Economics Lecture 5

INDIFFERENCE CURVE ANALYSIS

 The Budget line :What is Attainable

• A budget line (or more technically, the

budget constraint) is a schedule or curve
that shows various combinations of two
products a consumer can purchase with
a specific money income.
The Budget Line: Whole-Unit Combinations of A
and B Attainable with an Income of $12
Units of A Units of B
(Price = $1.50) (Price = $1) Total Expenditure
8 0 $12 (=$12+$0)
6 3 $12 (=$9+$3)
4 6 $12 (=$6+$6)
2 9 $12 (=$3+$9)
0 12 $12 (=$0+$12)
A consumers budget line. The budget line shows all the combinations of any two
products that can be purchased, given the prices of the products and the consumers
money income.
 The Budget line :What is Attainable
• The budget line has two other significant characteristics:
• Income changes The location of the budget line varies with the
money income. An increase in money income shifts the budget
line to the right. A decrease in money income shifts it to the left.
• Price changes A change in product prices also shifts the budget
line. A decline in the prices of both products- the equivalent of an
increase in real income – shifts the curve to the right. Conversely ,
an increase in the prices of products shifts the curve to the left.
• But these situation have some exceptions if price of one product
changes while price of another product and money income
remain constant.
 Indifference Curve: What is Preferred

• Budget lines reflect “objective” market data,

specifically income and prices. They reveal
combinations of products A and B that can be
purchased, given current money income and
prices.
• Indifference curves, on the other hand, reflect
“subjective” information about consumer
preferences for A and B.
 Indifference Curve: What is Preferred
(Cont’d)
• An indifference curve shows all the combinations of two
products A and B that will yield the same total satisfaction
or total utility to a consumer. Table 2 and Figure 2 present
a hypothetical indifference curve for products A and B. The
consumer’s subjective preferences are such that he or she
will realize the same total utility from each combination of
A and B shown in the table or on the curve. So the
consumer will be indifferent (will not care) as to which
combination is actually obtained.
• Indifference curves have several important characteristics.
An Indifference Schedule (Whole Units)

Combination Units of A Units of B

j 12 2
k 6 4
l 4 6
m 3 8
 Indifference Curves Are Downsloping
• An indifference curve slopes downward because more of one
product means less of the other if total utility is to remain
unchanged. Suppose the consumer moves from one
combination of A and B to another, say, from j to k in figure 2.
In so doing, the consumer obtains more of product B,
increasing his or her total utility. But because total utility is the
same everywhere on the curve, the consumer must give up
some of the other product, A, to reduce total utility by a
precisely offsetting amount. Thus “more of B” necessitates
“less of A”, and the quantities of A and B are inversely related.
A curve that reflects inversely related variables is downward-
sloping.
Indifference Curves Are Convex to the Origin

