INDIFFERENCE CURVE

ANALYSIS
M.A. 3rd SEMESTER
MICRO ECONOMIC THEORY
FOR THE LECTURES 7TH -29TH AUGUST 2020

Presented By-

Dr. Ankita Gupta

Associate Professor
1 Department of Economics
M.G.Kashi Vidyapith –Varanasi
 OVERVIEW

OBJECTIVES CONTENT

 Understand the ordinal utility  Indifference Curve –

analysis Properties and Assumptions
 Understand the Indifference  Consumer Euilibrium
Curves  Income Substitution and
 Derive the Demand Curve Price Effect
 Establishment of Law of
Demand

2
 INTRODUCTION
 In microeconomics, indifference curve is an important tool of analysis in the
study of consumer behavior.

 The concept of indifference curve analysis was first propounded by British

economist Francis Ysidro Edgeworth and was put into use by Italian
economist Vilfredo Pareto during the early 20th century. However, it was
brought into extensive use by economists J.R. Hicks and R.G.D Allen.

 Hicks and Allen criticized Marshallian cardinal approach of utility and

developed indifference curve theory of consumer’s demand. Thus, this
theory is also known as ordinal approach.

3
 ORDINAL UTILITY
 Modern economists, particularly Hicks gave ordinal utility
concept to analyze consumer behavior.

 He has used a tool, called indifference curve, for consumer

behavior analysis.

 Assumes that utility is expressible only in ordinal terms. This

implies that a consumer is only able to express his/her
preference for goods.

4
 INDIFFERENCE CURVE ANALYSIS

What is an 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.

5
 INDIFFERENCE CURVE ANALYSIS

 The Indifference curve analysis work on a simple graph

having two-dimensional. Each individual axis indicates a

single type of economic goods. If the graph is on the

curve or line, then it means that the consumer has no

preference for any goods, because all the good has the

same level of satisfaction or utility to the consumer. For

instance, a child might be indifferent while having a toy,

two comic book, four toy trucks and a single comic book.

6
 CONTD….
Indifference Map
The Indifference Map refers to a set of Indifference Curves
that reflects an understanding and gives an entire view of a
consumer’s choices. The below diagram shows an
Indifference map with three indifference curves.
According to the indifference curve approach, it is not possible
for the consumer to say how much utility he derives from the
consumption of a commodity, because utility is not a
measureable magnitude.
But a consumer can compare two or more combinations of
goods and say which of them he likes best or whether he likes
them all equally well. The Laws of Consumer Demand can be
deduced from these preferences.
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INDIFFERENCE CURVE

 An indifference curve is a locus of all

combinations of two goods which yield the
same level of satisfaction (utility) to the
consumers.
 Since any combination of the two goods on an
indifference curve gives equal level of
satisfaction, the consumer is indifferent to any
combination he consumes. Thus, an
indifference curve is also known as ‘equal
satisfaction curve’ or ‘Iso-utility curve’.
 On a graph, an indifference curve is a link
between the combinations of quantities which
the consumer regards to yield equal utility.
Simply, an indifference curve is a graphical
representation of indifference schedule.
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 INDIFFERENCE SCHEDULE

 The table given below is an example of indifference schedule

Table: Indifference schedule
 Combination Mangoes Oranges
A 1 14
B 2 09
C 3 06
D 4 04
E 5 02.5

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 ASSUMPTIONS OF INDIFFERENCE CURVE

The indifference curve approach is based upon the following assumptions:

1. Non-Satiety:
A rational person will prefer a larger quantity of a good than a smaller amount of it. It is
assumed that the consumer has not yet reached the satisfaction point in respect of
competition of a good. Satiety means saturation. And, indifference curve theory assumes that
the consumer has not reached the point of satiety. It implies that the consumer still has the
willingness to consume more of both the goods. The consumer always tends to move to a
higher indifference curve seeking for higher satisfaction.
2. Transitivity:
The consumer is supposed to be consistent about his tastes and preference. For example if
he prefers A to B and B to C then it follows that he also prefers A to C. This assumption is
called Transitivity.
3.Diminishing marginal rate of substitution
Marginal rate of substitution may be defined as the amount of a commodity that a consumer
is willing to trade off for another commodity, as long as the second commodity provides same
level of utility as the first one.
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 ASSUMPTIONS ……

4. Two commodities

5. It is assumed that the consumer has fixed amount of money, all of which is to be
spent only on two goods. It is also assumed that prices of both the commodities are
constant.

6. As indifference curve theory is based on the concept of diminishing marginal rate

of substitution, an indifference curve is convex to the origin.

7. Rational consumers

8. According to this theory, a consumer always behaves in a rational manner, i.e. a

consumer always aims to maximize his total satisfaction or total utility.
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 PROPERTIES OF INDIFFERENCE CURVE
INDIFFERENCE CURVE SLOPE DOWNWARDS TO RIGHT
 There are four basic properties of an indifference
curve. These properties are
 An indifference curve can neither be horizontal line
nor an upward sloping curve. This is an important
feature of an indifference curve.
 When a consumer wants to have more of a
commodity, he/she will have to give up some of
the other commodity, given that the consumer
remains on the same level of utility at constant
In the above diagram, IC is an indifference curve,
income. As a result, the indifference curve slopes and A and B are two points which represent
downward from left to right. combination of goods yielding same level of
satisfaction.
 The slope of the indifference curve is called the We can see that when X1 amount of commodity X
MRS which is the ratio of the marginal utilities of was consumed, Y1 amount of commodity Y was
the two commodities. This is expressed as also consumed. When the consumer increased the
MRS x,y = – ΔY /ΔX = MUx/MUy consumption of commodity X to X2, the amount of
commodity Y fell to Y2. And, thus the curve is
sloping downward from left to right.
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 CONTD…..
 Indifference curve is convex to the origin
 As mentioned previously, the concept of indifference curve is
based on the properties of diminishing marginal rate of
substitution.
 According to diminishing marginal rate of substitution, the rate
of substitution of commodity X for Y decreases more and more
with each successive substitution of X for Y.
 Also, two goods can never perfectly substitute each other.
Therefore, the rate of decrease in a commodity cannot be
equal to the rate of increase in another commodity.

