Indifference Curve

Analysis
 Contents
 Indifference curve analysis
 Scale of Preferences
 Assumption of Indifference curve analysis
 Diminishing Marginal Rate of Substitution (DMRS)
 Properties of Indifference curves
 The Budget Constrain and Budget line: Consumer
Equilibrium
 The indifference curve was developed by  If the various combinations are marked
J.R.Hicks and RGD Allen and replaced A, B, C, D and E, the consumer can
Cardinal Utility Analysis. express whether they prefers A to B, B
 The ordinal utility implies that the to C and so on. (A=B, B=C, C=A)
consumer is capable of simply comparing  Similarly, he can indicate his preference
the different levels of satisfaction. or indifference between any other
 An indifference curve reveals the various combinations.
combinations of two product or services  Indifference curve analysis does not use
which yield same level of satisfaction. cardinal numbers like 1, 2, 3,.. But
 Any combination of products or services instead it uses ordinal numbers like 1st,
on an indifference which give the same 2nd, 3rd …. Etc.
level of utility.  The consumer can only compare his
 Indifference curve analysis, the consumer levels of satisfaction in terms of degrees
compares the satisfaction obtained from “good, better, best or bad and worst and
different combinations of goods. cannot measure it in terms of numbers
as assumed by Marshallian analysis.
 Indifference Curve

Combinations Apple Orange Utility

A 1 11 100

B 2 7 100

C 3 4 100

D 4 2 100

E 5 1 100
 Y

11 A

Indifference
Curve
Orange

B
7 C
4 D
2
IC =100
0 1 2 3 4 X

Apple
 Scale of Preference
 A rational consumer always tries to seek maximum level of satisfaction
from the goods he buys. He will arrange them in different combinations
in the order of their level of satisfaction.
 Various combinations are marked A, B, C, D, E etc. The consumer can
express whether he prefers A to B, or B to A or indifferent between them.
 Consumer behaviour in terms of his preferences or rankings for different
combination of two goods say X and Y. – Scale of Preferences.
 Consumers are indifferent with any combination plotted in the
indifference curve.
 The various combinations of the two commodities which yield same
level of satisfaction so that consumer indifferent with those
combinations.
 The consumer is indifferent whether he buys the first combination of 9Y
+ 1 X or the last combination of 3 units of Y + 4 units of X or any other
combination.
 All combinations gives him equal level of satisfaction.
 Various combinations are plotted on a diagram and are joined by a lines
this becomes an indifference curve.
 Indifference Schedule
Y IC1 = 20

