Chapter 4
Consumer Demand : The Indifference Curve
Approach
4.1 Utility
A. Definiton
1. Traditional (cardinal concept)
Utility is a measure of the _______________ derived from consuming
goods. That is, an individual can tell how many utils he enjoys from
consuming a good.
Criticism :
Utility cannot be measured objectively. It is a __________ concept and is
not homogeneous.
2. Modern (ordinal concept)
Utility is simply an indicator for __________ options in accordance with
one’s ____________ .
E.g. To say I have a higher utility on chicken wing than ice-cream is the
same as saying that I would choose ______________ when I am
presented with a choice between ice-cream and chicken wing. There is no
absolute significance on the numerical values of utility that I assign to
ice-cream and chicken wing.
In fact, utility is nothing more than an arbitrary assignment of numbers
among options for the purpose of _____________ and ____________
human behaviour.
B. Utility and use value
Utility
Observable
Unobservable
Interpersonal comparison is possible
Interpersonal comparison is not
possible
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Use value
Usually measured in terms of money or
other goods
Usually used in case when measurement
cannot be in terms of money or other
goods sacrificed
Exercise 1
‘The postulate of utility maximization is that whatever an individual does, he
is maximizing utility. However, since utility is not observable, theory deriving
from this postulate is therefore not testable and hence not refutable.’
Do you agree ? Explain.
Ans. This postulate itself is not observable and tested. If ________________
_________________________________________________________
_________________________________________________________
However, the maximization postulate cannot be tested but __________
_________________________________________________________
_________________________________________________________
_________________________________________________________
_________________________________________________________
For example, ______________________________________________
_________________________________________________________
_________________________________________________________
_________________________________________________________
* Words from S.N.S. Cheung
For utility maximization postulate to be useful, one has to ask 2 questions :
 What gives rise to utility ? (E.g. friendship)
 What is the cost involved in obtaining that entity ? That is, what are
the things one has to give up in order to get that entity ? (E.g.2
million dollars)  things that are given up can then be measured
Think about this :
If utility is measured by the amount of another good one is willing to pay for a
good  concept of utility is similar to the concept of _______ ________.
4.2 Indifference Curve (IC) Analysis
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A. Basic assumptions
B. Meaning of the indifference curve
- Refer to table in p. . It is a 2-good model. The 4 combinations of X and
Y give the _________ level of total utility to Mr A.
- When we plot the data on a plane  indifference curve.
It shows all combinations of 2 goods that give the same total utility to a
particular individual.
- A set of ICs  indifference map
The further away is from the origin, the __________ is the level of total
utility obtained.
C. The slope of the IC
___________________________________ (MRS)
It is the amount of one good that must be added to a basket of goods to replace
one unit ___________ in the amount of another good, keeping the individual
on the _________ total utility level.
From the other side, it is the maximum amount of _________ ________ that a
person is willing to forgo for an ____________ unit of a good.
By definition, MRS =
D. Properties of IC
1. ICs are ____________ sloped
Since economic goods are ____________, reduction in the amount of one
good can be accompanied by an ___________ in the amount of another
good so as to remain at the same level of ________________ .
2. ICs cannot ____________
- point a and c are on the same IC  a is
b/
c/
a
______________ to c
U2 - similarly, point a is indifferent to ____
U1
 _____ is indifferent to _____
- But it should not be the case, point b in
fact is __________ to c.
3. ICs are ___________ to the origin
It is because of the postulate of _________________________.
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There is an interesting implication of this postulate : ‘Balanced bundles
of goods are preferred to extreme bundles.
Illustration :
4. There are infinite number of ICs
E. What if IC is not convex ?
1. Bad
A bad is an entity of which _______ is preferred to ________, e.g.
loneliness, dirtiness, risk.
(a) 2 bads
(b) 1 good and 1 bad
Y is a good and X is a bad
Y is a bad and X is a good
2. Neuter
It is an entity of which an individual is indifferent between having more
or less, e.g. charity.
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Y is a good and X is a neuter
X is a good and Y is a neuter
3. Free good
It is an entity of which no one wants more of because everyone is
___________ with the amount he or she has.
X is a free good
Y is a free good
4. Perfect substitutes
5. Perfect complements
Q. What if MRS is increasing instead of decreasing ?
Ans. IC will be _____________ to the origin.
F. Budget constraint
Budget line (BL) constraints the consumption behaviour of the individual.
1. Meaning
BL shows all combinations of 2 goods that are just obtainable, given an
individual’s money income and the prices of the 2 goods.
Illustration:
E.g. Income (I) = $100, Px = $10, Py = $5  combinations that can just
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be bought are :
Qx
0
Y
3
4
5
10