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 AN INDIFFERENCE CURVE CANNOT INTERSECT OR TOUCH
ANOTHER INDIFFERENCE CURVE

 This can be proved by showing

that if two indifference curves
on the same indifference map
intersect, there is logical
contradiction (or inconsistency).
Suppose I1, and I2 intersect as
in Fig, then from I1

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 CONTD…
 Point A lies on both I1, and I2. Since point A I2 like point C lies on I1,
the consumer is indifferent between A and C. Similarly we can say
that the consumer is indifferent between A and B. Applying the
transitivity assumption, then we can say that our consumer is
indifferent between B and C.
 But this is absurd since B contains more X than C while both B and C
contain the same amount of Y. We know that more is better (showing
higher utility) for the consumer. Hence B should be strictly preferred to
C, or B and C cannot show equal level of utility. This explains why
indifference curves cannot intersect.
 [... Transitivity implies that if A is preferred to B and B is preferred to C
then A is preferred to C.]
15
 TWO INDIFFERENCE CURVES
CANNOT INTERSECT
 In this image, IC1 and IC2 are two indifference
curves and C is the point where both the curves
intersect.
 According to indifference curve theory,
satisfaction at point C = satisfaction at point A
Also, satisfaction at point C = satisfaction at point
B
But, satisfaction at point B ≠ satisfaction at point
A.
 Therefore, two indifference curves cannot
intersect. Yet, two indifference curves need not be
parallel to each other.
 Higher indifference curve represents higher level
of satisfaction
 Higher the indifference curves, higher will be the
level of satisfaction. This means, any combination
16
of two goods on the higher curve give higher level
of satisfaction to the consumer than the
combination of goods on the lower curve.
HIGHER INDIFFERENCE CURVE REPRESENTS
HIGHER LEVEL OF SATISFACTION

In the above figure, IC1 and IC2 are two

indifference curves, and IC2 is higher than IC1.
We can also see that Q is a point on IC2 and S
is a point on IC2.
Combination at point Q contains more of both
the goods (X and Y) than that of the
combination at point S. We know that total utility
of commodity tends to increase with increase in
stock of the commodity. Thus, utility at point Q is
greater than utility at point S, i.e. satisfaction
yielded from higher curve is greater than
satisfaction yielded from lower curve.

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 THE BUDGET (PRICE) LINE
 In search for higher utility, the consumer faces a constraint — a limited budget
or income. The consumer does not have sufficient funds to purchase all
combinations of the two goods. The limits imposed by the budget are shown
through the consumer’s budget line. A budget line incorporates information on
both the limited income of the consumer to spend and the prices of two
purchasable goods.
 A budget line is a locus of points showing alternative combinations of two
goods that can be purchased with a fixed amount of money income and fixed
prices of the two goods.
 If we know the budget (or the spending power) of the consumer and his
Indifference Map we can find out what quantity of each commodity he will
purchase. With the same information we can measure the effect of changes in
the prices of commodities and of changes in the income of the consumer.

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 CONTD…..
 Suppose a consumer has a fixed income M which he
spends on two goods X and Y. Suppose Px is the price of
X and Py is the price of Y. Let OA be the amount of Y
which can be purchased if the whole of the consumer’s
income (M) is spent on Y. Then OA x Py = M. Or OA =
M/Py. Similarly, let OB be the amount of X which can be
purchased with M. Then OB x px = M. Join A and B. AB is
called the Price Line or the Budget Line or the
Consumption-Possibility Line (See Fig. 4.9). The line AB
has important characteristics. Every point on it shows a
possible distribution of the consumer’s income (M)
between X and Y.
 A budget line is derived from a given income and given
prices. So any change in income or price leads to a new
budget line.
 If the price of one of the purchasable commodities falls
there is a change in the slope of the budget line.
 The slope of the line is:
 OA ÷ OB = M/py ÷ M/px = M/py. py/xy = px/py.
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 This is known as the price ratio. The equation of the
budget line is M = Px. X + Py. Y.
 EQUILIBRIUM OF THE CONSUMER

 The equilibrium position of the consumer is

shown in Fig. 4.10. We assume a consumer with
a fixed income M, spending the whole of his
income only on two goods, X and Y. AB is the
consumption possibility line and IC1, IC2 etc. are
the indifference curves of the consumer.