X Y
A Combination Commodity Commodity Utility
9

Indifference Curve A 1 9 200

Commodity Y

B 2 6 200
B
6
4 C C 3 4 200
3 D IC1 = 200
D 4 3 200

0 1 2 3 4 X
Commodity X
 The indifference curve IC1 is the locus of the points A, B, C and D
showing the combinations of the two goods X and Y between which the
consumer is indifferent.
 It is the locus of point representing pairs of quantities between which
the individual is indifferent, so it is termed on indifference – equal
satisfaction all its points.
 Assumptions of Ordinal Utility Theory
 The indifference curve analysis of consumer’s behaviour makes, at least
implicitly the following assumptions
1. Rationality
2. Ordinal Utility
3. Transitivity and Consistency of Choice
4. Non-satiety
5. Diminishing Marginal Rate of Substitution
1. Rationality – the consumer is a rational being. He aims at maximising
his total satisfaction, given his income and prices of goods and services he
consumes. He has full knowledge of his circumstances.
2. Ordinal Utility – Indifference curve analysis assumes that utility can
be expressed only ordinally (rankings) – scale of preference
3. Non-satiety – consumer always prefers a larger quantity of all the
goods
 4. Transitivity and Consistency of Choice
 Consumer’s choices are transitive. Transitivity of choice means that if a
consumer prefers A to B and B to C, he must prefer A to C. If he treats
A= B and B = C, he must treat A = C.
 Consistency of choice means that, if he prefers A to B in one period, he
will not prefer B to A in another period or treat them as equal.
 The transitivity and consistency in consumer’s choices may be
symbolically expressed as follows
 Transitivity – If A > B, and B > C, then A > C and
 Consistency – If A > B, in one period, then B > or B = A
 5. Diminishing Marginal Rate of Substitution
 The marginal rate of substitution means the rate at which consumer is
willing to substitute one commodity (X) for another (Y)
 i.e., the units of Y he is willing to give up for one unit of X so that his
total satisfaction remains the same.
 This rate is given by ∆Y/∆X. The assumption is the ∆Y/∆X goes on
decreasing, when a consumer continues to substitute X for Y.
 Indifference Map
 An indifference map is a collection or group of indifference curves. It
represents various levels of satisfaction.
 The higher indifference curve represents higher level of satisfaction and
vice versa.
 Since consumer always prefers higher level of satisfaction, he always
move to higher indifference curve than a lower one.
 The higher indifference curve will be given higher order of preference and
so on.
 Since all the points on the same indifference curve yields the same level
of satisfaction, he is indifferent.
Diminishing Marginal Rate of
Substitution (DMRS)
 The concept of marginal rate of substitution is an
important tool of indifference curve analysis of demand.
 It may be defined as the rate at which an individual will
exchange successive units of one commodity for
another.
 For example, if at the beginning the individual has a small
amount of commodity X and a large amount of
commodity Y, then he will be willing to offer a large
amount of Y for an extra unit of X.
 As his supply of X increases, he will offer successively
smaller amounts of Y for additional units of X.
 MRS is thus, the ratio between the marginal quantities of two
commodities with which the individual is concerned.
 The marginal rate of substitution of X for Y (MRS XY) is the
amount of Y that will be given up for obtaining each additional
unit of X.
 To have the second combination and yet to be at the same level
of satisfaction, the consumer is prepared to forgo 3 units of Y for
obtaining an extra unit of X.
 Marginal Rate of Substitution shows the rate at which the consumer is
willing to substitute one commodity for another.

-∆X
MRSxy =
∆Y
Where, MRS = Marginal rate of substitution
∆X = Change in quantity of X
∆Y = Change in quantity of Y
 MRS can be defined as the rate at which an individual will exchange
successive units of one commodity for another
 Y IC1 = 200

