Class XI/Microeconomics/Consumer Equilibrium/ Indifference Curve Analysis

Ordinal Utility states that the satisfaction the consumer derived from the consumption of goods and services
cannot be measured in numbers.
Indifference curve: An indifference curve is a curve that represents all the combinations of two goods that give
the same satisfaction to the consumer. Since all the combinations give the same amount of satisfaction, the
consumer prefers them equally.

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.

Monotonic Preferences: A rational consumer always prefer more of a commodity as it offers him high level of
satisfaction.
Indifference map: family of Indifference Curves that represent consumer preferences over all the bundles of
the two goods.
The following diagram shows an indifference map consisting of three curves:

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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
IC1 offer the same satisfaction, but all combinations on IC2 give greater satisfaction than those on IC1.

Marginal Rate of Substitution:

This is the rate at which the commodities can be substituted with each other, so that total satisfaction of the
consumer remains same.
MRS = No of units consumer is willing to sacrifice/no of units the consumer is willing to gain
Example above, we have the following table:

Combination Good X Good Y MRS

A 1 12 –

B 2 6 6:1

C 3 4 2:1

D 4 3 1:1

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In this example, consumer initially gives up 6 units of good B to get an extra unit of good A. Hence, the MRS is 6:1.
Similarly, for subsequent exchanges, the MRS is 2:1 and 1:1 respectively. Therefore, the 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.
As the consumer accumulates more units of good X, the MRS starts falling – meaning he is prepared to give up
fewer units of good Y for good X. There are two reasons for this:

1. As consumer gets more units of food, his intensity of desire for additional units of food decreases.
2. Most of the goods are imperfect substitutes for one another. If they could substitute one another
perfectly, then MRS would remain constant.

MRS diminishes
MRS diminishes because of the law of DMU.
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

IC is convex because MRS diminishes. In order to obtain an additional unit of a commodity the consumer is
willing to sacrifice less and less. This is the diminishing marginal rate of substitution. The diminishing rate gives
a convex shape to the indifference curve. However, there are two extreme scenarios:

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

2. Two goods are perfect complementary goods – In such cases, the IC will be 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:

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The diagram that shows two ICs intersecting each other at point A. Since points A and B lie on IC1, they give the
same satisfaction level to an individual. Similarly, points 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
two ICs can touch or intersect each other.

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

This is because of monotonic preference that higher IC indicates higher level of satisfaction. A higher IC means
that a consumer prefers more goods.

• 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: Budget line is a graphical representation which shows all the possible combinations of the two
goods that a consumer can buy with the given income and prices of commodities.
Budget line equation:
P 1 X 1+ P 2 X 2 = M
Where, P1 and P2 are the prices of two commodities:
X1 and X2 are the quantities of two commodities
P1 X1 is the expenditure on commodity X1
P2 X2 is the expenditure of on commodity X2

Budget constraint: It shows the combination of two commodities whose expenditure can be less than or equal
to money income.
P 1 X1 + P 2 X2 < M

Budget set: It is the collection of all bundles of pieces of goods that a consumer can buy with his income at
the prevailing market prices.

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Market rate of Exchange: The rate at which market requires to sacrifice one commodity to gain an additional
unit of another commodity is called market rate of exchange.
MRE=Price Ratio, Px/Py

Features of budget line:

• Budget line is a straight line assuming that entire income is spent

• Slope of budget line represents price of both the goods. Slope of budget line is equal to price ratio of
two goods.
• It is negatively sloped, means that increase in consumption of one good is followed by decrease in
consumption of other good.

Shift in Budget Line

• Effect of a Change in the Income of Consumer:

If there is a change in the income of the consumer, then the budget line will shift. When there is an
increase in the income of the consumer, then he will be able to purchase more bundles of Good X and
Good Y, which were not possible for him earlier. This will shift the budget line to the right from AB to
A1B1. This new budget line will be parallel to the original budget line. Similarly, when there is a reduction
in the income of the consumer, then the budget line will shift to the left from AB to A 2B2.

• Effect of Change in Prices of the Commodities:

There are three cases in which the price can change. These are as follows:
i) Change in Prices of both Commodities: When the price of both goods changes, then the budget
line will shift. If the price of both goods falls then the Budget Line will shift right from AB to A1B1. As
now the consumer will be able to buy more units of that good. However, if the price of both goods
increases then the Budget Line will shift to the left from AB to A 2B2. As now consumer has to reduce
his consumption of both the goods.

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ii) Change in the Price of Commodity on the X-axis (Good X): When the price of Good X falls, then
the budget line will rotate to the right from, AB to A 1B. It means that the new budget line will meet
the Y-axis at the same point; i.e., B because the price of Good Y has not changed; however, it will
touch the X-axis at point A1, because the consumer can now buy more units of Good X with his same
income level. Similarly, if the price of Good X rises, then the budget line will rotate to the left from
AB to A2B.

iii) Change in the Price of Commodity on the Y-axis (Good Y): When the price of Good Y falls, then
the budget line will rotate to the right from, AB to AB 1. It means that the new budget line will meet
the X-axis at the same point; i.e., A because the price of Good X has not changed; however, it will
touch the Y-axis at point B1, because the consumer can now buy more units of Good Y with his same
income level. Similarly, if the price of Good Y rises, then the budget line will rotate to the left from
AB to AB2.

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Difference between budget line and budget set

Basis Budget Line Budget Set

A graphical representation of all possible

combinations of two goods which a The set of all possible combinations of
consumer can purchase with the given the two commodities a consumer can
Meaning
prices and income in a way that the cost afford to buy with his given income
of each of these combinations is equal to and price in the market.
the consumer’s money income.

All the bundles of a budget line lie only All the bundles of budget set lie either
Lies on
on the budget line. on or below the budget line.

A budget line represents the maximum A budget set represents all the sets of
Represents limit two goods that fall on or before the
a consumer can spend on buying goods. budget line.

The sets of two goods represented on the The sets of two goods represented on
Sets budget line are equal to the consumer’s the budget set are equal to or less
income. than the consumer’s income.

A budget set shows the different

A budget line is the border line of the
Interrelationship combinations of two goods helping in
budget set.
drawing a budget line.

Equation M = (PA x QA) + (PB X QB) M ≥ (PA x QA) + (PB X QB)

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Conditions of Consumer’s Equilibrium

The consumer’s equilibrium under the indifference curve theory must meet the following two conditions:

(i) MRSXY = Ratio of prices or PX/PY

Let the two goods be X and Y. The first condition for consumer’s equilibrium is that

MRSXY = PX/PY

a. If MRSXY > PX/PY, it means that the consumer is willing to pay more for X than the price prevailing in the
market. As a result, the consumer buys more of X. As a result, MRS falls till it becomes equal to the ratio of
prices and the equilibrium is established.

b. If MRSXY < PX/PY, it means that the consumer is willing to pay less for X than the price prevailing in the
market. It induces the consumer to buys less of X and more of Y. As a result, MRS rises till it becomes equal to
the ratio of prices and the equilibrium is established.

(ii) MRS continuously falls:

The second condition for consumer’s equilibrium is that MRS must be diminishing at the point of equilibrium,
i.e. the indifference curve must be convex to the origin at the point of equilibrium. Unless MRS continuously
falls, the equilibrium cannot be established.

Thus, both the conditions need to be fulfilled for a consumer to be in equilibrium.

IC1, IC2, IC3 and IC4 are the four indifference curves and AF is the budget line. With the constraint of budget
line, the highest indifference curve, which a consumer can reach, is IC2. The budget line is tangent to
indifference curve IC2 at point ‘E’.
All other points ie points B and S are on the budget line to the left or right of point ‘E’ will lie on lower
indifference curves and thus indicate a lower level of satisfaction. As budget line can be tangent to one and
only one indifference curve, consumer maximizes his satisfaction at point E, when both the conditions of
consumer’s equilibrium are satisfied:

(i) MRS = Ratio of prices or PX/PY:

At tangency point E, the absolute value of the slope of the indifference curve (MRS between X and Y) and that
of the budget line (price ratio) are same. Equilibrium cannot be established at any other point as MRSXY >
PX/PY at all points to the left of point E and MRSXY < PX/PY at all points to the right of point E. So, equilibrium
is established at point E, when MRSXY = PX/PY.

(ii) MRS continuously falls:The second condition is also satisfied at point E as MRS is diminishing at point E,
i.e. IC2 is convex to the origin at point E.
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