20
Qy
X
2. Slope of BL shows:
(a) Price ratio
Slope =
(relative price)
(b) Opportunity cost
3. Changes in budget constraint
(a) Changes in relative prices
E.g. Given I = $120, if
(i)
Px = Py = $4
(ii)
Px = $5, Py = $4

(iii)
Px = $3, Py = $4
Conclusion : A change in the relative price alters the _________ of the BL. The
higher the price of good X relative to the price of good Y, the ________ of the BL and
vice versa.
Q. How would you shift the BL if Py changes with I and Px remain the same ?
(b) Changes in money income
E.g. Given Px = $6, Py = $5, if
(i)
I = $120
(ii)
I = $90

(iii)
I = $150
Conclusion : With relative price being unchanged (i.e., the _________ of the BL
unchanged), when I increases, BL shifts __________ parallely and vice versa.
(c) Proportional changes in all prices
E.g. Given I = $120, if
(i)
Px = $4, Py = $6

(ii)
Px = $8, Py = $12
Conclusion : With fixed I and equal percentage change in all money prices (which
leaves relative prices unchanged, e.g. Px/Py =
in both cases)  if P rises, BL
shifts ____________ parallely and vice versa.
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(d) Offsetting changes in money income and prices
(i)
I = $120, Px = $4, Py = $6
(ii)
I = $132, Px = $4.4, Py = $6.6 
Conclusion : An equal percentage change in all prices is combined with an equal
percentage change in I, the BL will be ____________ .
G. Consumer’s equilibrium
-
Under IC analysis, an individual maximizes ___________ subject to
-
budget constraint.
To maximize utility, the household will try to attain the ___________ IC
given the budget constraint.
-
The tangency rule : the household is at equilibrium (maximizing his utility)
when the BL is ___________ to an IC.
Illustration :
H. Derivation of the consumer’s demand curve
A demand curve shows the relation between ____________ and
______________ of a good. We can derive this curve by using IC and BL.
1. Given the initial equilibrium situation below :
 1st combination :
2. Suppose the price of X falls, the BL rotates ___________ as more X can
be bought with the same money income, given the price of Y unchanged.
(a) The maximizing individual will reach a new equilibrium position.
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 2nd combination :
-
It is shown that ________ X is
consumed when Px falls.
(b) By plotting the value of Px and Qd of X, a ____________ sloping
demand curve is derived.
3. It is shown that every point on an individual demand curve represents an
_____________ position of a maximizing individual household.
4. The demand curve is called ___________________ demand curve. It
shows the relationship between P and Qd, holding __________________
constant.
*Supplementary Information :
1. Strong preference for a good is indicated by a ___________ IC and weak
preference by a __________ IC.
2. A change in preference in favour of good is represented by a __________
rotational shift of the IC.
3. If ICs are concave, the tangency point is a utility ___________ point.
Increasing MRS and specialization in consumption
Exercise 2
1. With concave ICs, draw the corner solution occurring on y-axis.
2. Show how convex ICs can have a corner solution.
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I. Reaction of a household to changes in income
1. When I changes with relative prices remain unchanged, it leads to
________ shift of the BL.
2. When I changes, the equilibrium position will change also. Joining all the
equilibrium points, we can get the ______________________ (ICC)
which shows the optimal amount of commodities bought at each possible
level of __________ __________, ceteris paribus.
3. It doesn’t follow that an increase in I must raise the demand for a good.
When the I of the household rises, the demand for good X decreases.
Then, good X is an _________ good.
(a) When X is an inferior good
(b) When Y is an inferior good
-
Conclusion :
If both goods are normal goods, the ICC will be __________ sloping.
If one good is superior/normal and another one is inferior, the ICC will be
__________ sloping.
The IC approach yields no definite prediction on the effect of a change in
I.
Exercise 3
1. Is it possible to draw an income-consumption curve for the case of both X and Y
being inferior ?
2. Draw the ICC for the cases below:
(a) when good X is a neutral good
(b) when good Y is a neutral good
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J. Reaction of the household to changes in price
1. When relative prices change with money income being constant, the BL
will
.
2. When relative price changes e.g. Px falls  the equilibrium position will
moves, attaining a
and
IC. Joining all these
equilibrium points, we will get the _________________________ (PCC)
which shows the optimal amount of commodities bought at different levels
of _________ ______ , holding the _________ income constant.
Exercise
4
1. (a) Sketch (i) a vertical
(ii) a horizontal PCC
(b) Derive the corresponding demand curves. What are the elasticities of
demand for the above cases ?
(a)(i)
(b)
0 A vertical PCC
0
(a)(ii)
A __________ D curve
(b)
0
A horizontal PCC
0 A _________________ D curve
2. Using IC approach to derive an upward sloping demand curve.
Y
Px
10
0
X
0
Qx
K. The substitution effect (SE) and real income effect (IE)
1. It is possible to the Qd to rise or fall arising from a decrease in P because
there are 2 effects resulting from a decrease in P.
(a) Substitution effect (SE)
When price of a good falls  it becomes relatively cheaper  consumer
would buy ________ of that good and consume _______ of its
substitute.
SE is always positive / negative.
(b) Income effect (IE)
- Changes in price will bring changes in _________ income or
purchasing power.
- When real income increase, a consumer will buy more if the good is a
_________ good and buy less if the good is ___________
 income effect is _________ for normal goods and is _________ for
inferior goods.
Illustration on SE and IE.
For example, income (I) = $6, price of apple (Pa) = $1, price of orange (Po) = $2
With given preference, we get the original combination : 2 apples & ___ oranges
Now, Po falls from $2 to $1  price effect --- SE & IE.
SE : With this change, buying the original combination needs only _____, to
hold the real income constant, _____ is supposed to be taken away.
∵ P ↓ Qd
∴ consumption of orange ___ , say, from ____ to ____  consumption
of apple ____ from ____ to ____ .
IE : With the change in price, real income rises by ____  buy more apple and
orange if both are _______ goods. (Say consumption of both apple and
orange rise by 1.)
To conclude the price effect :
Apple
Original combination
Orange
2
SE
+1
IE
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Price effect
New combination
2. Ways to decompose the price effect into SE and IE
(a) John Hick’s method (more commonly used)
(b) Eugene Slutsky’s method
3. Income effect and shapes of demand curve
(a) When IE > 0
Px
Y U1 U2
E1
/ E1

