Indifference curve analysis
The utility analysis lost its popularity because of its assumptions like utility can be measured, marginal
utility of money remain constant. To replace these old concepts the modern economists have
introduced an indifference curve analysis. This technique was originally developed by F.Y Edgeworth in
1881. Later picked up by Irving Fisher, who tried to give a concrete shape to it in 1892.It was further
developed by Pereto. In 1931, I.R Hicks and Allen gave a scientific treatment to this new analysis,
Indifference curve analysis is now being used in the analysis of many economic problems.
The indifference curve analysis excludes all the defects of utility analysis. It is based on ordinal utility.
Here utility cannot be measured but it can be ranked. It expresses the dissatisfaction in terms of scale of
preference. That’s why it is called ordinal approach.
According to indifference curve analysis utility can’t be measured but it can give preference or ranking
for different combinations of two or more goods for ex x and y, which gave the same satisfaction.
Therefore the consumer can select any good in the combination. So it is called as preference approach.
The indifference curve shows the various combinations of commodities which give sane satisfaction to
the consumer. The consumer may think of several commodities but for out convenience and simplicity
we shall assume two commodities only. An indifference schedule may be defined as a schedule of
various combinations of two goods that will be equally acceptable to the consumer. The various
combinations of the following two goods give the same satisfaction to the consumer.
Indifference Schedule
Combination
First
Second
Third
Fourth
Fifth
Oranges
20
15
11
8
6
Apples
1
2
3
4
5
The above indifference schedule shows the various combinations of the two commodities which derives
same satisfaction. The consumer is indifferent between these combinations which yields same
satisfaction. Now we can trace the indifference curve with the help of indifference schedule.
y
20
15
11
8
6
o
1
2
3
4
5
x
In this diagram the ox axis represents apples and oy axis represents oranges. IC curve is the indifference
curve. This curve shows the five combinations of two combinations that is 20 oranges and 1 apple, at
point A, 15 oranges and 2 apples at point B. In this way the combinations of the tow commodities
continues up to point E. If we join all these points we can get IC curve. It is called indifference curve.
Indifference map –
In the above set of indifference curve the consumer is able to derive a particular quality of satisfaction.
Suppose if he wanted to get more satisfaction this process of combination must be continued. For this
purpose we have to draw another indifference curve which is parallel to the previous indifference curve.
This can be shown in the following diagram.
This indifference maps shows the equal satisfactory combinations of the commodities at each level of
total income. There are various terms in this indifference map such as IC1, IC2, IC3, IC4, etc. All the points
on any one of the curve give the same satisfaction.
For example - Point AB on IC give the same satisfaction C and D point on IC2 give the same satisfaction.
Suppose if the consumer wanted to get more satisfaction he has to go for higher indifference curve. So
every indifference curve which moves upwards in the form of IC2, IC2, IC3, IC4 give higher satisfaction to
the consumer. Accordingly IC2 yields greater satisfaction than IC1 and IC3 will be greater than IC3 etc.
This indifference map represents a collection of indifference curves. Each curve shows certain level of
satisfaction to the consumer. The different IC curves are numbered in ascending order, as shown in the
diagram. So every IC curve which comes on right side derives greater satisfaction and left side curve
gives lesser satisfaction.
Properties of indifference curve.
1.
IC slopes downwards from left to right
The IC curve always slopes downwards from left to right, then only we can show the consumer is
purchasing one commodity more and the other one less. In our ex the consumer purchases more apples
and fewer oranges.
2.
IC curve should not be horizontal
In this diagram the IC curve is horizontal and it consists of combinations of apples and oranges but they
are equally substituted for 5 apples, here the HRS instead of decreasing it is equally substituted. In this
case the consumer will not get the same satisfaction from all the combinations. Actually satisfaction
may increase. Therefore the IC curve cannot be horizontal.
3.
The IC curve should not slop upwards to the right.
In this diagram the consumer moves upwards along with the curve. It implies he gets more and more of
both the commodities. Therefore the total satisfaction increases. At point P the consumer gets OM of
apples and ON of oranges. At point Q he gets ON1 of oranges and OM1 of apples, obviously at this point
the consumer gets more of both the commodities and the satisfaction will be greater than P. Therefore
the IC curve should not move upwards.