Combination Commodity Commodity X MRS

Y 9 A
A 20 1 -
Indifference Curve

Commodity Y
ΔY
B 16 2 4:1
ΔX
B
C 13 3 3:1 6
ΔY C
4
D 11 4 2:1 ΔX D
3 IC1 = 200
ΔY ΔX
E 10 5 1:1
0 1 2 3 4 X
Commodity X
 The marginal rate of substitution of X for Ys is 4:1
 The rate of substitution will then be the number of units of Y for
which one unit of X is a substitute.
 As the consumer proceeds to have additional units of X, he
willing to give away less and less units of Y so that the marginal
rate of substitution falls from 4:1 to 1:1 in the fourth
combination.
 In the above diagram at point B on the indifference curve IC 1 the consumer
is willing to give up 4 units of Y to get an additional unit of X.
 Hence, MRS = 4. As he moves along the curve from B to C, MRS xy = 4.
When the consumer moves downwards along the indifference curve, he
acquires more of X and less of Y.
 The amount of Y he is prepared to give up to get additional units of X
becomes smaller and smaller.
 The marginal rate of substitution of X for Y (MRS xy) is, in fact, the slope of
the curve at a point on the indifference curve, such as points B, C and D in
the diagram
 It means that the MRSxy is the ratio of change in good Y to a given
change in X.
 In the diagram, there are four triangles on the IC curve whose vertical
sides AX1B, BX2C and CX3D and DX4E represent diminish and the
horizontal sides X1A, X2B X3C and X4E signify which remains the
same.
 This also shows that as the consumer moves downwards along the curve,
he possesses additional units of X and gives up lesser and lesser units of Y
i.e., the MRS xy diminishes.
 It is due to this law of diminishing MRS that an indifference curve is
convex to the origin.
 Why Does MRS Diminish?.....
 The negative slope of the indifference curve implies that two
commodities are not perfect substitutes for each other.
 In case they are perfect substitutes, the indifference curve will be a
straight line with a negative slope.
 Since goods are not perfect substitutes for each other, the subjective
value attached to the additional quantity of a commodity decreases fast in
relation to the other commodity whose total quantity is decreasing.
 Therefore, when the quantity of one commodity (say, X) increases and that
of other (say, Y) decreases, it becomes increasingly difficult for the
consumer to sacrifice more and more units of commodity Y for one unit of
X.
 But, if he is required to sacrifice additional units of Y, he will demand
increasing units of X to maintain the level of his satisfaction. As a result,
the MRS decreases.
 Properties of Indifference curves
1. The indifference curve will be downward sloping from left o right.
2. An indifference curve are convex to origin
3. Two Indifference curve cannot interest or touch each other.
4. Upper indifference curves indicate a higher level of satisfaction than
the lower ones.
5. An Indifference curve cannot touch either axis.
1. The indifference curve
downward from left o right
(negative slope)
 An indifference curve has a negative
slope which implies that is slopes
downward from left to right
 When the amount of one good in the
combination is increased, the amount
of the other good is reduced.
 The level of satisfaction is to remain
the same on an indifference curve
2. An indifference curve are convex to origin
 Indifference curves have not only a negative
slope, but are also convex to the origin.
 The marginal rate of substitution diminished
because the more of one good and the less of
another a consumer has the more important
units of the second become relative to units of
the first
 Therefore he will be willing to part with lesser
and lesser quantities of y commodities at each
stage to acquire additional units of X
commodities.
 The shape of the indifference curve is therefore
3. Two Indifference curve cannot interest or
touch each other
 The important property of indifference curve
is that they cannot intersect each other.
 They represent two different sets of
combinations of two commodities providing
unequal amount of satisfaction.
 In other words, only one indifference curve
will pass through a point in the indifference
map.
 This property can be easily proved by first
making the two indifference curves cut each
other and then showing the absurdity or self-
contradictory result of the law
 4.Upper indifference curve
represents a higher level of
satisfaction
 The higher indifference curve will
represent a higher level of
satisfaction than a lower
indifference curve.
 The combinations which lie on a
higher indifference curve will be
preferred to the combinations which
lie on a lower indifference curve.
 IC2 is a higher indifference curve
than IC1, in the same way IC3
greater than IC2 etc.
5. An Indifference curve cannot
touch either axis
 The two indifference curve cannot
touch either axis.
 If any indifference curve for
example either IC1 or IC2 intersect
with OY and OX axis represents
only Y commodity and X
commodities respectively.
 But in reality indifference curve is a
combination of two goods which
yield same level of satisfaction by
moving from one combination to
other without changes in the level of
satisfaction
 The Budget constraint and the budget line

 A utility maximising consumer would like to reach the highest possible

indifference curve on his indifference map.
 But the consumer is assumed to have a limited income. Limited income
sets a limits to which a consumer can maximise his utility.
 The limitedness of income acts as a constraint. This is known as
budgetary constraint
CONSUMERS EQUILIBRIUM
 Consumer attains his equilibrium
when he maximises his total utility,
given his income and market prices
of goods and services he consumes.
 Under indifference curve analysis of
consumer behaviour, necessary
condition for total utility to be
maximum is that MRS must be
equal to the ratio of commodity
prices.
 Consumers equilibrium is illustrated in the above diagram A
hypothetical indifference map of the consumer is shown by
indifference curves IC1 IC2 and IC3.
 The line AB is the hypothetical budget line. Both necessary and
supplementary conditions of consumers equilibrium are fulfilled
at point E, where indifference curve IC 2 is tangent to the budget
line, AB.
 Since both, the curve IC2 and the budget line AB, pass through
point E, therefore, at this point, the slopes of the indifference
curve IC2 and budget line (AB) are equal.
 The consumer is therefore in equilibrium at point E