Indifference curve analysis

• What Is the Indifference Curve?

• An indifference curve is a graph that shows a combination
of two goods that give a consumer equal satisfaction and
utility, thereby making the consumer indifferent.
Indifference curve
• An indifference curve shows a combination of two goods
that give a consumer equal satisfaction and utility thereby
making the consumer indifferent.
• Along the curve, the consumer has no preference for
either combination of goods because both goods provide
the same level of utility.
• Each indifference curve is convex to the origin, and no
two indifference curves ever intersect.
Indifference curve
• Definition: An indifference curve is a graph showing
combination of two goods that give the consumer equal
satisfaction and utility. Each point on an indifference curve
indicates that a consumer is indifferent between the two
and all points give him the same utility.

Description: Graphically, the indifference curve is drawn

as a downward sloping convex to the origin. The graph
shows a combination of two goods that the consumer
consumes.
Indifference curve
Indifference curve
• The above diagram shows the U indifference curve
showing bundles of goods A and B. To the consumer,
bundle A and B are the same as both of them give him the
equal satisfaction. In other words, point A gives as much
utility as point B to the individual. The consumer will be
satisfied at any point along the curve assuming that other
things are constant.
Indifference curve
• Assumptions:
• 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 the good, provided that the amount of other goods at his
disposal remains unchanged. This is a very reasonable and realistic
assumption. This assumption implies that the consumer is not over-over
supplied with any good. When a consumer is over supplied or over-
satiated with one good, he will prefer a smaller quantity of that good to
the larger quantity. It is assumed that the consumer has not yet reached
the satisfaction point in respect of competition of a good.
• 2. Transitivity:
• The consumer is supposed to be consistent about his tastes and pre­
ference. 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.
Indifference curve
• 3. Diminishing Marginal rate of substitution:
• Suppose a consumer buys orange and apple. It can be assumed that as
more and more of units of apple are substituted for orange, the consumer
will be willing to give up fewer and fewer units of orange for additional units
of apple. As the quantity of orange consumed increases, more of it will be
required to compensate for loss of apple. This follows from the principle
that as the consumption of orange increases the desire for it will fall and as
the consumption of apple decreases the desire for it will increase.
• Therefore, the marginal rate of substitution of orange for apple increases
as the quantity of orange increases relatively to apple. Alternatively we can
say that the marginal rate of substitution of orange for apple diminishes as
the supply of apple diminishes. This is called the Principle of Diminishing
Marginal Substitutability. It is assumed that the two goods are not perfect
substitutes for one another and that want for the goods are not satiable.
• The Principle of Diminishing Marginal Substitutability corresponds to the
older law of diminishing marginal utility.
 Marginal rate of Substitution
• MRS of X for Y represents the amount of Y which the
consumer has to give up for the gain of one additional unit
of X so that his level of satisfaction remains the same.

