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INDIFFERENCE CURVES

Course: Seminar on Micro Economics


GROUP MEMBERS: ALKA SINGH
MAHAK ARORA
PARAS HANDA
PRIMAL SHARMA

Cardinal versus ordinal utility


Early economists assumed that people are able to

assign meaningful utility numbers (utils) to their


satisfaction in one situation vis--vis their
satisfaction in an alternative situation.
For example, the utils generated by each brownie
you eat or book you read would be recorded as if you
have utilometer imbedded in your system.
Cardinal measurement of utilitySatisfaction,
liketemperatureordistance,isassumed
measurableinmeaningful,absolutenumbers.

Ordinal Utility Genesis


Cardinal measures are possible when incremental units

are constant and reasonably objective, but utility is


roughly measurable at best. As there is no one born
equipped with a utilometer to precisely measure
satisfaction.
In the 1930s, Nobel prize-winner Sir John Hicks followed
the leads of Vilfredo Pareto and Francis Y. Edgeworth to
develop indifferenceanalysis, an underpinning for the
theory of consumer behavior that dispenses with
cardinally-measured utility. Hicks argued that ranking
our preferences is the best we can do.

INDIFFERENCE CURVES
The technique of indifference curves was originated by

Francis 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 .

Assumptions:
Rational behavior of the consumer
Utility is ordinal
Diminishing marginal rate of substitution
Consistency in choice
Transitivity in choice making
Goods consumed are substitutable

Axioms of rational choice


Completeness
if A and B are any two situations, an individual
can always specify exactly one of these
possibilities:
A is preferred to B
B is preferred to A
A and B are equally attractive

Axioms of rational choice


Transitivity
if A is preferred to B, and B is preferred to C,
then A is preferred to C
assumes that the individuals choices are
internally consistent

Axioms of rational choice


Continuity
if A is preferred to B, then situations suitably
close to A must also be preferred to B
used to analyze individuals responses to
relatively small changes in income and prices

Definition
An indifference curve is the locus of points

representing all the different combinations of two


goods which yield equal level of utility to the
consumer.
Indifference schedule is a list of various
combinations of commodities which are equally
satisfactory to the consumer concerned.

Two Indifference Schedules


SCHEDULE 1

SCHEDULE2

Good X

Good Y

Good X

Good Y

12

14

10

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
succesive additions of X in his stock so that satisfaction remains equal as
compared to his intial 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 Curves
An indifference curve shows a set of consumption

among which the individual is indifferent


Quantity of Y

Combinations (X1, Y1) and (X2, Y2)


provide the same level of utility
Y1
Y2

U1
X1

X2

Quantity of X

Shape of Indifference Curve

Indifference curve slope down and to the right, and

the slope becomes less steep the farther right you go


(this shape is sometimes described
as convex or convextotheorigin). Why?
The curves slope down to the right because any
combination on the curve would yield equal
satisfaction.

Indifference Curve
An indifference curve shows various combinations of goods that

yield the same utility, but different indifference curves show


different levels of utility.
For instance, the green indifference curve on the graph below
indicates a higher level of utility than the red or the blue
indifference curves. Economists assume that people want to attain
the highest level of utility possible (I3 is better than I2 which is
better than I1)
There are an infinite number of indifference curves in the
indifference map, and each persons indifference map is unique to
that person.

Indifference Curve Map

Indifference Curve Map


Each point must have an indifference curve through it

Quantity of y

Increasing utility
U3
U2
U1

U1 < U2 < U3
Quantity of x

Utility
Given these assumptions, it is possible to show that

people are able to rank in order all possible


situations from least desirable to most
Economists call this ranking utility

if A is preferred to B, then the utility assigned to A exceeds the


utility assigned to B

U(A) > U(B)

Utility is affected by the consumption of physical

commodities, psychological attitudes, peer group


pressures, personal experiences, and the general
cultural environment
Economists generally devote attention to
quantifiable options while holding constant the
other things that affect utility

ceterisparibus assumption

Preferences and Utility


Marginal Rate of Substitution, MRSyx :
The rate at which a consumer is willing to sacrifice one
good (y) in return for more of another good (x).
Principle of Diminishing Marginal Rate of
Substitution : A rule stating that, for any convex
indifference curve, when moving down the curve from the
top (northwest) to the bottom (southeast), the absolute
value of that curves slope must be continuously declining

Marginal Rate of Substitution


MRS changes as x and y change
reflects the individuals willingness to trade y for x

At (x1, y1), the indifference curve is steeper.


The person would be willing to give up more
y to gain additional units of x

Quantity of y

At (x2, y2), the indifference curve


is flatter. The person would be
willing to give up less y to gain
additional units of x

y1
y2

U1

x1

x2

Quantity of x

Marginal Rate of Substitution


The negative of the slope of the
indifference curve at any point is called
the marginal rate of substitution (MRS)
Quantity of y

dy
MRS
dx
y1
y2

U1

x1

x2

Quantity of x

U U1

Properties of Indifference Curves


Higher indifference curves are

preferred to lower ones.