E2
E2’
BL1
0
BL2
/ E2
B2’
D
X
SE IE
(b) When IE = 0

(c) When IE < 0
(i) SE > IE

(ii) SE = IE
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Qx

(iii) SE < IE

L. Some applications of the IC approach
1. Indirect tax
If it is imposed on good X  Px ______  BL rotates _________ ……….
2. Income tax
This will _______ real income  parallel________ shift of the BL ………
3. Price subsidy
If it is given to good X  Px _____  BL rotates _______ ……….
4. Cash subsidy
It will ________ real income  parallel ________ shift of the BL……..
People will consume more of the subsidized good under price / cash subsidy.
However, given the same amount of subsidy, people will prefer it to be in price
/ cash subsidization.
5. Voucher
- It is a gift of income to be spent on a specified good.
- Consumer is not allowed to spend part of the voucher on other goods.
- If coupons entitle a consumer to buy a certain good at a lower price, the
BL will be that shown on p.
6. Buffet dinner
- Customers are allowed to eat as much as they desire after paying a fixed
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admission charge  BL is a _________ line.
-
The IC theory implies that given the same expenditure, one consumers
_______ food at a buffet than when food is priced on a per plate basis.
7. Other special pricing arrangements
Actually, the ‘position’ of BL is determined by ________ (real).
the ‘slope’ of BL is determined by _________ _______.
the ‘shape’ of BL is determined by _________ ____________.
constant price
_________ price
_________ price ___________ /
_____________
BL1
BL2
8. Extracting consumer’s surplus
9. Time as a constraint
Refer to the textbook p.114
10. Number of children per family
Refer to the textbook p.110
***THE END***
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