combination Good X Good Y M RSxy

A 1 12
B 2 8 4
C 3 5 3
D 4 3 2
E 5 2 1
Indifference curve
• Properties (Characteristics) of Indiffe­rence Curves:
• Indifference curves have the following four properties
• 1. indifference curves slope downward to the right.
• 2. indifference curves are convex to the origin.
Indifference curve
• 3. Indifference curves can never intersect each other.
• 4. higher indifference curve shows the higher level of
satisfaction than the lower indifference curve
Indifference Curve
• Downward Sloping: An indifference curve slope
downward, which means, that with the more consumption
of one good the consumption of the other is to be reduced
to maintain the utility. Here, the principle of the marginal
rate of substitution (MRS) applies, which means the
increased consumption of one commodity is to be set off
by the reduced consumption of another commodity, so as
to have the same level of satisfaction or utility. Thus, the
indifference curve is negatively sloped.
Indifference curve
Indifference curve
• Convex to the Origin: The indifference curves are
convex to the origin because of the diminishing marginal
rate of substitution. The MRS diminishes because of the
decline in the marginal utility, which means with more and
more consumption of one commodity, the customer’s
utility starts declining and he is not willing to consume it
more at the cost of the other commodity. For
example, let’s say there are two chocolates, dairy milk,
and Nestle, with more and more consumption of dairy milk
chocolates the utility continues to decline, and the
customer will no more give up the Nestle chocolates to
buy the dairy milk. Here, MRS shows the slope of the
indifference curve.
Indifference curve
Indifference curve
• Cannot Intersect or be tangent to each other: The
indifference curves can not intersect with each other,
because if it does so, then the combinations of two
commodities lying on two different curves will yield the
same level of satisfaction which is not correct.
• Thus, it is clear from the properties of the indifference
curve that the customer realizes an equal satisfaction and
the utility from the use of different combinations of two
commodities.
Indifference curve
Indifference curve
•
Higher the indifference curve, the higher is the level
of satisfaction: The consumer derives more satisfaction
from the combination of two goods on a higher
indifference curve because more units of both the
commodities are used that will surely be more satisfying
than the lower quantity combinations.
Indifference curve
Budget Line
• Definition: A budget line is a straight line that slopes
downwards and consists of all the possible combinations
of the two goods which a consumer can buy at a given
market price by allocating all his/her income. It is an
entirely different concept from that of an indifference curve
, though they are both are essential for consumer
equilibrium. Budget line shows the possible combinations
of two goods that can be purchased by spending a given
amount of income
• The two essential components of a budget line are:
• The purchasing power of a consumer, i.e. his/her income;
• The market price of both commodities.
Budget line
• Equation of Budget Line
• The concept of the budget line is precisely explained
through the following equation:
• Where,
Px is the price of goods X;
Qx is the quantity of goods X;
Py is the price of goods Y;
Qy is the quantity of goods Y;
M is the income of the consumer.
• M= x
Example: A person has 50/- for buying pens. He/She has the
following options for allocating his/her amount such that he/she
derives the maximum utility from limited income:
The above Budget schedule can be plotted on a graph to obtain
the appropriate budget line for this instance;
Budget line
• Slope of the Budget Line and Prices of two Goods:
• It is also important to remember that the slope of the
budget line is equal to the ratio of the prices of two goods.
Suppose the given income of the consumer is M and the
given prices of goods X and Y are Px and Py respectively.
The slope of the budget line BL is OB/OL. We intend to
prove that slope OB/OL is equal to the ratio of the price of
goods X and Y.
• The quantity of good X purchased if whole of the given
income M is spent on it is OL.
Budget line
Now, the quantity of good Y purchased if whole of the given
income M is spent on it is OB.
Budget line
Budget line
• It is thus proved that the slope of the budget line BL
represents the ratio of the prices of two goods.
Consumer Equilibrium
•
"A consumer is said to be in equilibrium at a point where the price line is touching
the highest attainable indifference curve from below".
•
• Conditions:
•
• Thus the consumer’s equilibrium under the indifference curve theory must meet the
following two conditions:
•
• First: A given price line should be tangent to an indifference curve or marginal rate of
satisfaction of good X for good Y (MRSxy) must be equal to the price ratio of the two
goods. i.e.
•
• MRSxy = Px / Py slope of indifference curve =slope of budget line
• Px/py = Mux/muy