20
 CONTD….
 The consumer may with M, buy OC of X and NC of Y. In this case he is on
indifference curve IC1. But with the same income M, he can also buy OM of
X and PM of Y. In this case he is on IC3 which denotes a better situation than
IC1. It can be assumed, as a rule of rational behaviour, that the consumer will
try to secure the maximum possible satisfaction from his income. He will,
therefore, be on the highest indifference curve that he can reach with his
income.
 A glance at Fig. 4.10 shows that the highest indifference curve the consumer
can reach is IC3 which just touches the consumption possibility line AB. AB is
the tangent of IC3 at P. Once the consumer reaches this position he will not
shift his purchase pattern, unless his income changes or unless the price of
X or of Y becomes different. From this reasoning we can conclude that the
equilibrium position of the consumer is at the point where the Consumption
Possibility Line is the tangent of an Indifference Curve.
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 CONTD….
The rate of decrease in consumption of coffee is
not the same as rate of increase in consumption of
cigarette.
Similarly, rate of decrease in consumption of
coffee has gradually decreased even with constant
increase in consumption of cigarette.
Thus, indifference curve is always convex (neither
concave nor straight).
Indifference curve cannot intersect each other
Each indifference curve is a representation of
particular level of satisfaction.
The level of satisfaction of consumer for any given
combination of two commodities is same for a
consumer throughout the curve. Thus, indifference
curves cannot intersect each other.

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PRICE CONSUMPTION CURVE

The bottom part of the Fig. 4.13 is derived from

the top part. In both parts, the horizontal axis
shows the quantity of apple which will be
bought, but in the bottom part of the diagram,
the vertical axis shows the price of apples. This
part of the diagram is a conventional demand
curve diagram. At the original price of apple;
the consumer’s preference for apples will be at
point X, and quantity q, will be consumed. This
is shown in both parts of the Fig. 4.13. The
budget line AB also corresponds to a particular
price of apples, and is shown in the bottom part
as point X.

Fig: Deriving the 23

demand curve from
PCC
 INCOME EFFECT
 The income effect is the change in the consumption of goods by
consumers based on their income.
 The substitution effect happens when consumers replace cheaper
items with more expensive ones when their financial conditions
change.
 The income effect can be both direct (when it is directly related to a
change in income) or indirect (when consumers must make buying
decisions not directly related to their incomes).
 A small reduction in price may make an expensive product more
attractive to consumers, which can also lead to the substitution
effect.

24
 CONTD….
 The income effect is the change in the consumption of goods based on income. This
means consumers will generally spend more if they experience an increase in
income, and they may spend less if their income drops. But the effect doesn't dictate
what kind of goods consumers will buy. They may opt to purchase more expensive
goods in lesser quantities or cheaper goods in higher quantities, depending on their
circumstances and preferences.
 The income effect can be both direct or indirect. When a consumer chooses to make
changes to the way he or she spends because of a change in income, the income
effect is said to be direct. For example, a consumer may choose to spend less on
clothing because his income has dropped.
 An income effect becomes indirect when a consumer is faced with making buying
choices because of factors not related to her income. For instance, food prices may
go up leaving the consumer with less income to spend on other items. This may
force her to cut back on dining out, resulting in an indirect income effect.
 The MPC explains how consumers spend based on income. It is a concept based
on the balance between the spending and saving habits of consumers.
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 INCOME CONSUMPTION CURVE
 In consumer choice theory, the income-consumption curve is a curve in a graph in
which the quantities of two goods are plotted on the two axes; the curve is
the locus of points showing the consumption bundles chosen at each of various
levels of income.
 The income effect in economics can be defined as the change in consumption
resulting from a change in real income. This income change can come from one of
two sources: from external sources, or from income being freed up (or soaked up)
by a decrease (or increase) in the price of a good that money is being spent on. The
effect of the former type of change in available income is depicted by the income-
consumption curve discussed in the remainder of this article, while the effect of the
freeing-up of existing income by a price drop is discussed along with its companion
effect, the substitution effect, in the article on the latter. For example, if a consumer
spends one-half of his or her income on bread alone, a fifty-percent decrease in the
price of bread will increase the free money available to him or her by the same
amount which he or she can spend in buying more bread or something else.
26
 INCOME CONSUMPTION CURVE

Thus, the income consumption curve (ICC) can be used to derive the
relationship between the level of consumer's income and the quantity purchased
of a commodity by him. The curve showing the relationship between the levels
of income and quantity purchased of particular commodities has therefore been
27
called Engel curve.
 ICC- NORMAL GOODS
 The income effect is a phenomenon observed
through changes in purchasing power. It reveals
the change in quantity demanded brought by a
change in real income. The figure 1 on the left
shows the consumption patterns of the consumer
of two goods X1 and X2, the prices of which
are p1 and p2 respectively. The initial bundle X*, is
the bundle which is chosen by the consumer on
the budget line B1. An increase in the money
income of the consumer, with p1 and p2 constant,
will shift the budget line outward parallel to itself.
 Thus, it can be said that, with variations in income
of the consumers and with the prices held constant
the income–consumption curve can be traced
out as the set of optimal points.
 Income–consumption curve for different type