Indifference curves are downward
sloping.
Indifference curves do not cross.
Indifference curves are bowed
inward.

Property 1: Higher indifference curves are


preferred to lower ones.

Consumers usually prefer more of something


to less of it.
Higher indifference curves represent larger
quantities of goods than do lower
indifference curves.

Property 2: Indifference curves are downward sloping.

A consumer is willing to give up one good only


if he or she gets more of the other good in
order to remain equally happy.
If the quantity of one good is reduced, the
quantity of the other good must increase.
For this reason, most indifference curves slope
downward.

Property 3: Indifference curves do not cross.

Quantity
of Pepsi
C
A
B

Quantity
of Pizza

Property 4: Indifference curves are bowed inward.

Quantity
of Pepsi
14
MRS = 6
8

4
3
0

People are more willing to


trade away goods that they
have in abundance and less
willing to trade away goods of
which they have little.

MRS = 1

B
1
7

Indifference
curve
Quantity
of Pizza

Perfect Substitutes
Nickels

6
4
2

I1
1

I2
2

I3
3

Dimes

Perfect Complements
Left
Shoes

I2

I1

Right Shoes

Budget Line or Budget Constraint


Essential for understanding the theory of

consumers equilibrium.
The budget line shows all the different
combinations of two goods that a consumer can
purchase given his money income and price of two
commodities
When a consumer attempts to maximize his
satisfaction, there are two constraints:

Paying the prices for the goods


Limited money income

Budget Equation

Px*X + Py*Y=M
M := Income of the consumer
Px := Price of good X
Py := Price of good Y
X := Quantity of good X
Y := Quantity of good Y

A budget line

Units of good Y

Units of Units of Point on


good X good Y budget line

0
5
10
15

30
20
10
0

a
b

Assumptions
PX=2
PY= 1
Budget = 30

Units of good X

Budget Line Continued


Budget line graphically shows the budget constraint.
The combination of commodities lying to the right of

the budget line are unattainable because income of


the consumer is not sufficient to buy those
combinations.
The combinations of goods lying to the left of the
budget line are attainable.

Budget Space
A set of all combinations of the two commodities that can

be purchased by spending the whole or a part of the given


income.

Changes in Price and Shift in Budget Line


At the lower price of X,

the given income


purchases OL of X which
is greater than OL.

At the higher price of X,

the given income


purchases OL of X
which is less than OL.

Changes in Income and Shift in Budget Line


BL initial budget line
If consumers income

increases while prices of


both X and Y remain
unaltered, the price line
shifts upwards i.e. BL
and is parallel to BL.
Similarly it will shift
downward i.e. BL, if
income decreases.

Slope of Budget Line and Prices of two goods


Slope of budget line BL is equal to the ratio of
prices of two goods.
Slope of budget line = OB/OL
= Px / Py

Consumer Equilibrium
It refers to a situation in which a consumer with given

income and given prices purchases such a combination of


goods which gives him maximum satisfaction and he is
not willing to make any change in it.
Assumptions:

1) The consumer has a given indifference map exhibiting


his scale of preferences for various combinations of two
goods, X and Y.
2) Fixed amount of money to spend and has to spend
whole of his money on two goods.
3) Prices of goods are given and constant for him. He
cannot influence those prices.
4) Goods are homogeneous and divisible.

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.

Conditions
A given price line must 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

The second order

condition is that indifference


curve must be convex to the
origin at the point of
tangency.

Income Effect : Income Consumption Curve


The income effect means the change in consumers

preferences of the goods as a result of a change in his


money income.
Income consumption curve traces out the income effect on
the quantity consumed of the goods.
Income effect for a good is said to be positive when with the

increase in income of the consumer, his consumption of


good also increases. (Normal Goods)
Income effect for a good is said to be negative when with
the increase in income of the consumer, his consumption of
good decreases. (Inferior Goods)

Income Consumption Curve

Continued
With the given budget line P1L1, the consumer is
initially in equilibrium at point Q1 on the
indifference curve IC1 and is having OM1 of X and
ON1 of Y.
As income increases budget line shifts upwards i.e.
from P1L1 to P1L2 to P3L3 and so on.
With budget line P2L2, equilibrium is at Q2 on IC2.
Similarly it changes with next budget lines.
If now various points Q1, Q2, Q3 and Q4 showing
consumers equilibrium at various levels of income
are joined together, we will gwt Income
Consumption Curve.

