INDIFFERENCE CURVE

ANALYSIS

DR. LAXMI NARAYAN YADAV

ASSISTANT PROFESSOR OF
ECONOMICS
GOVT. P.G. COLLEGE FOR WOMEN,
BHODIA KHERA, FATEHABAD, HARYANA
 OBJECTIVES

 To Understand Consumer
Preferences using Indifference
Curve.
 To understand Budget Constraints.
 To Understand the Conditions which 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.
 LECTURE OUTLINE

. 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 those
combination of two goods
which give the same level of
satisfaction to the consumer.

Thus consumer is indifferent towards all the

combinations lying on the same indifference curve.
In other words, consumer gives equal
preference to all such combinations.
 INDIFFERENCE CURVES

24
22 A(1, 22)
20
INDIFFERENCE 18
SCHEDULE 4 )
16 2, 1
(Table Showing B(
14 0 )
Different , 1
Combinations
Combinati Applesgiving
Orange 12 ( 3
C

8)
on Equal Satisfaction)
s 10

4,

7)
D(
A 1 22

5,
8
Oranges

E(
B 2 14 6
4
C 3 10
2 Apples
D 4 8
0
E 5 7 1 2 3 4 5 6
 INDIFFERENCE CURVES

24
22 A(1, 22)
20
INDIFFERENCE 18
SCHEDULE 16 , 14)
Combinat Apples Orange
14 B(2 )
ion s 10
12 3,
A 1 22 C(

8)
B 2 14 10

4,

7)
D(
8

5,
C 3 10

E(
Oranges

6
D 4 8 IC1
4
E 5 7 2
Apples
0
1 2 3 4 5
 MARGINAL RATE OF
SUBSTITUTION (MRS)

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.

Decrease in the Consumption = Y ∆Y

of(-)
MRS =
Increase
xy in the Consumption of X ∆X
 DIMINISHING MARGINAL
RATE OF SUBSTITUTION

Combinat Apple Oranges MRS

ion s
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 =
16 -∆ O/∆ A = 8:1
14 MRS =
MRS is measured 12 B 4:1
by the slope of 10
MRS =
the indifference 8
C 2:1
Oranges

curve 6

D
IC1

E
4
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

 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
always preferred to less.
 PROPERTIES OF IC
4. Higher indifference curve
represents higher satisfaction.

Indifference
map
This is because the
combinations lying on More is preferred
higher indifference to 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)
need not to be 8
parallel to each other Oranges
6
IC1
4
(because of Different
2 Apples
MRS on different 0
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

in
tta
Com Apples Orange Total
na
bina (@ Rs. s budget U le
tion 6 @ Rs. 2 (Rs.)=6x ab
per Per unit A+2xO le
unit) ab
i n
t a
t
A
A 0 12 24
B 1 9 24
C 2 6 24
D 3 3 24 Budget line
E 4 0 24 corresponding to
budget of Rs. 24
 BUDGET LINE
3 Pa
Slope = ∆ Oranges/∆Apples = (-) = (-)
1 Po
141 The slope is the negative of
A the ratio of the prices of the
2
10 two goods.The slope indicates
B
8 the rate at which the two
6 C goods can be substituted
Oranges

-3 without changing the amount

4 D
of money spent.
2 +1
E
0
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.
IC1
14
12
A
10
A Combination A can
8
not be attained
Oranges

6
4 due to budget
2 Budgetconstraints
0 B Line
1 2 3 4 Apples
5
 CONDITIONS OF
CONSUMER EQUILIBRIUM

Point B does not

IC1
12 maximize satisfaction
because there exist a
10
B point C which is
8 attainable and yields a
C higher satisfaction.
6
Oranges

2 Budget
Line
0
1 2 3 4 Apples
5
 CONDITIONS OF CONSUMER
EQUILIBRIUM
Equilibrium occurs (Point C)
when the consumer selects the
Combination which reaches the
(U highest attainable
na
12 A tIndifference
ta curve.
in At Equilibrium (Point
10 ab
le) C) we would have
Oranges