28
 ICC- INFERIOR GOODS
 The figure on the right (figure 3), shows the
consumption patterns of the consumer of two
goods X1 and X2, the prices of which
are p1 and p2 respectively, where B1 and B2 are
the budget lines and I1 and I2 are the indifference
curves. Figure 3 clearly shows that, with a rise in
the income of the consumer, the initial budget
line B1 moves outward parallel to itself to B2 and
the consumer now chooses X' bundle to the initial
bundle X*. The figure shows that, the demand for
X2 has risen from X21 to X22 with an outward shift
of the budget line from B1 to B2 (caused due to
rise in the income of the consumer). This
essentially means that, good X2 is a normal good
as the demand for X2 rose with an increase in the
income of the consumer.
 In contrast, it is to be noted from the figure, that
the demand for X1 has fallen from X11 to X12 with
an outward shift of the budget line from B1 to B2
(caused due to rise in the income of the
consumer). This implies that, good X1 is an
inferior good as the demand for X1 fell with an 29
increase in the income of the consumer.
ICC- PERFECT SUBSTITUTES
 The figure on the right depicts the case of two goods
X1 and X2 which are perfect substitutes, prices of which
are p1 and p2 respectively. Here, I1, I2, I3, I4 and I5 are the
straight line indifference curves, B1, B2 and B3 are the
budget constraints and X*, X' and X" are the bundles
chosen by the consumer. If it is assumed that p1 < p2 then
the consumer would consume only X1 as this would
maximize his utility.
 In the figure on the right, B1 is the initial budget line and
the consumer chooses X* as his optimal bundle and as
the money income of the consumer rises, his budget line
will shift outward and parallel to itself to B2. At the budget
line B2 and the indifference curve I4, the consumer will
choose X'. Subsequently, as the income rises further, the
budget line will again shift outward and parallel to itself to
B3, where, the consumer will choose the optimal bundle
X".
30
 ICC- PERFECT COMPLEMENTS
 In case of perfect complements, the same
amount of goods will be consumed by the
consumer irrespective of say income, prices
etc. As the level of consumption remains the
same, the income–consumption curve for
perfect complements is the diagonal line
passing through the origin as shown in Figure 5
on the left.
 In the figure on the left, X*, X' and X" are the
utility maximization points where the budget
constraint lines B1, B2 and B3 touch the kinks
of the L-shaped indifference curves I1, I2 and
I3 respectively. By joining these points of utility
maximization, the income–consumption curve
for perfect complements is obtained. 31
 ENGEL CURVE
 The Engel curve, named after the German statistician Ernst
Engel (1821-96), is a relation between the demand for a
good and the income of its buyers, the former depending on
the latter.
 The Engel curve of an individual consumer can be obtained
from his ICC. As, every point on the ICC for an individual
consumer like the curve given in Fig. 6.17, is a combination
of three items—his money income (M), his demand for good
X and that for good Y.
 For example, the point E1 is a combination of money
income, L1M1 i.e., the money income represented by the
budget line L1M1, demand for good X = x1 and the demand
for good Y = y1, i.e., the point E1 is a combination (L1M1, x1,
y1). Similarly, the point E2 is a combination of (L2M2, x2, y2),
and so on.
 Therefore, the points on the ICC in Fig. 6.17 gives a set of
combinations of money income and demand for X like
(L1M1, x1), (L2M2, x2), etc. and another set of combinations
32
of money income and the demand for good Y like (L1M1, y1),
(L2M2, y2), etc.
NORMAL GOODS –ENGEL CURVE X INFERIOR GOOD

ICC in Fig is sloping upward towards right

throughout its length, the consumer Consequently, the Engel curve for an
purchases more of both the goods as his inferior good (X or Y) would be bending to
money income increases, prices the horizontal axis, provided measures the
remaining the same. quantity of the good along vertical axis,
because after a certain level, as income
rises, the consumer reduces the purchase
of the good. This sort of an Engel curve
has been shown in Fig. 6.20. 33
 SUBSTITUTION EFFECT

 The substitution may occur when a consumer replaces cheaper or

moderately priced items with ones that are more expensive when a
change in finances occurs. For example, a good return on an
investment or other monetary gains may prompt a consumer to
replace the older model of an expensive item for a newer one.
 The inverse is true when incomes decrease. Substitution in the
direction of buying lower-priced items has a generally negative
consequence on retailers because it means lower profits. It also
means fewer options for the consumer.
34
 CONTD….
 While the substitution effect changes consumption patterns in favor of
the more affordable alternative, even a modest reduction in price may
make a more expensive product more attractive to consumers.
 For instance, if private college tuition is more expensive than public
college tuition—and money is a concern—consumers will naturally be
attracted to public colleges. But a small decrease in private tuition
costs may be enough to motivate more students to begin attending
private schools.
 The substitution effect is not just limited to consumers. When
companies outsource part of their operations, they are using the
substitution effect. Using cheaper labor in a different country or by
hiring a third party results in a drop in costs. This nets a positive result
for the corporation, but a negative effect for the employees who may
be replaced.
35
PRICE EFFECT –INCOME EFFECT- SUBSTITUTION EFFECT
 How the price effect can be decomposed into income effect and
substitution effect is is explained by the methods below:

 Decomposing Price Effect: Compensating Variation in Income:

