Indifference Curve

Definition: The Indifference Curve shows the different combinations of two goods that give
equal satisfaction and utility to the consumers. In other words, the indifference curve is the
graphical representation of different combinations of goods (generally two), for which the
consumers are indifferent, in terms of the overall satisfaction and the utility.

Assumptions of Indifference Curve

1. Only two goods are taken into the consideration. It is assumed that the customer has to make
a choice between two goods, provided their prices remains constant.
2. It is assumed that the customer is not saturated with both the commodities and look for
more benefits from these two, to have a higher curve to have more satisfaction.
3. The satisfaction level cannot be measured; thus, the customer ranks his preferences.
4. It is assumed that the marginal rate of substitution diminishes, as more units of one good
have to be set off by the reduction in the units of the other commodity. Thus, the indifference
curve is convex to the origin.
5. It is assumed that the consumer is rational and will make his choice objectively to have an
increased utility and the satisfaction.

The concept of Indifference curve can be further comprehended through an illustration

below:

Combination Product-A (in number) Product-B (in number)

L 1 10

M 2 9

N 3 8

O 4 7

P 5 6
 The consumer is indifferent between the Product-A and product-B, shown by 5 different
combinations Viz. L, M, N, O, P. This means that combination L (10A+1B) gives an equal
level of satisfaction and utility as (9A+ 2B), (7A+4B) and so on.. The IC curve shown in the
figure above is generated by joining these combinations

Properties of Indifference Curve

Definition: The Indifference Curve is the graphical representation of the combination of
two goods, that gives equal satisfaction and utility to the consumer.

Properties of Indifference Curve

1. Downward Sloping: An indifference curve slope downward, which means, that with the
more consumption of one good the consumption of the other is to be reduced to maintain the
utility.Here, the principle of the marginal rate of substitution (MRS) applies, which means the
increased consumption of one commodity is to be set off by the reduced consumption of
another commodity, so as to have the same level of satisfaction or utility. Thus, the
 indifference curve is negatively sloped.

2. Convex to the Origin: The indifference curves are convex to the origin because of the
diminishing marginal rate of substitution. The MRS diminishes because of the decline in the
marginal utility, which means with more and more consumption of one commodity, the
customer’s utility starts declining and he is not willing to consume it more at the cost of the
other commodity.For example, let’s say there are two chocolates, dairy milk, and Nestle,
with more and more consumption of dairy milk chocolates the utility continues to decline,
and the customer will no more give up the Nestle chocolates to buy the dairy milk. Here,
MRS shows the slope of the indifference curve.

3. Higher the indifference curve, the higher is the level of satisfaction: The consumer
derives more satisfaction from the combination of two goods on a higher indifference curve
 because more units of both the commodities are used that will surely be more satisfying than
the lower quantity combinations.

4. Cannot Intersect or be tangent to each other: The indifference curves can not intersect
with each other, because if it does so, then the combinations of two commodities lying on two
different curves will yield the same level of satisfaction which is not correct.

Thus, it is clear from the properties of the indifference curve that the customer realizes an
equal satisfaction and the utility from the use of different combinations of two commodities.

Indifference Map
Definition: The Indifference Map is the graphical representation of two or more
indifference curves showing the several combinations of different quantities of commodities,
which consumer consumes, given his income and the market price of goods and services.
The consumer preferences give rise to several combinations of commodities, each yielding
the same level of satisfaction. Hence, it is critical to understand the preferences of the
consumer as these vary from individual to individual and market to market. The concept of
the indifference map can be further understood through a figure given below:

The space between axis X and Y is called as the Indifference Plane or Commodity Space.
This plane is comprised of finite points, each point representing the different combinations of
goods X and Y. It is possible to identify two or more points on the indifference plane, which
shows different combinations of good X and Y, yielding the same level of utility.

Thus, it is always possible to draw a number of indifference curves without intersecting or

being tangent to each other. These indifference curves Viz. IC1, IC2, IC3, IC4, drawn
graphically represents the indifference map. Thus, an indifference map may contain several
IC curves positioned on the basis of the consumer’s preferences.

Ordinal Approach to Consumer Equilibrium

Definition: The Ordinal Approach to Consumer Equilibrium asserts that the consumer is
said to have attained equilibrium when he maximizes his total utility (satisfaction) for the
given level of his income and the existing prices of goods and services. The ordinal approach
defines two conditions of consumer equilibrium: Necessary or First Order Condition and
Supplementary or Second Order Condition.
To understand how the consumer reaches his equilibrium using the ordinal approach we need
to understand the following terms:

 Indifference curve: The indifference curve shows the different combinations of two
substitutes (goods) that yield the same level of satisfaction (utility) to the consumer. This
means that the consumer is indifferent towards the consumption of two goods which are
closely related to each other.
 Indifference Map: The indifference map contains different indifference curves showing
the combinations of different quantities of two substitute goods on the basis of the
consumer preferences. The consumer can make different combinations of goods by
consuming less of one commodity or the other in such a way that all the combinations
yield the same level of satisfaction.
 Marginal Rate of Substitution (MRS): The marginal rate of substitution defines the rate
at which one commodity is substituted for another in such a way that the total utility
(satisfaction) remains the same.
 Budget Line: As per the properties of the indifference curve, higher the indifference
curve on the indifference map, the higher is the utility derived from the consumption.
Thus, the consumer tries to reach to the highest possible indifference curve with two
strong constraints: limited income and market price of goods and services.Since the
amount of income in hand decides how high consumer can reach on his indifference map
acts as a budgetary constraint. Therefore, the budget line represents the different quantity
combinations of available commodities that a consumer can purchase given his level of
income and the market price of goods and services.
Now, let’s understand how consumer reaches his equilibrium using the ordinal utility
approach:

Necessary Condition or First Order Condition: Under the first order condition, the
consumer reaches his equilibrium in the same manner as he does under the cardinal approach
of the two-commodity model. It is expressed as:

By implication,

Thus, the necessary condition of the cardinal approach to consumer

equilibrium can be written as:

Supplementary or Second Order Condition: The first order

condition is necessary but not sufficient. Thus, the second order or supplementary condition
requires that the necessary condition must be accomplished at the highest possible
indifference curve on the indifference map.
In the figure above, there are three indifference curves, Viz. IC1, IC2, and IC3 presenting a
hypothetical indifference map of the consumer. AB is the hypothetical budget line. At point
‘E’, the indifference curve IC2and Budget line AB intersect and hence, therefore, the slope of
IC2 = AB. At this point, both the necessary condition and the supplementary condition get
fulfilled, and hence, the consumer attains equilibrium at point ‘E’.

We know that between any two points on the indifference curve:

ΔY. MUy = ΔX. MUx

Thus, the slope of the indifference curve can be written as:

The slope of budget line is given as:

In the figure above, at point ‘E’, MRS x, y = Px /Py and hence the consumer is
said to have attained equilibrium at this point. The IC2 is tangent with the budget line AB,
which shows that the consumer has reached to the highest possible indifference curve for a
given level of his income and the market price of goods and services. Thus, at point ‘E’
consumer consumes quantity OQx of X and OQy of Y, which yields him the maximum utility
or satisfaction.

Budget Line
Definition: The Budget Line, also called as Budget Constraintshows all the combinations
of two commodities that a consumer can afford at given market prices and within the
particular income level.

We know that the higher the indifference curve, the higher is the utility, and thus, utility
maximizing consumer will strive to reach the highest possible Indifference curve. But, he has
two strong constraints: limited income and given the market price of goods and services.
The income in hand is the main constraint (budgetary) that decides how high a consumer can
go on the indifference map. In a two commodity model, the budgetary constraint can be
expressed in the form of the budget equation:

Px . Qx + Py . Qy =M

Where,
Px and Py are the prices of commodity X and Y and Qx, and Qy is their respective quantities.
M= consumer’s money income

The Budget equation states that the consumer’s expenditure on commodity X and Y cannot
exceed his money income (M). Thus, the quantities of commodities X and Y that a consumer
can buy from his income (M) at given prices Px and Py can be calculated through the budget
equation given below:
 The values of Qx and Qy are
plotted on the X and Y axis, and a line with a negative slope is drawn connecting the points
so obtained. This line is called the budget line or price line.

Income and Substitution Effects of a Price Change

A change in the price of a commodity alters the quantity demanded by consumer. This is known
as price effect. However, this price effect comprises of two effects, namely substitution effect and
income effect.

Substitution Effect

Let us consider a two-commodity model for simplicity. When the price of one commodity falls, the
consumer substitutes the cheaper commodity for the costlier commodity. This is known as
substitution effect.