4. The IC curves are Convex at the origin.
The IC curves are convex to the origin, and then only we can show the diminishing marginal rate of
substitution. (DMRS)
In this diagram IC is convex to the origin because the consumer purchases more apples and fewer
oranges. This indicates the HRS. If the IC curve were to be concave or straight like HRS may not be
appropriate, therefore, the IC curve must be always convex to the origin.
5. Indifference curve cannot intersect each other
This can be shown in the following diagram
In this diagram the two indifference curves intersect each other. The satisfaction point A lies on IC2
represents higher satisfaction to the consumer than the point B which lies on IC1 but the point C which
lies on both the curve shows the satisfaction point A and B are equal. This is actually impossible
therefore IC curve cannot intersect each other.
6
Every indifference curve to the right represents higher level of satisfaction.
Every indifference curve which comes right derives greater satisfaction because the right side IC2 cure is
above the IC1 therefore any combination on IC2 gives more satisfaction than IC1. In the same way IC3
gives more satisfaction than IC2 and so on.
7
IC curve will not touch any axis
In indifference curve cannot touch either axis. This can be shown in the diagram. If IC2 touches X axis a
point M the consumer will purchase only apples and not oranges. In the same manner if IC1 touches y
axis at point L the consumer will purchase only oranges not apples. But the consumer wanted to buy
two commodities. Therefore, the IC curve cannot touch any axis.
Marginal Rate of Substitution
The concept is the basis of indifference curve and the modern theory of consumer demand. If
the consumer exchanges additional unit of one commodity for another commodity it called
marginal rate of substation (MRS). In this MRS the consumer reduces the consumption of one
commodity and increase the consumption of another commodity if he wants to get same
amount of satisfaction. To explain this concept we can consider earlier examples.
Combination
Oranges
Apples
Substitution
1
20
1
-
2
15
2
5:1
3
11
3
4:1
4
8
4
3:1
5
6
5
2:1
This table shows the five different combinations of apples and oranges which derive the same
amount of satisfaction to the consumer because all the five combinations represented by the
same indifference curve. Here the consumer increases the purchase of apples and reduces the
purchase of purchase of oranges. It means he is substituting apples for oranges. The rate of
substitution between apples and oranges goes on diminishing, in the 1st combination 20
oranges and one apple is the 1st stage of satisfaction. In the 2nd stage 15 oranges and 2 apples
to get one apples extra the consumer has to forgo 5 oranges. It means 5 oranges were
substituted for one apple. The ratio of apples and oranges is 5:1. In the third combination the
ratio is 4:1. In the 5th combination the rate of substitution the ratio of substitution will be 2:1.
Thus the rate of substitution goes on diminishing. It means if the consumer increase the
purchase of apples the stock of oranges on the other hand decreases and the satisfaction of
additional unit of orange increases. That’s why the consumer substitutes only 5 oranges for one
apple. The rate at which the consumer purchases one commodity by forgoing the other
commodity is called marginal rate of substitution.
In this diagram we have drawn a stair case which descends to the right. The steps of this staircase are
equal width but the height of the staircase diminishes from top to bottom. This is due to the fact that
the no of apples continues to increase and the no of oranges continues o decrease at a progressively
diminishing rate, because of this reason the IC curve is convex to the origin.
Consumer’s equilibrium through indifference curve
The consumer spends all his income o maximise his satisfaction it is called consumer equilibrium. It s not
possible to know the consumer equilibrium by indifference curve only. For this we must know the
income of the consumer and price of the goods. Therfore we should consider both indfference map and
price line. If we incorporate the price line into indifference map we can get consumer equilibrium.
Price line or Budget line
If the consumer spends all his income on various conbinations of two substitutable commodities which
consists a line is called price line or budget line. This can be explained by an example.
Suppose that the consumer has a sum of Rs 20 in his pocket and he want to spend it on two
commodities manely coffee and cigereate. The price of coffee is Rs 2 and the price of cigerete is Rs 1.
Now consumer can purchase 10 cups of coffee or 20 cigeretes ot he can purchase both .