Income Consumption Curve in Case of Good X being Inferior Good

Income Consumption Curve in Case of Good Y being Inferior Good

Income Consumption Curves of Normal Goods

Income Consumption Curves of Inferior Goods

Engel curve
An Engel curve describes how household expenditure on a

particular good or service varies with household income. There


are two varieties of Engel Curves. Budget share Engel Curves
describe how the proportion of household income spent on a
good varies with income. Alternatively, Engel curves can also
describe how real expenditure varies with household income.
They are named after the German statistician Ernst
Engel (18211896) who was the first to investigate this
relationship between goods expenditure and income
systematically in 1857. The best-known single result from the
article is Engels Law which states that the poorer a family is,
the larger the budget share it spends on nourishment.

The Shape of Engel Curves

The shape of Engel curves depend on many

demographic variables and other consumer


characteristics. A goods Engel curve reflects its income
elasticity and indicates whether the good is an inferior,
normal, or luxury good. Empirical Engel curves are
close to linear for some goods, and highly nonlinear for
others.
Graphically, the Engel curve is represented in the firstquadrant of the Cartesian coordinate system. Income is
shown on the Y-axis and the quantity demanded for
the selected good or service is shown on the X-axis.

The Shape of Engel Curves


(Contd.)

For normal goods, the Engel curve has a positive

gradient. That is, as income increases, the quantity


demanded increases. Amongst normal goods, there
are two possibilities. Although the Engel curve
remains upward sloping in both cases, it bends
toward the y-axis for necessities and towards the xaxis for luxury goods.

The Shape of Engel Curves


(Contd.)

For inferior goods, the Engel curve has a negative

gradient. That means that as the consumer has more


income, they will buy less of the inferior good
because they are able to purchase better goods.

Applications Of Engel Curves

In microeconomics Engel curves are used for equivalence scale

calculations and related welfare comparisons, and determine properties


of demand systems such as aggregability and rank.
Engel curves have also been used to study how the changing industrial
composition of growing economies are linked to the changes in the
composition of household demand
In trade theory, one explanation inter-industry trade has been the
hypothesis that countries with similar income levels possess similar
preferences for goods and services (the Lindner hypothesis), which
suggests that understanding how the composition of household demand
changes with income may play an important role in determining global
trade patterns.
Engel curves are also of great relevance in the measurement of
inflation and tax policy

Substitution Effect
It is the change in the quantity of good.

purchased due to change in their relative


prices alone, while real income of the
consumer remains the same.

Substitution Effect(Contd.)

Substitution Effect (Contd.)


In this diagram the consumer with given money income and

given prices of two goods represented by price line PL is in


equilibrium at point Q on the indifference curve IC. He buys ON
quantity of good Y and OM of good X.
We suppose now that the price of good X has fallen and the price

of good Y remains the same. With the fall in the price line shifts
from PL to PL/. Consumers real income is raised because
commodity X is cheaper now. This increase in the real income of
the consumer is to be wiped out for finding out the substitution
effect. The reduction in the money income of the consumer is to
be made by so much amount which keeps him on the same
indifference curve IC.

Indifference Curve Analysis - Price Effect

When there is no change in the income of the

consumer, no change in the price of one commodity,


and there is a change in the price of another
commodity, there will be a change in the
consumption made by the consumer. This change in
consumption is known as the Price Effect. Though
money income does not increase, the real income
increases, generating more purchasing power.

Indifference Curve Analysis - Price Effect (Contd.)


Under the Price Effect, there will be a

change in the equilibrium position of


the consumer. This can be shown in
the following diagram.

In this diagram PCC is the Price

Consumption Curve. It is sloping


downwards to the right. Any point on
the Price Consumption Curve will
indicate the equilibrium position of
the consumer under the Price Effect.
In this diagram when the price of
X falls, the consumer purchases
more of X and less of Y.

Indifference Curve Analysis - Price Effect (Contd.)


Shapes of Price Consumption Curve

With a fall in the price of one commodity there will be some


extra income with the consumer. It can distribute this real
extra income on the two commodities in different ways. So
the Price Consumption Curve will have different shapes.
Below we draw the different shapes of the Price
Consumption Curve.

Indifference Curve Analysis - Price Effect (Contd.)


In the above diagram

PCC is the price


consumption curve. It
is a horizontal straight
line. It indicates that
with a fall in the price
of X, the consumer
purchases more of X
and the same quantity
of Y

Indifference Curve Analysis - Price Effect (Contd.)


In the above diagram

PCC, the price


consumption curve, is
sloping upwards to the
right. This indicates
that with a fall in the
price of X the
consumer purchases
more of X and more of
Y.

Indifference Curve Analysis - Price Effect (Contd.)


In this diagram the

price consumption
curve is sloping
upwards to the left.
This indicates that
with a fall in the price
of X, the consumer
purchases less of X.
This is applicable in
case of Giffen goods.

Questions