Chapter 31

Indifference curves
and budget lines
LEARNING INTENTIONS

In this chapter you will learn how to:

• define the meaning of an indifference curve and a budget line
• explain the causes of a shift in the budget line
• analyse the income, substitution and price effects for normal,
inferior and Giffen goods
• evaluate the limitations of the model of indifference curves.

ECONOMICS IN CONTEXT

Why the Oreo cookie was changed for the Chinese biscuit
market
The Oreo cookie is the best-selling cookie brand in the world. The
Oreo brand, owned by Mondelēz International, is sold in more
than 100 countries. Billions of Oreo cookies are produced each
year.

Figure 31.1: Green tea Oreo biscuits for the Chinese market

Oreo cookies were introduced to China by Kraft Foods in 1996.

The product was packaged and marketed in the same way as in the
US market. Sales in China were poor and then began to fall at a
time when Chinese consumers were buying more and more
biscuits. Despite expensive marketing campaigns, every single
packet of Oreo biscuits sold in China was losing the company
money. To find a solution, the company decided to consult focus
groups of Chinese consumers.
The research showed that the company had not taken into account
the preferences of Chinese consumers. The biscuit was too sweet
for Chinese tastes. Food scientists then developed a series of
alternative products with various levels of sweetness and with
different elements such as colour and thickness. Chinese
consumers also preferred a softer, wafer-like texture compared to
the harder American cookie that was being sold to them.
The research allowed the company to produce a new biscuit that
was less sweet and with a more wafer-like texture. The research
also led the company to review its packaging. Oreo packs were
reduced in size and this made them easier to sell in convenience
stores and street kiosks. As a result, sales quickly grew. New
flavours exclusive to China were introduced. In 2006, Oreo
became the number 1 selling biscuit in China.
What can be learned from the Oreo experience in China? The main
conclusion is that consumer tastes differ. There is no guarantee
that what is a best-selling good in one market will become a major
seller in a different market.
Discuss in a pair or a group:
• Choose another product from a multinational company that is
widely on sale in your country (e.g. McDonalds, KFC,
Nescafé, Cadbury’s Dairy Milk). Consider the product’s
appeal to consumers in your country.
• Now choose a similar product made by a domestic producer
in your own country. Think about its appeal. Compare the
appeal of the two products and consider whether this has
anything to do with economics.
31.1 Indifference curves
As explained in Section 7.3, a change in price of a good causes a
movement along the demand curve. An individual’s demand curve
therefore is a reflection of a consumer’s preferences. However, it does
not always follow that consumers will buy more of a good when its
price falls. Consumers will only buy a particular good if it is something
that they actually want or prefer when having to choose between
alternatives. Consumer preferences can be represented by indifference
curves (see Figure 31.2).

Figure 31.2: Indifference curves

An indifference curve shows all of the combinations of two goods that

give the consumer equal satisfaction or utility. Figure 31.2 shows three
examples of indifference curves out of the many that can apply to a
particular consumer. The consumer in indifference curve I1 is
indifferent with respect to combinations x, y or z since each are on the
same indifference curve. The indifference curve slopes downwards to
indicate that a fall in the quantity consumed of one good is accompanied
by an increase in the consumption of the other good, given the same
level of satisfaction. In Figure 31.2, for example, if the consumer moves
from point z to point y, the consumption of good X falls at the expense
of an increase in consumption of good Y. Point y represents a situation
where the consumer is still equally happy with the combination of
goods that are being consumed.
It is possible to produce an indifference map - a diagram showing a
number of different indifference curves. This shows many more than
just the three combinations of goods for three levels of satisfaction
shown in Figure 31.2. Higher indifference curves represent higher
levels of satisfaction; consumers are being rational when preferring to
be on a higher and not a lower indifference curve. I2 provides a higher
level of satisfaction than I1. A rational consumer will always opt for the
highest indifference curve. Indifference curves cannot cross each other
as this would be where a consumer was being irrational in the choices
being made. As a result the consumer would not get the maximum
possible amount of satisfaction.

TIP

Extension content: Indifference maps are not covered in the

syllabus, but it is useful to know about them. An indifference map
shows a number of indifference curves (Figure 31.2 has just three). A
move to an indifference curve further from the origin, say from I1 to
I2 or from I2 to I3 in Figure 31.2, represents an increase in a
consumer’s level of satisfaction.

The slope of the indifference curve is important – it represents the

extent to which the consumer is willing to substitute one good for
another. In Figure 31.2, all three curves slope more steeply from left to
right, showing that when consuming large amounts of good Y, the
consumer is willing to give up rather more of this good than when
consumption of good X is small. The rate at which the consumer is
willing to substitute one good for another in this way is known as the
marginal rate of substitution.
31.2 Budget lines
As shown in Section 6.4, consumers are restricted in what they are able
to buy due to their limited disposable income and the prices of goods.
These two principles of consumer behaviour (disposable income and
prices of goods) are brought together through a budget line. A budget
line shows numerically all the possible combinations of two goods that
a consumer can purchase with a given income and given prices of the
two goods.
Suppose a person has $200 to spend on two goods, X and Y. Assume
the price of Y is $20 and the price of X is $10. Table 31.1 shows the
possible combinations that can be purchased. Each of the combinations
costs $200 in total. Figure 31.3a shows the budget line for this situation.
Any point along this line will produce an outcome where consumption
is maximised for this level of income.
Quantity of Y ($20 each) Quantity of X ($10 each)
10 0
9 2
8 4
7 6
6 8
5 10
4 12
3 14
2 16
1 18
0 20
Table 31.1: Combinations of X and Y with a budget of $200

Figure 31.3: Budget lines

Causes of a shift in the budget line

If there is a change in the price of one good, with income remaining
unchanged, then the budget line will pivot. For example, if the price of
X falls, then more of this good can be purchased at all levels of income.
The budget line will move outwards, from its pivot at point A. This is
shown in Figure 31.3b. So, if the price of X falls by half, then 40 of
good X can now be purchased with an income of $200.
As the price of X has fallen relative to that of Y, which is unchanged,
consumers will substitute X for Y. This is known as the substitution
effect of a price change. It is always the case that the rational consumer
will substitute towards the good which has become relatively cheaper.
With the fall in the price of X, the consumer actually has more money to
spend on other goods, X included. Real income has therefore increased,
which may mean that a consumer may now purchase even more of good
X. This is called the income effect of a price change.

ACTIVITY 31.1

1 Re-draw Figure 31.3a to show how it would change:

a if the price of X increased, leaving the price of Y
unchanged
b if the price of Y decreased, leaving the price of X
unchanged.
2 In your own words, describe the substitution and income
effects of:
a an increase in the price of a normal good, such as a
restaurant meal
b a decrease in the price of an inferior good, such as a
meal from a street vendor.

The effect of a change in income on the

consumption of goods X and Y
The budget line and the indifference curve can now be used together to
show the effect of a change in income on the consumption of two goods
– see Figure 31.4. A consumer’s choice is optimal at the point where the
budget line touches, or is at a tangent to, the highest indifference curve.
So, E1 will give the consumer the maximum combined consumption of
goods X and Y given the budget constraint shown by the budget line B1.

Figure 31.4: The effect of an increase in income on consumption of

goods X and Y

If income increases then this will allow the consumer to choose a better
combination of goods X and Y. More of each good will usually be
consumed. So, if the budget constraint rises to B2, then the consumer
will increase consumption of good Y and also of good X, albeit to a
lesser extent. E2 is the new optimal position, where more of both goods
are being consumed. The change in position from E1 to E2 is what
occurs when both goods are normal goods. If the increase in income or
budget constraint results in less of one good being consumed then this is
indicative that this good is an inferior good. When there is a fall in
consumer income, the budget line shifts downwards in a parallel way.
This indicates that both goods are normal and that less of each will be
consumed. In the case of an inferior good, there will be an increase in
the consumption of this good.

ACTIVITY 31.2

1 Re-draw Figure 31.4 to show the change in consumption of

goods X and Y when there is a decrease in consumer income.
Assume that both are normal goods.
2 Re-draw Figure 31.4 to show the change in consumption
when good X is an inferior good.
Compare your diagrams with another learner. If your diagrams are
different, try to understand why. If necessary, correct your
diagram.
31.3 The income and substitution effects of a
price change
The income and substitution effects of a price change can be explained
for normal and inferior goods using indifference curves and budget
lines.
Figure 31.5 shows the income and substitution effects when there is an
increase in price of a normal good. If the price of good X increases, this
means that consumers have less spending power. The loss of spending
power is represented by a new budget line B2. The price of good Y is
unchanged, which is why B2 pivots downwards towards the origin,
indicating that less of good X can now be consumed with the same level
of income.