• An Indifference Curve is convex (bowed inward) to the origin

of the graph. Its slope diminishes or becomes flatter as we
move down the curve from j to k to l and so on. Technically
the slope of an Indifference Curve at each point measures
the marginal rate of substitution (MRS) of the combination
of two goods represented by that point. The slope or MRS
shows the rate at which the consumer who possesses the
combination will substitute one good for the other (say, B for
A) to remain equally satisfied. The diminishing slope of the
Indifference Curve means that the willingness to substitute B
for A diminishes as more of B is obtained.
Indifference Curves Are Convex to the Origin
Contd…
• The rationale for this convexity-that is, for a diminishing MRS-is
that a consumer’s subjective willingness to substitute B for A
(or A for B) will depend on the amounts of B and A he or she
has to begin with. ConsiderTable2 and Figure 2 again, beginning
at point j. Here, in relative terms ,the consumer has a
substantial amount of A and very little of B. Within this
combination, a unit of B is very valuable (that is, its marginal
utility is high), while a unit of A is less valuable ( its marginal
utility is low). The consumer will then be willing to give up a
substantial amount of A to get , say,2 more units of B. in this
case, the consumer is willing to forgo 6 units of A to get 2 more
units of B; the MRS if 6/2 or 3, for the jk segment of the curve.
Indifference Curves Are Convex to the Origin
Contd…
But at point k the consumer has
less A and more B. Here A is
somewhat more valuable and B
less valuable, ‘at the margin’. In
a move from point k to point l,
the consumer is willing to give
up only 2 units of A to get 2
more units of B, so the MRS is
only 2/2, or 1 .Having still less of
A and more of B at point l, the
consumer is willing to give up
only 1 unit of A in return for 2
more units of B and the MRS
falls to ½ between l and m .
Indifference Curves Are Convex to the Origin
Contd…
• In general, as the amount of B increases the
marginal utility of additional units of B decreases.
Similarly as the quantity of A decreases, its marginal
utility increases . In Figure 2 we see that in moving
down the curve, the consumer will be willing to give
up smaller and smaller amounts of A to offset
acquiring each additional unit of B. The result is a
curve with a diminishing slope, a curve that is
convex to the origin. MRS declines as one moves
southeast along the indifference curve.
 The Indifference Map
• An indifference map is a set of indifference curves
. Curves further from the origin indicate higher
levels of total utility. Thus any combination of
product A and B represented by a point on I4 has
greater total utility than any combination of A and
B represented by a point on I3, I2 or I1.
• (Look at slide below)
The Indifference Map
 Equilibrium at Tangency
The consumer’s equilibrium position. The consumer’s
equilibrium position is represented by point X, where the
black budget line is tangent to indifference curve I3. The
consumer buys 4 units of A at $1.5 per unit and 6 of B at $1
per unit with a $12 money income. Points Z and Y represent
attainable combinations of A and B but yield less total
utility, as is evidenced by the fact that they are on lower
indifference curves. Point W would entail more utility than
X, but it requires a greater income than the $12 represented
by the budget line.
(Look at slide below)
Equilibrium at Tangency
 Equilibrium at Tangency Contd…
• In previous slide, the consumers equilibrium position is at point
X, where the budget line is tangent to I3.
• Here Y will not be the equilibrium position. Because Y is on a
lower indifference curve, I2. By moving ‘down’ the budget line –
by shifting dollars from purchases of A to purchases of B – the
consumer can attain an indifference curve further from the
origin and thereby increase the total utility derived from the
same income .
• Same situation for point Z also. Point Z is on a lower indifference
curve , I1. By moving up the budget line- by reallocating dollars
from B to A – the consumer can get on higher indifference curve
I3 and increase total utility.
Equilibrium at Tangency
 Equilibrium at Tangency Contd…
•• Now
  come to the point W on indifference curve I4. It is true
that W would yield a greater total utility than X, Point W is
beyond (outside) the budget line and that’s why not
attainable by the consumer. Point X represents the optimal
attainable combination of products A and B . Note that
according to the definition of tangency , the slope of the
highest attainable indifference curve equals the slope of the
budget line . Because the slope of the indifference curve
reflects the MRS and the slope of the budget line is PB/PA, the
consumers optimal or equilibrium position is the point where
MRS =
 The Measurement of Utility
• There is an important difference between the marginal utility theory of
•  
consumer demand and the indifference curve theory. The marginal-utility
theory assumes that utility is numerically measurable, that is , that the
consumer can say how much extra utility he or she derives from each extra
unit of A or B. The consumer needs that information to realize the utility –
maximizing (equilibrium) position, as indicated by

• The indifference curve approach imposes a less stringent requirement on

the consumer. He or she need only specify whether a particular combination
of A and B will yield more than, less than, or the same amount of utility as
some other combination of A and B will yield. The consumer need only say,
for example, that 6 of A and 7 of B will yield more (or less) satisfaction than
will 4 of A and 9 of B. indifference curve theory does not require that the
consumer specify how much more (or less) satisfaction will be realized.
 The Measurement of Utility Contd.
• When we compare the equilibrium situations in the
two theories, we find that in the indifference curve
analysis the MRS equals PB /PA at equilibrium;
however, in the marginal-utility approach the ratio of
marginal utilities equals PB /PA . We therefore deduce
that at equilibrium the MRS is equivalent in the
marginal-utility approach to the ratio of the marginal
utilities of the last purchased units of the two
products.