INDIFFERENCE CURVE

ANALYSIS

Or
Ordinal Utility Analysis
 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.
 INDIFFERENCE CURVE
• The technique of indifference curves was
originated by F. Y. Edgeworth in England in 1881. It was
then refined by Vilfredo Pareto, an Italian economist in
1906. This technique attained perfection and systematic
application in demand analysis at the hands of Prof. John
Richard Hicks and R.G.D. Allen in 1934.

• Hicks discarded the Marshallian assumption of cardinal

measurement of utility and suggested ordinal
measurement which implies comparison and ranking
without quantification of the magnitude of satisfaction
enjoyed by the consumer .
 Assumption of Ordinal Utility Analysis or
Indifference Curve approach

1. Consumer is rational or Rationality : Consumer’s Objective is

maximization of utility, subject to Price and consumption
expenditure

2. Utility is ordinal: Utility cannot be measured cardinally. It can

be expressed ordinally can rank according to the satisfaction or
utility of each basket.

3. Consistence in choice : if the consumer prefers combinations of

A of good to the combinations B of goods, he then remains
consistent in his choice. i. e. If A > B, then never become B > A
4. Consumer’s Preference is Transitive: if A is preferred over
combination B, B is preferred over C, then combination A is preferred
over combination C. i.e. If A > B and B > C, then A > C

5. Diminishing Marginal Substitution of goods: In the Indifference

Curve analysis, the principle of Diminishing Marginal Rate of
Substitution is assumed. The MRS is the rate at which the consumer is
willing to substitute one commodity (X) for another (Y). This rate is
given Y
MRS=
X
That is Convexity of Indifference curve or Negative slop of indifference

5. Non – satiety : it means that, a consumer always prefers a large

quantity of all goods.
 Indifference curve
• An indifference curve is the geometrical
device which measure the level of
satisfaction derived by the consumer from
the consumption of different combinations
of two goods.
• An Indifference curve (IC) is the locus of all
those combinations of two goods which
give the same level of satisfaction to the
consumer.
Indifference curve - IC
➢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 curve can be derived on the

basis of indifference schedule

➢Indifference schedule is a list or tabular

presentation of various combinations of two
commodities which are equally satisfactory to the
consumer concerned.
 Two Indifference Schedules
SCHEDULE 1 SCHEDULE2
Good X Good Y Good X Good Y
1 12 2 14
2 8 3 10
3 5 4 7
4 3 5 5
5 2 6 4

➢In Schedule 2,consumer has initially 2 units of

goods X and 14 units of Y. So questions arises
how much of Y would consumer be ready to
abandon for successive additions of X in his stock
so that satisfaction remains equal as compared to
his initial one i.e 2X+14Y.
 Schedule 1 or Schedule 2?
• Any combination in schedule 2 will give
consumer more satisfaction than in schedule
1.
• The reason for this is that more of a
commodity is preferable to less of it.
• In simple terms, greater quantity of a good
gives an individual more satisfaction than the
smaller quantity of it, the quantity of other
goods with him remaining the same.
 INDIFFERENCE SCHEDULE
(Table Showing Different Combinations giving Equal
Satisfaction)
Combination Apples Oranges

A 1 22
B 2 14
C 3 10
D 4 8
E 5 7
INDIFFERENCE CURVES

24
22 A(1, 22)
20
18
16
14
12
10
8
Oranges

6
4
2 Apples
0
1 2 3 4 5 6
INDIFFERENCE CURVES

24
22 A(1, 22)
20
18
16
14
12
10
8
Oranges

6
4 IC1
2
0
Apples
1 2 3 4 5
 ➢An Indifference Map
➢A graph showing a whole set of indifference
curves is called an indifference map. An
indifference map, in other words, is comprised of
a set of indifference curves. Each successive
curve further from the original curve indicates a
higher level of total satisfaction.
 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 of Y = (-) ∆Y

MRSxy =
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
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 to Less
higher indifference
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 Different 2
MRS on different Apples
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.
• A budget line or price line represents the
various combinations of two goods which can
be purchased with a given money income and
assumed prices of goods".
Budget line, B=Px.Qx + Py.Q
If consumer has total budget Rs. 24 and price of
X goods Px=rs.6 and price of Y goods is rs.2,
then
24= 6Qx+2Qy
If Qy=0, then Qx=24/6=4units of X
If Qx=0, then Qy=24/2=12 units of Y
 BUDGET LINE

Com Apples Oranges Total

binat (@ Rs. 6 @ Rs. 2 budget
ion per unit) Per unit (Rs.)=6xA
+2xO
A 0 12 24
B 1 9 24
C 2 6 24
D 3 3 24
E 4 0 24 Budget line 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 B two goods.The slope indicates
8 the rate at which the two
6 C goods can be substituted
Oranges

4 -3 D without changing the amount

2
of money spent.
+1
0
E
1 2 3 4 5
Apples
 Changes or Shift in Price Line or Budget Line
➢The price line is determined by the income of the consumer and the
prices of goods in the market. If there is a change in the income of the
consumer or in the prices of goods, the price line shifts in response to a
exchange in these two factors.
➢(i) Income changes: When there is change in the income of the
consumer, the prices of goods remaining the same, the price line shifts
from the original position. It shifts upward or to the right hand side in a
parallel position with the rise in income.

➢(ii) Price changes. If there is a change in the price of one good, the
income of the consumer and price of other good is held constant. When
there is a fall in the price of one good say commodity X, the consumer
purchases more of that good than before. A price change causes the
 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
8 per unit, then for a budget of
Oranges

L2
6 Rs. 24, price line will shift
4 L1 (Pa = 4)
outward to L2
2 L3 (Pa=12)
0 (Pa=6)

1 2 3 4 5 6
Apples
 Changes or Shift in Price Line or Budget Line
Price changes. If there is a change in the price of one good, the income of the
consumer and price of other good is held constant. When there is a fall in the
price of one good say commodity A, the consumer purchases more of that good
than before. A price change causes the budget line to rotate

➢What will happen to Price Line

• Price of commodity B fall?

• Price of Commodity B Rice ?

• Price of commodity A rice ?

 EFFECT OF CHANGE IN THE
BUDGET/INCOME

If budget (Income) of the consumer

18 increases to Rs. 36, then budget line
16 will 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 6
Apples
 Changes or Shift in Price Line or Budget Line

➢Income changes: When there is change in the income of the consumer, the
prices of goods remaining the same, the price line shifts from the original
position. It shifts upward or to the right hand side in a parallel position with the
rise in income.

➢Rise in income.

➢A fall in Income?????
 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 Combination A can not be
8
attained due to budget
Oranges

6
4 constraints
2 Budget Line
0 B
1 2 3 4 Apples
5
 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 Apples
5
 CONDITIONS OF CONSUMER
EQUILIBRIUM
Equilibrium occurs (Point C) when the
consumer selects the Combination which
reaches the highest attainable
Indifference curve.
12 A
10
At Equilibrium (Point C) we
would have slope of Indifference
Oranges

8
C Curve (MRSxy) equal to
6
IC the slope of Budget Line
4
4 IC 3

(Attainable) IC (Px/Py)
2
2 IC 1

0
B
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
12 A
MRS will be increasing at E
10 whereas it should be
8
Oranges

IC1 E diminishing at the

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

If budget (Income) of the consumer

18 increases to Rs. 36, then budget line
16 will 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 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 CURVE (ICC)
10 Curve Showing points of equilibrium at
8 C various levels of
Oranges

6 L3
B consumer income given
4
constant product price.
2 A
0
Apples
1 2 3 4 5 6
 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 L3 with the increase in consumer
4 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 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
consumer will remain on same
A
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
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
8 per unit, then for a budget of
Oranges

L2
6 Rs. 24, price line will shift
4 L1 (Pa = 4)
outward to L2
2 L3 (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
 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)
+Income Effect (NP)
Oranges F E
D

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 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
 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 substitution and
Income Effect with the help of suitable diagrams.
 FURTHER READINGS
➢ M. L. Jhingan, Modern
Microeconomics Konark
Publication, New Delhi.
➢ A. Koutsoyiannis, Modern
Micro Economics, McMillan
Press, London
➢ Paul Samuelson and Nordhaus: Economics, Tata
McGraw Hill Publishing Company, New Delhi.
➢ Boumol, William J and Blinder Alan S ‘Microeconomics:
Principles and Policy’ Thomson, 1st Indian Edition (2007)
THANK YOU