•
• Second: The second order condition is that indifference curve must be convex to the
origin at the point of tangency
Consumer Equilibrium
• Assumptions:
•
• The following assumptions are made to determine the consumer’s equilibrium position.
•
• (i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction given his
income and prices.
•
• (ii) Utility is ordinal: It is assumed that the consumer can rank his preference according to
the satisfaction of each combination of goods.
•
• (iii) Consistency of choice: It is also assumed that the consumer is consistent in the choice
of goods.
•
• (iv) Perfect competition: There is perfect competition in the market from where the
consumer is purchasing the goods.
•
• (v) Total utility: The total utility of the consumer depends on the quantities of the good
consumed.
Consumer Equilibrium
Consumer Equilibrium
• In the diagram 3.11, there are three indifference curves IC1,
IC2 and IC3. The price line PT is tangent to the indifference curve
IC2 at point C. The consumer gets the maximum satisfaction or
is in equilibrium at point C by purchasing OE units of good Y
and OH units of good X with the given money income.
• The consumer cannot be in equilibrium at any other point on
indifference curves. For instance, point R and S lie on lower
indifference curve IC1 but yield less satisfaction. As regards
point U on indifference curve IC3, the consumer no doubt gets
higher satisfaction but that is outside the budget line and hence
not achievable to the consumer. The consumer’s equilibrium
position is only at point C where the price line is tangent to the
highest attainable indifference curve IC2 from below.
Consumer Equilibrium
• 2) Slope of the Price Line to be Equal to the Slope of Indifference Curve:
• The second condition for the consumer to be in equilibrium and get the
maximum possible satisfaction is only at a point where the price line is a
tangent to the highest possible indifference curve from below. In fig. 3.11, the
price line PT is touching the highest possible indifferent curve IC2 at point C.
The point C shows the combination of the two commodities which the
consumer is maximized when he buys OH units of good X and OE units of
good Y.
• Geometrically, at tangency point C, the consumer’s substitution ratio is equal
to price ratio Px / Py. It implies that at point C, what the consumer is willing to
pay i.e., his personal exchange rate between X and Y (MRSxy) is equal to
what he actually pays i.e., the market exchange rate. So the equilibrium
condition being Px / Py being satisfied at the point C is:
• Price of X / Price of Y = MRS of X for Y
• The equilibrium conditions given above states that the rate at which the
individual is willing to substitute commodity X for commodity Y must equal the
ratio at which he can substitute X for Y in the market at a given price.
Consumer Equilibrium
• Explanation:
• The consumer’s consumption decision is explained by
combining the budget line and the indifference map. The
consumer’s equilibrium position is only at a point where
the price line is tangent to the highest attainable
indifference curve from below.
• (1) Budget Line Should be Tangent to the Indifference
Curve:
• The consumer’s equilibrium in explained by combining the
budget line and the indifference map
Consumer Equilibrium
• (3) Indifference Curve Should be Convex to the Origin:
• The third condition for the stable consumer equilibrium is that the
indifference curve must be convex to the origin at the point of
equilibrium. In other words, we can say that the MRS of X for Y
must be diminishing at the point of equilibrium. It may be noticed
that in fig. 3.11, the indifference curve IC 2 is convex to the origin
at point C. So at point C, all three conditions for the stable-
consumer’s equilibrium are satisfied.
• Summing up, the consumer is in equilibrium at point C where
the budget line PT is tangent to the indifference IC 2. The market
basket OH of good X and OE of good Y yields the greatest
satisfaction because it is on the highest attainable indifference
curve. At point C:
• MRSxy = Px / Py
Consumer surplus and producer surplus
• Consumer surplus
• Consumer surplus is derived whenever the price a
consumer actually pays is less than they are prepared to
pay. A demand curve indicates what price consumers are
prepared to pay for a hypothetical quantity of a good,
based on their expectation of private benefit.
• For example, at price P, the total private benefit in terms
of utility derived by consumers from consuming quantity,
Q is shown as the area ABQC in the diagram.
• Consumer surplus = willingness to pay – actual pay
• CS= total utility- no.of units purchased.price
Consumer surplus and producer surplus
Consumer surplus and producer surplus
• Producer surplus
• Producer surplus is the additional private benefit to
producers, in terms of profit, gained when the price they
receive in the market is more than the minimum they
would be prepared to supply for. In other words they
received a reward that more than covers their costs of
production.
• The producer surplus derived by all firms in the market is
the area from the supply curve to the price line, EPB.
Consumer surplus and producer surplus
Consumer surplus and producer surplus
• Economic welfare
• Economic welfare is the total benefit available to society
from an economic transaction or situation.
• Economic welfare is also called community surplus.
Welfare is represented by the area ABE in the diagram
below, which is made up of the area for consumer surplus,
ABP plus the area for producer surplus, PBE.
• In market analysis economic welfare at equilibrium can be
calculated by adding consumer and producer surplus.
• Welfare analysis considers whether economic decisions
by individuals, organisations, and the government
increase or decrease economic welfare.
Consumer surplus and producer surplus