 In the method of decomposing price effect by compensating variation

we adjust the income of the consumer so as to offset the change in
satisfaction and bring the consumer back to his original indifference
curve, that is, his initial level of satisfaction which he was obtaining
before the change in price occurred.
36
 CONTD…
 For instance, when the price of a commodity falls and consumer
moves to a new equilibrium position at a higher indifference curve his
satisfaction increases. To offset this gain in satisfaction resulting from
a fall in price of the good we must take away from the consumer
enough income to force him to come back to his original indifference
curve.
 This required reduction in income (say, through levying a lump sum
tax) to cancel out the gain in satisfaction or welfare occurred by
reduction in price of a good is called compensating variation in
income.
 This is so called because it compensates (in a negative way) for the
gain in satisfaction resulting from a price reduction of the commodity.
How the price effect is decomposed into substitution effect and
income effect is illustrated in Fig 1
37
 DIAGRAMMATIC EXPLANATION
 When the price of good X falls and
as a result budget line shifts to PL2,
the real income of the consumer
rises, i.e., he can buy more of both
the goods with his given money
income. That is, price reduction
enlarges consumer’s opportunity set
of the two goods.
 With the new budget line PL 2 he is in
equilibrium at point R on a higher
indifference curve IC2 and thus gains
in satisfaction as a result of fall in
price of good X. 38
 Now, if his money income is reduced by CONTD….
the compensating variation in income so
that he is forced to come back to the
indifference curve IC1 as before, he would
buy more of X since X has now become
relatively cheaper than before. In Fig. as
result of the fall in price of X, price line
switches to PL2.
 Now, with the reduction in income by
compensating variation, budget line shifts
to AB which has been drawn parallel to
PL2 so that it just touches the indifference
curve ICX where he was before the fall in
price of X. Since the price line AB has got
the same slope as PL2, it represents the
changed relative prices with X relatively
cheaper than before.
39
 Now, X being relatively cheaper than CONTD…
before, the consumer in order to
maximize his satisfaction in the new
price-income situation substitutes X for
Y.
 Thus, when the consumer’s money
income is reduced by the compensating
variation in income (which is equal to PA
in terms of Y or L2B in terms of X), the
consumer moves along the same
indifference curve IC, and substitutes X
for Y with price line AB, he is in
equilibrium at S on indifference curve
IC, and is buying MK more of X in place
40
of Y.
 CONTD….
 This movement from Q to S on the
same indifference curve IC,
represents the substitution effect
since it occurs due to the change in
relative prices alone, real income
remaining constant. If the amount of
money income which was taken
away from him is now given back to
him, he would move from S on
indifference curve IC, to R on a
higher indifference curve IC2.
 In Fig. 8.36 the various effects on the
purchases of good X are:
41
 CONTD….
 The movement from S on a lower
indifference curve to R on a higher
indifference curve is the result of
income effect. Thus the movement
form Q to R due to price effect can be
regarded as having been taken place
into two steps first from Q to S as a
result of substitution effect and
second from S to R as a result of
income effect. In is thus manifest that
price effect is the combined result of
a substitution effect and an income
effect.
42
 :
DECOMPOSING PRICE EFFECT EQUIVALENT VARIATION IN
INCOME
 Price effect can be split up into substitution and
income effects through an alternative method of
equivalent variation in income. The reduction in price
of a commodity increases consumer’s satisfaction as
it enables him to reach a higher indifference curve.
 Now, the same increase in satisfaction can be
achieved through bringing about an increase in his
income, prices remaining constant. This increase in
income of the consumer prices of goods remaining
the same, so as to enable him to move to a higher
subsequent indifference curve at which he in fact
reaches with reduction in price of a good is called
equivalent variation in income because it represents
the variation in income that is equivalent in terms of
gain in satisfaction to a reduction in price of the
good. 43
 CONTD…
 When the price of good X falls, the consumer can purchase more of both the
goods, that is, the purchasing power of his given money income rises. It means that
after the fall in price of X, if the consumer buys the same quantities of goods as
before, then some amount of money will be left over. In other words, the fall in price
of good X will release sonic amount of money. Money thus released can be spent
on purchasing more of both the goods.
 It therefore follows that a change in price of the good produces an income effect.
When the power to purchase goods rises due to the income effect of the price
change, or in other words, when some amount of money is released as a result of
the fall in price, the consumer has to decide how this increase in his purchasing
power is to be spared over the two goods he is buying. How he will spread the
released purchasing power over the two goods depends upon the nature of his
income consumption curve which in turn is determined by his preferences about the
two goods.

44
 CONTD…..
 From above it follows, that, as a result of the increase in his
purchasing power (or real income) due to the fall in price,
the consumer will move to a higher indifference curve and
will become better off than before. It is as if the price had
remained the same but his money income was increased. In
other words, a fail in the price of good X does to the
consumer what an equivalent rise in money income would
have done to him.
 As a result of fall in price of X, the consumer can therefore
be imagined as moving up to a higher indifference curve
along the income consumption curve as if his money
income has increased, prices of X and Y remaining
unchanged. Thus, a given change in price can be thought of
as an equivalent to an appropriate change in income. 45
CONVEX INDIFFERENCE CURVES AND CORNER EQUILIBRIUM

 When a consumer’s preferences are such that he likes to

consume some amount of both the goods, he reaches an
equilibrium position at the point of tangency between the
budget line and his indifference curve.
 This equilibrium position at the point of tangency which lies
within commodity space between the two axes is often called
interior solution.
 The economic implication of the interior solution is that
consumer’s pattern of consumption is diversified that is, he
purchases some amount of both the commodities. Our
knowledge of the real world tells us that consumers’ pattern of
consumption is quite diversified and they often buy a basket or
bundle of several different goods instead of spending their
entire income on a single commodity.
46
 CONTD….
 In the context of two commodity model which is generally
assumed in indifference curve analysis, assumption of
diversification in consumption and an interior solution, which
imply that consumer purchases some amount of both goods, is
correct.
 However, in the real world o many commodities we often find
that a typical consumer does not buy positive amounts of a the
goods and services available in the market. In fact, a typical
consumer buys only a small number of goods available in the
market. How to explain this real world phenomenon?

47
 Convex Indifference Curves and Corner Equilibrium:
 The reason for not purchasing a commodity by a CONTD….
consumer may be that the price or opportunity cost of
that particular commodity may be too high for him. One
may like to have Maruti car, air conditioner or a colour
TV, but may not actually have it on account of their
prices being too high. The indifference curve analysis
enables us to explain even this phenomenon. Consider
Figure where indifference map between two goods X
and Y and budget line BL are such that the interior
solution is not possible and consumer in its equilibrium
position at point B will not consume any quantity of
commodity X.
 This is because as seen in the Figure the price of
commodity X is so high that budget line is steeper than
the indifference curves between the two commodities. In
economic terms it means that the price or opportunity Corner Equilibrium in case
cost of commodity X in the market is greater than the of convex IC only Y good is
marginal rate of substitution of X for Y which indicates bought
willingness to pay for the commodity X.

48
 On the other hand, in Figure the

indifference map between the two goods is
CONTD….
such that the budget line BL is less steep
than the indifference curves between the
two goods so that the MRSy > PX/Py for all
levels of consumption along the budget line
BL. Therefore, he maximizes his
satisfaction at the corner point L where he
buys only commodity X and none of Y. In
this case price of commodity Y and
willingness to pay (i.e. MRS) for it are such
that he does not consider it worthwhile to
purchase even one unit of it.

49
 CORNER EQUILIBRIUM AND CONCAVE INDIFFERENCE
CURVES
 The indifference curves are usually convex to the origin. Convexity of
indifference curves implies that the marginal rate of substitution of X for Y
falls as more of X is substituted for Y. Thus, indifference curves are convex
to the origin when principle of diminishing marginal rate of substitution holds
good and which is generally the case. But the possibility of indifference
curves being concave to the origin cannot be ruled out in some exceptional
cases. Concavity of the indifference curves implies that the marginal rate of
substitution of X for y increases when more of X is substituted for Y.
 It will be clear from the analysis made below that in case of indifference
curves being concave to the origin the consumer will choose or buy only
one good. In other words, concavity of indifference curves implies that the
consumer has a distaste for variety, that is, does not like diversification in
consumption. However, distaste for variety cannot be considered a normal
or model behaviour, so we regard convexity to be the general case. But
when consumers have a distaste for variety and diversification the case of
concave indifference curves will occur. 50
 CONTD…
 In case of concave indifference
curves, the consumer will not be in
equilibrium at the point of tangency
between budget line and indifference
curve, that is, in this case interior
solution will not exist. Instead, we
would have corner solution for
consumer’s equilibrium. Let us take
Fig. here indifference curves are
shown to be concave. The given
budget line BL is tangent to the
indifference curve IC2 at point Q.

51
 CONTD….
 But the consumer cannot be in equilibrium at Q since by moving along the given
budget line BL he can get on to higher indifference curves and obtain greater
satisfaction than at Q. Thus by moving to K on the given budget line BL, he will get
more satisfaction than at Q since K lies on a higher indifference curve than Q. He
can increase his satisfaction still more by moving to point Z on the budget line BL.
 Thus, as he moves upward from tangency point Q on the budget line his satisfaction
will go on increasing until he reaches the extremity point B. Likewise, if from Q he
moves downward on the budget line, he will get on to higher indifference curves and
his satisfaction will go on increasing till he reaches the other extremity point L.
 In these circumstances the consumer will choose only one of two goods: he will buy
either X or Y depending upon whether L or B lies on the higher indifference curve. In
the situation depicted in Fig point B lies on a higher indifference curve than point L.
Therefore, the consumer will choose only Y and will buy OB of Y. It should be
carefully noted that at B the budget line is not tangent to the indifference curve IC5,
even though the consumer is here in equilibrium. It is clear that when a consumer
has concave indifference curves, he will succumb to monomania, that is, he will 52
consume only one good.
 CORNER SOLUTION IN CASE OF PERFECT SUBSTITUTES AND
PERFECT COMPLEMENTS
 Another case of corner solution to the
consumer’s equilibrium occurs in case of perfect
substitutes. As seen above, indifference curves
for perfect substitutes are linear. In their case
too, tangency or interior solution for consumer’s
equilibrium is not possible since the budget line
cannot be tangent to a point of the straight-line
indifference curve of substitutes.
 In this case budget line would cut the straight-
line indifference curves.
 Two possibilities can be visualized either the
slope of the budget line BL can be greater than
the slope of indifference curves, as in Fig.
8.25
53
 The slope of the budget line can be CONTD….
less than the slope of indifference
curve, as in Fig.8.26

 However the corner solution of

equilibrium point lies on point L in
both figures because that is the
highest attainable IC in the given
budget line

54
 CORNER SOLUTION FOR COMPLEMENTS
 Another non-normal case is of perfect complementary
goods, is depicted to Figure 8.27. Indifference curves
of perfect complementary goods have a right-angled
shape. In such a case the equilibrium of the
consumer will be determined at the corner Fig.8.27.
 In case of perfect complements equilibrium point of
the indifference curve IC2 which is indifference curve
just touching the budget line BL at point C
Indifference curve IC2 is the highest possible
indifference curve to which the consumer can go. In
Figure 8.27, given the budget line BL the consumer
will be in equilibrium at point Con indifference curve
IC2 and will be consuming OM of X and ON of Y.

55
LAW OF DEMAND -ESTD

56
 CONTD….
 It will be seen from Fig. 8.37 that with price line
PL1, the consumer is in equilibrium at Q on
indifference curve IC1. Suppose price of good X
falls, price of Y remaining unaltered, so that
budget line is now PL2. With budget line PL2, he
is in equilibrium at R on indifference curve ICZ.
Now, a line AB is drawn parallel to PL1 so that it
touches the indifference curve IC2 at S.
 It means that the increase in real income or
purchasing power of the consumer as a result of
the fall in price of X is equal to PA in terms of Y or
LXB in terms of X. Movement of the consumer
from Q on indifference curve IC, to S on higher
indifference curve IC2 along the income
consumption curve is the result of income effect
of the price change. But the consumer will not be
57
finally in equilibrium at S.
 CONTD…..
 This is because now that X is relatively cheaper than 1 he will
substitute X, which has become relatively cheaper, for good Y,
which has become relatively dearer. It will be a profitable thing
for the consumer to do so. Thus the consumer will move along
the indifference curve IC2 from S to R.
 This movement from S to R has taken place because of the
change in relative prices alone and therefore represents
substitution effect. Thus the price effect can be resolved into
income and substitution effects, showing in this case
58
substitution along the subsequent indifference curve.
 CONTD….
 This movement from S to R has taken
place because of the change in relative
prices alone and therefore represents
substitution effect. Thus the price effect
can be resolved into income and
substitution effects, showing in this case
substitution along the subsequent
indifference curve.
 In Fig the magnitudes of the various
effects are:
 Price effect = MN
 Substitution effect = MH
 In Fig MH = MH + HN
 Or Price effect = Income Effect +
59
Substitution Effect
ADVANTAGE OF BREAKING UP PRICE EFFECT INTO
INCOME AND SUBSTITUTION EFFECTS:
 A distinct advantage of viewing the price effect as a sum of
income effect and substitution effect is that through it the nature
of response of quantity purchased to a change in the price of a
good can be better and easily explained. In case of most of the
goods, the income effect and substitution effect work in the same
direction. But, in some cases, they may pull in different
directions.
 The direction of substitution effect is quite certain. A fall in the
relative price of a good always leads to the increase in quantity
demanded of the good. In other words, substitution effect always
induces the consumer to buy more of the cheaper good. But the
direction of income effect is not so certain. 60
 CONTD…
 With a rise in income, the individual will generally buy more of a good.
But with the rise in income the individual will buy less of a good if it
happens to be an inferior good for him since he will use better or
superior substitutes in place of the inferior good when his income
rises.
 Thus the income effect may be either positive or negative. If for a
good the income effect is positive, as is usually the case, it will act in
the same direction as the substitution effect, that is, both will work
towards increasing the quantity demanded of the good whose price
has fallen. For the inferior good in which case income effect is
negative, income effect of the price change will work in opposite
direction to the substitution effect.
 The net effect of the price change will then depend upon the relative
strengths of the two effects. To sum up, price effect is composed of
income effect and substitution effect and further that the direction in
which quantity demanded will change as a result of the fall in price will
depend upon the direction and strength of the income effect on the
one hand and strength of the substitution effect on the other. 61
 CONTD….
 The impact of a change in the price of a good on
consumption can be decomposed into two effects an income
effect and a substitution effect. To see what these two effects
are, consider how our consumer might respond when he
learns that the price of Y has fallen. He might reason in the
following ways
 (This is the income effect.)
 • “Now that the price of Y has fallen, I get more pints of Y for
every X that I give up. Because X is now relatively more
expensive, I should buy less X and more Y.” (This IS
the substitution effect.) Which statement do you find more
compelling?
Figure shows graphically how to decompose the change in
the consumer’s decision into the income effect and the
substitution effect. When the price of Pepsi falls, the
consumer moves from the initial optimum, point A, to the
new optimum, point C. We can view this change as occurring
in two steps. First, the consumer moves along the initial
indifference curve, 1\, from point A to point B. The consumer
is equally happy at these two points, but at point B, the
marginal rate of substitution reflects the new relative price.
(The dashed line through point B reflects the new relative
price by being parallel to the new budget constraint.) Next,
the consumer shifts to the higher indifference curve, 12, by
62
moving from point B to
 DEMAND CURVE
 A demand curve shows how much quantity of a good will be
purchased or demanded at various prices, assuming that tastes and
preferences of a consumer, his income, prices of all related goods
remain constant.
 This demand curve showing explicit relationship between price and
quantity demanded can be derived from price consumption curve of
indifference curve analysis.
 In Marshallian utility analysis, demand curve was derived on the
assumptions that utility was cardinally measurable and marginal utility
of money remained constant with the change in price of the good. In
the indifference curve analysis, demand curve is derived without
making these dubious assumptions.

