AMAN KUMAR SINGH

What is an Indifference Curve

It is a curve that represents all the combinations of goods that give the same satisfaction to the consumer.
Since all the combinations give the same amount of satisfaction, the consumer prefers them equally.
Hence the name Indifference Curve.

Assumptions of Indifference Curve:

· The consumer is rational. Also, he possesses full information about all the relevant aspects of the
economic environment in which he lives.

· The consumer can rank combination of goods based on the satisfaction they yield. However, he can’t
quantitatively express how much he prefers a certain good over the other.

· If a consumer prefers A over B and B over C, then he prefers A over C.

· If a combination X has more commodities than the combination Y, then X is preferred over Y.

Here is an example to understand the indifference curve better.

Peter has 1 unit of food and 12 units of clothing. Now, we ask Peter how many units of clothing is he
willing to give up in exchange for an additional unit of food so that his level of satisfaction remains
unchanged.

Peter agrees to give up 6 units of clothing for an additional unit of food. Hence, we have two combinations
of food and clothing giving equal satisfaction to Peter as follows:

1 unit of food and 12 units of clothing

2 units of food and 6 units of clothing

By asking him similar questions, we get various combinations as follows:

Combination Food Clothing

A 1 12
B 2 6
C 3 4
D 4 3
Graphical Representation:

The diagram shows an Indifference curve (IC). Any combination lying on this curve gives the same level
of consumer satisfaction. It is also known as Iso-Utility Curve.

Indifference Map

An Indifference Map is a set of Indifference Curves. It depicts the complete picture of a consumer’s
preferences. The following diagram showing an indifference map consisting of three curves:
We know that a consumer is indifferent among the combinations lying on the same indifference curve.
However, it is important to note that he prefers the combinations on the higher indifference curves to
those on the lower ones.

This is because a higher indifference curve implies a higher level of satisfaction. Therefore, all
combinations on IC 1 offer the same satisfaction, but all combinations on IC2 give greater satisfaction than
those on IC1.

Marginal Rate of Substitution (‘MRS’)

This is the rate at which a consumer is prepared to exchange a good X for Y. If we go back to Peter’s
example above, we have the following table:

Combination Food Clothing MRS

A 1 12 -
B 2 6 6
C 3 4 2
D 4 3 1

In this example, Peter initially gives up 6 units of clothing to get an extra unit of food. Hence, the MRS is
6. Similarly, for subsequent exchanges, the MRS is 2 and 1 respectively. Therefore, MRS of X for Y is the
amount of Y whose loss can be compensated by a unit gain of X, keeping the satisfaction the same.

Interestingly, as Peter accumulates more units of food, the MRS starts falling – meaning he is prepared to
give up fewer units of clothing for food. There are two reasons for this:

· As Peter gets more units of food, his intensity of desire for additional units of food decreases.

· Most of the goods are imperfect substitutes for one another. If they could substitute one another
perfectly, then MRS would remain constant.

Properties of Indifference Curve

An IC slopes downwards to the right

This slope signifies that when the quantity of one commodity in combination is increased, the amount of
the other commodity reduces. This is essential for the level of satisfaction to remain the same on an
indifference curve.

An IC is always convex to the origin

From our discussion above, we understand that as Peter substitutes clothing for food, he is willing to part
with less and less of clothing. This is the diminishing marginal rate of substitution. The rate gives a
convex shape to the indifference curve. However, there are two extreme scenarios:

Two commodities are perfect substitutes for each other – In this case, the indifference curve is a straight
line, where MRS is constant.

Two goods are perfect complementary goods – An example of such goods would be gasoline and water
in a car. In such cases, the IC will be L-shaped and convex to the origin.
Indifference curves never intersect each other

Two ICs will never intersect each other. Also, they need not be parallel to each other either. Look at the
following diagram:

Fig 3 shows tow ICs intersecting each other at point A. Since A and B lie on IC1, the give the same
satisfaction level. Similarly, A and C give the same satisfaction level, as they lie on IC2. Therefore, we can
imply that B and C offer the same level of satisfaction, which is logically absurd. Hence, no tow ICs can
touch or intersect each other.

A higher IC indicates a higher level of satisfaction as compared to a lower IC

A higher IC means that a consumer prefers more goods than not.

An IC does not touch the axis

This is not possible because of our assumption that a consumer considers different combinations of two
commodities and wants both of them. If the curve touches either of the axes, then it means that he is
satisfied with only one commodity and does not want the other, which is contrary to our assumption.
Budget Line

Since a higher indifference curve represents a higher level of satisfaction, a consumer will try to reach the
highest possible IC to maximize his satisfaction. In order to do so, he has to buy more goods and has to
work under the following two constraints:

· He has to pay the price for the goods; and

· He income is limited, restricting the availability of money for purchasing these goods

As can be seen above, a budget line shows all possible combinations of two goods that a consumer can
buy within the funds available to him at the given prices of the goods. All combinations that are within his
reach lie on the budget line.

A point outside the line (point H) represents a combination beyond the financial reach of the consumer.
On the other hand, a point inside the line (point K) represents under-spending by the consumer.
Consumers Equilibrium

In order to display the combination of two goods X and Y, that the consumer buys to be in equilibrium,
let’s bring his indifference curves and budget line together.

We know that,

Indifference Map – shows the consumer’s preference scale between various combinations of two goods

Budget Line – depicts various combinations that he can afford to buy with his money income and prices of
both the goods.

In the following figure, we depict an indifference map with 5 indifference curves – IC1, IC 2, IC3, IC 4, and
IC 5 along with the budget line PL for good X and good Y.

From the figure, we can see that 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.

So, which combination will he choose?

Let’s say that he chooses the combination R. From Fig. 1, we can see that R lies on a lower indifference
curve – IC1. He can easily afford the combinations S, Q, or T which lie on the higher ICs. Even if he
chooses the combination H, the argument is similar since H lies on the curve IC1 too.

Next, let’s look at the combination S lying on the curve IC 2. Here again, he can reach a higher level of
satisfaction within his budget by choosing the combination Q lying on IC3 – higher indifference curve level.
The argument is similar for the combination T since T lies on the curve IC2 too.

Therefore, we are left with the combination Q.

What happens if he chooses the combination Q?

This is the best choice since Q lies on his budget line and pts puts him on the highest possible
indifference curve, IC 3. While there are higher curves, IC4 and IC 5, 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 IC. 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 Q,

MRSxy = MU x /MU y = P x/Py

Therefore, we can say that consumers equilibrium is achieved when the price line is tangential to the
indifference curve. Or, when the marginal rate of substitution of the goods X and Y is equal to the ratio
between the prices of the two goods.

Criticism of the indifference Curve Analysis

· The indifference curve analysis is based on the wrong assumption that the consumer is familiar with
his entire preference schedule. It may not be realistic on our part to make this assumption because it
is not physically possible for a consumer to have complete knowledge of all the combinations of the
tow goods, which afford him equal satisfaction.

· It is pointed out that indifference curve analysis tells us nothing new. It has hardly contributed any
concept, which has not already been established by the utility analysis.

· The indifference curve analysis is based on the assumption of economic rationality. Like the old utility
analysis is also built upon the assumption that the consumer behaves in a irrational manner when it
comes to spending money on goods.

· The indifference curve analysis is based on the usual assumption that the consumer spends his
money income on more than two goods.

· The indifference curve analysis is only micro economic in character. It deals only with the choice of an
individual consumer or it studies the equilibrium of an individual consumer. It throws little light on the
analysis of group choices or group equilibrium.

· The indifference curve analysis involves the unrealistic assumption of continuity. Indifference curves
are continuous curves on which are located all possible conceivable combinations of the two goods
whether they are actually available in the market or not. It is quit possible that the price line comes to
be tangent to an indifference curve at point representing a particular combination, which is not
actually available in the market.
· The indifference curve analysis is not very amenable to empirical research. In utility analysis there is
a great scope for empirical research we can collect the actual market prices and also fined out the
quantities available at those prices.
· This analysis is based upon the weak-ordering hypothesis. According to this hypothesis, the
consumer can be indifferent between certain combinations of the two goods. This position of
indifference assumed by the indifference curve analysis is quite unrealistic according to the critics.

· The indifference curve analysis is exceedingly complicated. Unlike the comparatively simple utility
analysis the indifference curve analysis is very complex and complicated necessitating s sufficiently
developed level of understanding.

· The analysis is predominantly introspective. Prof. Samuelson has criticized the indifference curve
analysis on the ground that it studies consumer’s behavior on the basis of imaginary drawn
indifference curves. It is an account of this basic defect that he has recently developed his behaviorist
method of deriving the theory of demand.

Despite these defect and draw backs the fall remains that the indifference curve analysis marks a
considerable improvement over the conversational utility analysis.