As per the illustration of the diagram the consumer can spend his entire income on cigarette,
he can purchase 20 cigarettes or 10 cups of coffee. If we join A and B points we get the price
line. In this diagram the consumer can purchase any combination of both the commodities
which comes on AB price line.
He cannot purchase the point E above the price line because the consumer doesn’t have at his
disposal the necessary money and this point E and above the price line. Therefore any
combination of the two commodities must follow on the budget line.
In order to explain how the consumer achieves equilibrium or achieves maximum satisfaction we have
to bring together he indifference map and the price line.
In this diagram the consumer reaches his equilibrium at point T because the price line touches
the IC3 curve at this point. Accordingly the consumer can purchase OM quantity of coffee and
ON quantity of cigarette with his limited income the consumer is able to purchase only on IC3
curve and he will be in equilibrium position.
The substitution effect
The substitution effect takes place when the income of the consumer remains constant and the
relative prices of the tow commodities changes. Suppose the price of one commodity rises and
the other decreases now the consumer is neither better off nor worse off than before. However
he will rearrange this purchase to compensate the loss. It means the consumer substitutes
relatively cheaper goods for the relatively costlier ones. This can be shown in the following
diagram.
Let us assume the consumer purchases oranges and apples. Supose if the price of the apple rises and the
oranges decreases at this moment the consumer wil purchase more oranges and less apples.
In this diagram the consumer is in equilibrium at point Q because the price line AB touches the IC curve.
Here the consumer purchases OM of oranges and ON of apples now the price of apples rises and the
oranges decreases. Due to change in price consumer’s budget line wil also change from AB to A1B1. At
this level the consumer purchases OM1 of more oranges and ON1 of fewer apples. Now the consumer
is in equilibrium at the point Q1 because the new budget line A1B1 touches the IC curve at this
point. This is consumers new equilibrium point this is the substitution point.
Income effect
The effect of changing consumer’s income on his satisfaction is known as the income effect.
Here the consumer will be able to enjoy more or less satisfaction when his income increases or
decrease assuming that the prices of the two commodities remain constant. Every increase in
income takes him to higher indifference curve. He becomes better off than before. Every
decrease in income on the contrary brings him down to the lower indifference curve. He
becomes worse off than before. The income consumption curse traces the income effect.
The income effect can be shown in the following diagram.
Let us suppose that the consumer wants to burchase apples and oranges. At AB price line the soncusmer
is in equilibrium at point T1 because IC! Curve intersects the price line AB. At this point the consumer
purchases 5 oranges and 5 apples. If the income of the consumer increases the price line shifts upwards
in the form of A1B1, A2B2, A#B# respectively. The increase in the income enables the consumer to
xonsume more of both the commodities. The equilibriem point 3 will also move towards higher IC curve
in the form of T1,T2,T3. If we join all these equilibrium points we obtain the curve known as
income curve. The income doesn’t trace the effect of a change in income of the consumer on
the consumption of commodities.
The price effect
The effect of a change in the price of a commodity on its purchase is known as the price effect.
We shall now assume that the money income of the consumer remains constant and the prices
of orange falls and apples remain unchanged or constant. Now the consumer purchases more
oranges. The fall in the price of oranges actually increases the real income of the consumer
though his money income remains constant. The cheapness of the oranges induces the
consumer into purchasing more and the price line shifts towards right.
This price effect can be show in the following diagram.
In this diagram the consumer is in equilibrium at point Q where the IC curve is tangent to AB price line.
At this level the consumer purchases 10 oranges and 10 apples. Now the income of the consumer and
the price of oranges fall. Now the consumer wants to purchase more of ornges his price line will rotate
anti clock wise in the form of AB1. Suppose if the price of orange is still falling the price line will shift
towards right in the form of AB2 and the consumer equilibrium point will also changes from Q ro Q1.
Here the connsumer will go on purchaing more and more oranges. There we get new equilibrium points
such as Q,Q1,Q2 etc. If we join al these points we get a curve known price consumption curve (PCC).
Suppose if there is any rise in prices of orange the consumer purchases less of oranges and the price line
will be clockwise.
The price consumption curve shows only various combination of oranges and apples that give maximum
satisfaction to the consumer.