Figure 31.5: The income and substitution effects of an increase in price

of good X

The change that occurs consists of two stages:

• A movement along I1 to point E2. This is the substitution effect,
so-called since the consumer buys less of good X as it is now
relatively more expensive than good Y.
• A shift downwards to a lower indifference curve I2 moving from
E2 to E3.This is the income effect, so-called because the consumer
has less spending power due to the increase in price of good X.
The income effect is negative, resulting in a decrease in
consumption of both goods
The income effect in Figure 31.5 has been eliminated by removing the
reduction in real income through including an imaginary budget line
that is parallel to the new budget line but at a tangent to the original
indifference curve.
Figure 31.6 shows the substitution and income effects when there is a
decrease in the price of good X. The consumer is in equilibrium at E1. A
fall in the price of good X is equivalent to a rise in real income; the
budget line pivots to B2. The substitution effect is the move from E1 to
E2 where more of good X is now being consumed. The income effect is
positive and involves the move from E2 to E3 as the consumer reaches a
higher indifference curve through a further increase in consumption of
good X.

Figure 31.6: The income and substitution effects of a decrease in price

of good X

A third example, the case of good X being an inferior good, is shown in

Figure 31.7. The point about good X in this case is that as real income
increases, consumers will substitute more expensive, better quality
goods for good X. As a consequence, the income effect is negative but
not enough to outweigh the substitution effect.

Figure 31.7: The case of an inferior good

TIP

Drawing accurate figures such as Figures 31.5, 31.6 and 31.7 is quite
demanding and can use up much writing time. Consider whether a
diagram is really necessary, especially if you cannot remember how
to draw it accurately.

A fourth case is the unusual case of a type of inferior good, known as a

Giffen good. With a Giffen good, demand falls as the price of the good
falls and demand increases as the price increases. For low-income
families, this could be a staple food such as rice or wheat flour. As the
price of the staple food increases, consumption will increase since real
income has fallen. More rice or wheat flour is now being consumed
instead of other types of food. The demand curve is upward sloping as
the income effect is negative and greater than the substitution effect.
Alternatively, when the price of an essential food item decreases,
demand for this good falls as real income has now increased. The
individual has more to spend on other things as the food item takes up a
large part of their small income.

ACTIVITY 31.3

Assume good X in Figure 31.7 is a Giffen good. Re-draw the

diagram to show the substitution and income effects when the
price of good X falls. (Hint: you need to move point E3 further
left).

TIP

When writing answers or drawing diagrams, remember that the

substitution effect is always positive; the income effect can be
positive or negative depending on the type of good. The substitution
effect is always shown by a movement along an indifference curve;
the income effect is represented by a shift from one budget line to
another.

REFLECTION

You may have found the topics in this chapter difficult to

understand. How did you try to improve your understanding of the
different types of indifference curve diagrams?

KEY CONCEPT LINK

The margin and decision-making: The use of indifference curves

and budget lines are relevant examples of how decision-making by
individuals is based on choices at the margin.
31.4 Limitations of the model of indifference
curves
The indifference curve model aims to provide a simple representation of
reality. In this chapter, indifference curves have been used to explain
consumer behaviour when there are two goods and consumer income is
fixed. With these assumptions, it is reasonably straight forward for a
consumer to be indifferent to the combinations of the two goods that
will provide a particular level of satisfaction. There are three main
limitations to the indifference curve model:
• In reality, consumers have to choose from many more goods than
just two. Sometimes they may have to choose between hundreds of
goods in the case of everyday food products.
• The term ‘indifference’ implies that consumers are willing to
accept any combination of the two goods as represented by an
indifference curve. Some economists point out that consumers
express their wants and needs in terms of preference or rank order,
and not indifference.
• Indifference curves assume that consumers act rationally. This is
not always true.

THINK LIKE AN ECONOMIST

The growing popularity of veganism in the UK

The number of people in the UK eating a diet free of animal
products has soared. It is estimated that nearly 2% of the
population (around 1.1 million people) was vegan at the beginning
of 2020. By 2025, about one-quarter of the UK population are
forecast to be vegans or vegetarians. Many people who are not
vegans or vegetarians are choosing to eat less meat.

Figure 31.8: A vegan meal

What are the reasons for this major shift in diet? People’s reasons
for cutting down on meat include health benefits, concerns about
animal welfare and the environment.
In 2020, McDonald’s launched its first fully vegan meal in the UK.
Other food retailers have introduced vegan products including
Greggs, the largest bakery chain, which started selling vegan
sausage rolls in 2019. The introduction of the vegan sausage roll
had a major positive impact on Greggs’ sales and profits. What is
happening in the UK is also taking place in many other high-
income countries, including the USA.
1 What are the likely economic effects of the popularity of
veganism on farmers and food retailers in the UK and
elsewhere?
2 Are there any global implications of what is happening in the
UK and elsewhere?