Income Effect
Suppose the consumer’s money income is constant. Again, let us consider a two-commodity
model for simplicity. Assume that the price of one commodity falls. This results in an increase in
the consumer’s real income, which raises his purchasing power. Due to an increase in the real
income, the consumer is now able to purchase more quantity of commodities. This is known as
income effect.
Hence, according to our example, the decline in the price level leads to an increasing
consumption. This occurs because of the price effect, which comprises income effect and
substitution effect. Now, can you tell how much increase in consumption is due to income effect
and how much increase in consumption is due to substitution effect? To answer this question, we
need to separate the income effect and substitution effect.
How to separate the income effect and substitution effect?
Let us look at figure 1. Figure 1 shows that price effect (change in Px), which comprises
substitution effect and income effect, leads to a change in quantity demanded (change in Qx).

Figure 1

The splitting of the price effect into the substitution and income effects can be done by holding
the real income constant. When you hold the real income constant, you will be able to measure
the change in quantity caused due to substitution effect. Hence, the remaining change in quantity
represents the change due to income effect.
To keep the real income constant, there are mainly two methods suggested in economic
literature:

1. The Hicksian Method

2. The Slutskian method

The Hicksian Method

Let us look at J.R. Hicks’ method of bifurcating income effect and substitution effect.
In figure 2, the initial equilibrium of the consumer is E1, where indifference curve IC1is tangent to
the budget line AB1. At this equilibrium point, the consumer consumes E1X1 quantity of
commodity Y and OX1 quantity of commodity X. Assume that the price of commodity X decreases
(income and the price of other commodity remain constant). This result in the new budget line is
AB2. Hence, the consumer moves to the new equilibrium point E3, where new budget line AB2 is
tangent to IC2. Thus, there is an increase in the quantity demanded of commodity X from X1 to
X2.
An increase in the quantity demanded of commodity X is caused by both income effect and
substitution effect. Now we need to separate these two effects. In order to do so, we need to
keep the real income constant i.e., eliminating the income effect to calculate substitution effect.
According to Hicksian method of eliminating income effect, we just reduce consumer’s money
income (by way of taxation), so that the consumer remains on his original indifference curve IC1,
keeping in view the fall in the price of commodity X. In figure 2, reduction in consumer’s money
income is done by drawing a price line (A3B3)parallel to AB2. At the same time, the new parallel
price line (A3B3) is tangent to indifference curve IC1 at point E2. Hence, the consumer’s
equilibrium changes from E1 to E2. This means that an increase in quantity demanded of
commodity X from X1 to X3 is purely because of the substitution effect.
We get the income effect by subtracting substitution effect (X1X3) from the total price effect
(X1X2).

Income effect = X1X2 - X1X3 = X3X2

The slutskian Method

Now let us look at Eugene Slutsky’s method of separating income effect and substitution effect.
Figure 3 illustrates the Slutskian version of calculating income effect and substitution effect.
In figure 3, AB1 is the initial budget line. The consumer’s original equilibrium point (before price
effect takes place) is E1, where indifference curve IC1 is tangent to the budget line AB1. Suppose
the price of commodity X falls (price effect takes place) and other things remain the same. Now
the consumer shifts to another equilibrium point E2, where indifference curve IC3 is tangent to the
new budget line AB2. Consumer’s movement from equilibrium point E1 to E2 implies that
consumer’s purchase of commodity X increases by X1X2. This is the total price effect caused by
the decline in price of commodity X.

Now the task before us is to isolate the substitution effect. In order to do so, Slutsky attributes
that the consumer’s money income should be reduced in such a way that he returns to his
original equilibrium point E1 even after the price change. What we are doing here is that we make
the consumer to purchase his original consumption bundle (i.e., OX1 quantity of commodity X
and E1X1 quantity of commodity Y) at the new price level.
In figure 3, this is illustrated by drawing a new budget line A4B4, which passes through original
equilibrium point E1 but is parallel to AB2. This means that we have reduced the consumer’s
money income by AA4 or B4B2 to eliminate the income effect. Now the only possibility of price
effect is the substitution effect. Because of this substitution effect, the consumer moves from
equilibrium point E1 to E3, where indifference curve IC2 is tangent to the budget line A4B4. In
Slutsky version, the substitution effect leads the consumer to a higher indifference curve.

Thus, income effect = X1X2 - X1X3 = X3X2