminishing Marginal Utility,

Consequently, consumer is willing to give up less and less units of oranges for every additional unit of apple.

Therefore, Marginal rate of substitution of apples for oranges diminishes.

As Consumption by Consumer

Marginal Utility goes on

1) Increases 1) Diminishing

2) Decreases 2) Increasing

Constant Marginal rate of substitution

The Marginal rate of substitution is constant if to obtain one more unit of X, only one unit of Y is sacrificed to maintain same level of satisfaction.Marginal rate of substitution of Perfect Substitutes is constant. Table 3.

Combination Apples Oranges MRS= Loss Y/Gain X

A 1 10 _

B 2 9 1/1

C 3 8 1/1

D 4 7 1/1

Indifference

Curve will be a Straight line

falling downwards from left to

right.

Increasing Marginal rate of substitution

It implies that as the stock of a commodity increases with the consumer he substitutes it for the other commodity at an increasing rate to maintain the same level of satisfaction. Table 4.

Combinations Apples Oranges MRS= Loss Y/Gain X

A 1 10 _

B 2 9 1/1

C 3 7 2/1

D 4 4 3/1

Indifference Curve will be

Concave to the point of origin.

Classifications of Goods

Type of goods

Price effect Income effect

Shape of Demand Curve

1) Normal Goods

Negative Positive Slopes Upward

2) Inferior Goods

Negative Negative Slopes Downward

3) Giffen’s Goods

Positive Negative Slopes Upward

Comparison:

Basis of Difference

Law of Diminishing Marginal Utility

Law of Diminishing Marginal Rate of Substitution

1) Measurement in Cardinal/Ordinal numbers

Unrealistic assumption that marginal utility can be measured in Cardinal numbers.

Realistic assumption that utility can be measured in Ordinal numbers.

2) Independence of Commodities

Utility of one commodity is independent of the utility of other commodity.

Utility of one commodity is dependent of the utility of other commodity.

3) Marginal utility of money (MUm)

Assumption is that MUm remains constant.

No such assumption.