8
C slope of Indifference
6 IC
IC
Curve (MRSxy)
4

4 3

(Attainable) equal
IC to the slope of
2
2 IC
Budget Line (Px/Py)
1

B
0
1 2 3 4 5 6
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
A
12 MRS will be increasing at E
10 whereas it should be
8
Oranges

IC1 E diminishing at the

6
equilibrium point.
4
2 Budget
0 B
Line
1 2 3 4 Apples
5
 EFFECT OF CHANGE IN
THE BUDGET/INCOME

If budget (Income) of the

18 consumer increases to
16 Rs. 36, then budget line
14 will shift outward to L2
12 I=3
10 6 If budget (Income) of
8 L2 the consumer
Oranges

6 L1 reduces to Rs. 12,

4 then budget line will
(I=12) (I=2
2
L3 4) shift inward to L3
0
1 2 3 4 5 6
Apples
 UNDERSTANDING
INCOME EFFECT
INCOME EFFECT: Effect on the
consumer equilibrium caused by
18 L2 change in his income if relative prices
16 remain constant.
14
12 L1 INCOME CONSUMPTION
10 CURVE (ICC) Curve Showing
8 C points of equilibrium at
Oranges

6 L3 various levels of
4 B
consumer income
2 A
given constant
0
productApples
price.
1 2 3 4 5 6
 NEGATIVE INCOME EFFECT

L2 ICC for Inferior Goods

18
16
14 NEGATIVE ICC: in
B case of inferior goods
12 L1
10 ICC is negative
Oranges

8 showing decrease in
6 L3 the quantity
4 A demanded of a good
2 with the increase in
0
consumer income.
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 would enable
A him to buy his original
G
combination of goods at he
new price.
Oranges

N E
D F
P

I1 I2
B
I3
O M Q H C Apples
Substitution Effect
 HICKS MEASURE

According to Hicks Constant

real income means that
A
consumer will remain on same
indifference curve as before
G the change in price
N E
Oranges

D F
P

I1 I2
B
O M Q H C 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
16 Rs. 24, price line will shift
14 inward to L3
12 If price of Apples
10 decreases from Rs.
8 6 per unit to Rs. 4
Oranges

L2
6
(P = 4)
per unit, then for a
4 L1 a
budget of Rs. 24,
2 L3 (Pa=12) price line will shift
(Pa=6)
0
outward
Apples to L2
1 2 3 4 5 6
 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
 DECOMPOSITION
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)
G
= Substitution
Effect (MN)
Oranges F E +Income Effect
D
(NP)
I1 I2
I3
B
M N P H C
Apples
O

 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
A Price Effect (MP)
= Substitution
G
Effect (MN) +
Income Effect

Oranges
D E
F (NP)

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

Substitution
Nature of Income Effect
Price
Goods 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
 SUMMING UP

Indifference curve analysis is an

improved technique of Analysing
consumer’s behaviour.

Beside explaining consumer equilibrium and

consumer surpluse, indifference curves are useful
in the field of Production, Distribution, Exchange,
Public Finance and International Trade. But it has
a number of questionable assumptions.
Accordingly, Samuelson has forwarded the
Hypothesis of Revealed Preference to explain
consumer behaviour.
 IMPORTANT QUESTIONS
 What is Indifference Curve?
Explain Its Main Properties?
 Explain income effect and
price effect using diagram.?
 Define Marginal Rate of
Substitution.
 What do you understand by term consumer
equilibrium? Explain consumer equilibrium
with the help of Indifference Curve
Technique.
 Explain decomposition of price effect into
 FURTHER READINGS
 M. L. Jhingan,
Modern
Microeconomics
Konark
Publication, New
Delhi.
 A. Koutsoyiannis,
Modern Micro
Economics,
McMillan Press,
London
 Paul Samuelson and Nordhaus: