INDIFFERENCE
CURVE
ANALYSIS
OBJECTIVE
S
To Understand Consumer Preferences
using Indifference Curve.
To understand Budget Constraints.
To Understand the Conditionswhich Enable
Consumer to Maximize his Satisfaction.
To Understand the Effect of Price and Income
Changes on Consumer Equilibrium.
To Understand Price Effect and the Methods
by which Price Effect can be Decomposed.
OUTLINE
S
Indifference Curves:
Definition, Shape, Assumptions and
Properties.
Budget Line: Definition, Shape and
Effect of Price and Income Changes
Consumer Equilibrium: Conditions, Shifting
of Equilibrium when price and Income changes
and decomposition of price effect into income
and Substitution effects.
DEFINITION: IC
An Indifference curve (IC) is
the locus of all
combination those give
which of the
two
same goods
levelof
satisfaction to the consumer.
Thus
combinations lying is
consumer on the same indifference
indifferent curve.
towards all
In other
the words, consumer gives equal
preference to all such combinations.
INDIFFERENCE
CURVES
INDIFFERENCE SCHEDULE
(Table Showing Different 24
Combinations giving Equal 22 A(1, 22)
Satisfaction)
20
18
Combination Apples Oranges 16
14
A 1 22 12
B 2 14 10
8
Oranges
C 3 10
6
D 4 8 4
E 5 7 2 Apples
0
1 2 3 4 5 6
INDIFFERENCE
CURVES
24
22 A(1, 22)
20
INDIFFERENCE SCHEDULE 18
16
Combination Apples Oranges
14
A 1 22 12
B 2 14 10
C 3 10 8
Oranges
6
D 4 8
4 IC1
E 5 7 2
0 Apples
1 2 3 4 5
OF
SUBSTITUTION(MR
S)
The marginal rate of substitution of X for Y
(MRSxy) is defined as the amount of Y, the
consumer is just willing to give up to get
one more unit of X and maintain the same
level of satisfaction.
MRSxy = Decrease in the Consumption of Y = (-) ∆ Y
Increase in the Consumption of X ∆X
DIMINISHING
MARGINAL RATE OF
SUBSTITUTION
Combination Apples Oranges MRS
A 1 22 ---
B 2 14 8:1
C 3 10 4:1
D 4 8 2:1
E 5 7 1:1
As the consumer increases the consumption of
apples, then for getting every additional unit of
apples, he will give up less and less of oranges, that
is, 8:1, 4:1, 2:1, 1:1 respectively This is the Law of
Diminishing MRS.
LAW OF DIMINISHING MRS
24 A
22
20
18 MRS = -O/A = 8:1
16
14 MRS = 4:1
MRS is measured 12
by the slope of 10 MRS = 2:1
the indifference 8
Oranges
curve 6
4 IC1
2
0 Apples
1 2 3 4 5
ASSUMPTIONS OF IC
ANALYSIS
Rational Consumer
Ordinal Utility
Non-Satiety (More is Preferred to Less)
Diminishing Marginal Rate of Substitution.
Consistency: If a consumer prefer A to B in
one period then he will not prefer B to A in another
period.
Transitivity: If a consumer prefer A to B and B to C,
then he must prefer A to C.
PROPERTIES OF IC
1. An Indifference curve has
negative slope i.e. it slope
downwards from left to right.
2. Indifference curve is always convex to the
origin. This implies that two goods are
imperfect substitutes and MRS between two
goods decreases as a consumer move along
an indifference curve. IC will
be straight line if MRS is constant and
L shaped in case of
Complimentary.
PROPERTIES OF IC
3. Two Indifference curves
never intersect or become
tangent to each other.
This will violet the rule of
Transitivity because: on
IC1 A is equally
preferred to B and on
IC2 A is equally
preferred to C.
This implies B is equally
preferred to C, which can
not be because more is
PROPERTIES OF IC
4. Higher indifference curve
represents higher satisfaction.
This is because the
combinations lying on More is preferred to
higher indifference Less
curve contain more of
either one or both
goods and more is
always preferred to
less.
PROPERTIES OF IC
5. Indifference curve touches
neither X-axis nor Y-axis
(By Definition)
X
12
6. Indifference curve 10 A(0, 10)
8
need not to be
parallel to each other Oranges
6
4 IC1
(because of 2
Different MRS on Apples
0
different ICs) 1 2 3 4 5
BUDGET CONSTRAINTS
(What is Attainable)
Budget constraints limit an
individual’s ability to consume
in light of the prices they must
pay for various goods and
services.
Budget line or Price Line: Shows all possible
combinations of two goods that the consumer
can buy if he spends the whole of his given sum
of money on his purchases at the given prices.
BUDGET LINE
Com Apples Oranges Total
budget
binat (@ Rs. 6 @ Rs. (Rs.)=6
ion per 2 xA
unit) Per unit +2xO
A 0 12 24
B 1 9 24
C 2 6 24
D 3 3 24 Budget line corresponding to
E 4 0 24 budget of Rs. 24
BUDGET LINE
3 Pa
Slope O ranges/ (-) (-)
Apples 1
141 The slope is the negative
P of
A o
the ratio of the prices of the
2
10 B two [Link] slope indicates
8 the rate at which the two
6 C goods can be substituted
Oranges
4 -3 D without changing the amount
of money spent.
2 +1
0
E
1 2 3 4 5
Apples
CONSUMER
EQUILIBRIUM
Consumers choose a combination
of goods that will maximize the
satisfaction they can achieve,
given the limited budget available
to them.
The maximising combination must satisfy two
conditions:
It must be located on the budget line.
Must give the consumer the most
preferred combination of goods and
services.
CONDITIONS OF
CONSUMER
EQUILIBRIUM
Condition-1:
Budget Line should be Tangent
16 to the Indifference Curve.
14
IC1
12
A
10
A
8 Combination A can not be
attained due to budget
Oranges
6
4 constraints
2 Budget Line
0 B
1 2 3 4 5 Apples
CONDITIONS OF
CONSUMER EQUILIBRIUM
Point B does not maximize
12
IC1 satisfaction because there exist a
10
point C which is attainable and
B yields a higher satisfaction.
8
6 C
Oranges
2
Budget Line
0
1 2 3 4 5 Apples
CONDITIONS OF CONSUMER
EQUILIBRIUM
Equilibrium occurs (Point C) when the
consumer selects the Combination which
reaches the highest attainable Indifference
curve.
12 A At Equilibrium (Point C) we would
10
have slope of Indifference Curve
Oranges
8
C (MRSxy) equal to the
6 IC
IC
Slope of Budget Line
4
4 3
(Attainable)
IC 2 (Px/Py)
2 IC
1
0
B
1 2 3 4 5
Apples
CONDITIONS OF
CONSUMER
EQUILIBRIUM
Condition-2: Indifference
Curve must be convex to
the origin.
16 Combination E can not be
14
equilibrium point Because
12 A
MRS will be increasing at E
10 whereas it should be
Oranges
8
IC1 E diminishing at the
6
4
equilibrium point.
2 Budget Line
0 B
1 2 3 4 5 Apples
EFFECT OF CHANGE
IN THE
BUDGET/INCOME
If budget (Income) of the consumer
18 increases to Rs. 36, then budget line will
16
shift outward to L2
14 I=36
12
10 If budget (Income) of the
8 L2 consumer reduces to Rs. 12,
Oranges
6 L1
then budget line will shift
4 (I=24)
(I=12) inward to L3
2 L3
0
1 2 3 4 5 Apples
UNDERSTANDIN
G INCOME
EFFECT
INCOME EFFECT: Effect on the
consumer equilibrium caused by
18 L2 change in his income if relative
16 prices remain constant.
14 INCOME CONSUMPTION CURVE (ICC)
12 L1 Curve Showing points of equilibrium at
10 various levels of
8 C consumer income given
Oranges
6
B constant product price.
4
L 3
2 A
0
1 2 3 4 5 6 Apples
NEGATIVE INCOME
EFFECT
L2 ICC for Inferior Goods
18
16
14 NEGATIVE ICC: in case of
B inferior goods ICC is negative
12 L1
10 showing decrease in the
Oranges
8 quantity demanded of a good
6 with the increase in consumer
4
L 3
A income.
2
0
1 2 3 4 5 6 Apples
SUBSTITUTION
EFFECT
Substitution Effect refers to change
in the amount of goods purchased due
to change in their relative prices
alone, while real income of the
consumer remains constant.
The substitution of relatively cheaper good for
a relatively expensive good is called
substitution effect. There are two methods to
measure substitution effect (i) Slustky’s Measure
and (ii) Hicks Measure.
SLUSTKY MEASURE
According to Slustky
Measure real income is
constant if the consumer is
left with an income which
A would enable him to buy
G his original combination of
goods at he new price.
Oranges
N E
D F
P I2
I1
B
I3
C
O M Q
Apples
H
HICKS
MEASURE
According to Hicks Constant
real income means that
A consumer will remain on
same indifference curve as
G before the change in price
N E
Oranges
D F
I1 I2
B
M Q C
O
H Apples
Substitution Effect
EFFECT OF CHANGE
IN PRICE OF A GOOD
If price of Apples increases from Rs. 6 per unit to
Rs. 12 per unit, then for a budget of Rs. 24, price
line will shift inward to L3
16
14
12 If price of Apples decreases
10 from Rs. 6 per unit to Rs. 4 per
8 unit, then for a budget of Rs. 24,
Oranges
L2 price line will shift
6
4 L1 (Pa =
2 L3
4) outward to L 2
(Pa=12)
0 (Pa=6)
1 2 3 4 5 6
Apples
UNDERSTANDING
PRICE EFFECT
PRICE EFFECT: The price effect may
be defined as the change in the
consumption of goods when the price
of either of the two goods changes
while the price of the other good and
the income of the consumer remain
constant.
PRICE CONSUMPTION CURVE
(PCC)
C
A B
DECOMPOSITIO
N OF PRICE
EFFECT
• Price Effect has two components:
– the substitution effect; and
– the income effect.
There are two main methods of decomposition of
the price effect into the income and substitution
effect :
(i) The Hicksian method; and
(ii) The Slutsky method
THE SLUSTKY’s
APPROACH
A Price Effect (MP) =
Substitution Effect
G
(MN)
E +Income Effect (NP)
Oranges D F
I1 I2
I3
B
O M N P H C
Apples
Price Effect: Movement from D to E = MP
Substitution Effect: Movement from D to F = MN
Income Effect: Movement from F to E = NP
THE HICKSIAN
APPROACH
Price Effect (MP) =
A
Substitution Effect (MN)
G + Income Effect (NP)
Oranges
D E
F
I1 I2
B
O M N P H C Apples
Price Effect: Movement from D to E = MP
Substitution Effect: Movement from D to F = MN
Income Effect: Movement from F to E = NP
PRICE EFFECT AND
NATURE OF GOODS
Nature of Goods Income Substitution Price
Effect Effect Effect
Normal Goods +ve +ve +ve
Inferior goods -ve (weak) +ve (strong) +ve
Giffen's Goods -ve (strong) +ve (weak) -ve
DERIVATION OF
DEMAND CURVE
FROM PCC