63
HOW TO DERIVE INDIVIDUAL’S DEMAND CURVE FROM
INDIFFERENCE CURVE ANALYSIS?

64
 CONTD…
Let us suppose that a consumer has got income of Rs. 300 to spend on goods. In Fig. money
is measured on the Y-axis, while the quantity of the good X whose demand curve is to be
derived is measured on the X-axis. An indifference map of a consumer is drawn along with the
various budget lines showing different prices of the good X. Budget line PL1 shows that price of
the good X is Rs. 15 per unit.
As price of good X falls from Rs. 15 to Rs. 10, the budget line shifts to PL2. Budget line
PL2 shows that price of good X is Rs. 10. With a further fall in price to Rs. 7.5 the budget line
takes the position PL3. Thus PL3 shows that price of good X is Rs. 7.5. When price of good X
falls to Rs. 6, PL4 is the relevant budget line.
The various budget lines obtained are shown in the column 2 of the Table Tangency points
between the various budget lines and indifference curves, which when joined together by a line
constitute the price consumption curve shows the amounts of good X purchased or demanded
65
at various prices.
 CONTD…
 With the budget line PL1 the consumer is in equilibrium at point Q1 on the price
consumption curve PCC at which the budget line PL1 is tangent to indifference curve IC1.
In his equilibrium position at Q1 the consumer is buying OA units of the good X. In other
words, it means that the consumer demands OA units of good X at price Rs. 15.

 When price falls to Rs. 10 and thereby the budget line shifts to PL2, the consumer comes
to be in equilibrium at point Q2 the price-consumption curve PCC where the budget line
PL2 is tangent to indifference curve IC2. At Q2, the consumer is buying OB units of good
X.

 In other words, the consumer demands OB units of the good X at price Rs. 10. Likewise,
with budget lines PL3 and PL4, the consumer is in equilibrium at points Q3 and Q4 of price
consumption curve and is demanding OC units and OD units of good X at price Rs. 7.5
and Rs. 6 respectively. It is thus clear that from the price consumption curve we can get
information which is required to draw the demand curve showing directly the amounts
demanded of the good X against various prices. 66
 LIMITATIONS
 Indifference curve analysis is claimed to be superior to utility
analysis because of its closeness to the reality. But, still it is
criticised by many economists due to some unrealistic
assumptions, it is based upon. Further, Schumpeter says, “The
new technique has neither proved anything new, nor has
proved anything old, wrong”.
 Robertson blamed this analysis by pointing out it as an old
wine in a new bottle. Many other economists such as F.H.
Knight, Armstrong, Boulding criticised the analysis in several
ways. Some of the limitations of this analysis are:

67
 CONTD…
 (i) The indifference curve analysis is utility analysis in a new grab. It
has simply substituted new concepts and equations instead of the
old ones. The old principle of diminishing marginal utility has been
replaced by the new principle of diminishing marginal rate of
substitution. The old equation of consumer equilibrium.
 MUA/PA = MUB/PB = MUM
 is replaced by a new equation, which says that the consumer is in
equilibrium, when the marginal rate of substitution between the two
commodities, which is the ratio of their marginal utilities is equal to
their price ratio. This is nothing but the reformulation of previous
equation in a modified form.
 (ii) Indifference curve analysis assumes that consumers are familiar
with their preference schedules. But, it is not possible for a consumer
to have a complete knowledge of all the combinations of the two
commodities, total satisfactions from them, rates of substitutions and
total incomes. At best he can tell his preferences in the
neighbourhood of his existing position. Moreover, the preferences of
this consumer keep changing.
68
 CONTD…
 vi) This analysis assumes perfect divisibility of the commodities. But, consumer is often
faced by lumpy units. So, the continuity of indifference curves is not ensured as
assumed by indifference curves analysis, as also large number of very closed placed
indifference curves. Further, choices with extreme combinations (too much of
commodity ‘X’ and very little of ‘Y’ and vice-versa) are not observed in the real world.
 (vii) Indifference curve analysis is micro economic in character. It is not possible to draw
indifference curves indicating the choices of a group or a country as a whole. In this
respect, utility analysis has an edge over, as it goes by a general opinion based on past
experience and observation.
 (viii) Indifference curve analysis is not amenable to statistical investigation and
empirical research, as the entire analysis is based upon theoretically formulated cross-
effect relationships and not upon statistical observations. In view of Samuelsson,
indifference curves are imaginary.
 (ix) Indifference curve analysis fails to explain consumer behaviour under risk and
uncertainty.
 Thus, indifference curve analysis is not free from defects of its own. Even some of these
defects were appreciated by Hicks, who sought to remove them in his later work ‘A
Revision of Demand Theory’ published in 1956. The approach is a considerable 69
improvement over the conventional utility approach and has gained popularity among
economists.
70
 CONCLUSION
 In our analysis above, we have shown that corner solution of consumer s equilibrium is
possible even when his indifference curves between goods are convex. It is worth noting that
in case of convex indifference curves, corner equilibrium is however not inevitable, it occurs
only when price of a commodity is too high as compared to the marginal rate of substitution
of even the first unit of the commodity.
 However, when the indifference curves are concave consumer’s equilibrium will inevitably be
a corner solution. This implies that more of commodity X a consumer has the more useful or
significant in terms of satisfaction an extra unit of it becomes. Therefore, the concave
indifference curves do not seem to be plausible or realistic.
 Now, as seen above, the concavity of indifference curves for a consumer implies that the
consumer spends his entire income on a commodity and therefore buys only one commodity.
However, consumption of one good only by a consumer which the concavity of indifference
curves leads us to believe is quite unrealistic. Observations in the real world reveal that
consumers do not spend their entire income on a single commodity and in fact purchase a
multitude of different goods and services. This rejects the existence of concave indifference
curves.

71
 REFERENCES FOR MATERIAL AND DIAAGRAMS

 https://economictimes.com/definition/indifference-
curve
 https://www.economicsdiscussion.net/indifference
-curves/indifference-curves-definition-properties-
and-other-details

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