Indifference Curve Analysis

Indifference Curve Analysis Kishor Bhanushali

Indifference Curve Analysis The indifference curve analysis is a technique for explaining how choices between two alternatives are made. Indifference curve is locus of different combinations of two commodities between which consumer is indifferent

Indifference Schedule Combinati Apples on

Mangoes

A

15

1

B

11

2

C

8

3

D

6

4

E

5

5

Properties of indifference curve 1. Indifference curves will be downward sloping 2. Tow indifference curves cannot intersect or touch each other 3. An indifference curve must of convex to the origin

Indifference Curve & Map Indifference Curve

Indifference Map Y

Y

a

A

a’

B

a”

C IC

IC 0

b b’ b”

X

0

IC IC X

Budget Line or Budget Constraints Budget 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 purchase at the given prices Shift in budget line due to change in income, prices reaming the same Shift in budget line due to change in prices, income remaining the same

Marginal Rate of Substitution MRS refers to the amount of one good that an individual is willing to give up for an additional unit of another good while maintaining the same level of satisfaction or remaining on the same indifference curve Indifference Schedule Combination

Apples

Mangoes

MRS

A

15

1

-

B

11

2

4

C

8

3

3

D

6

4

2

E

5

5

1

( X )( MUx)  ( Y )( MUy ) MUx / MUy  Y / X

The Equilibrium Position of Tangency

The consumer is in equilibrium when he maximizes his utility, given his income and market prices of the commodities. X

A

E IC3 IC2 IC1

0

B

V

Degree of Substitutability and Indifference Curves

Y

o

Ordinary Good

Y

Xo

Perfect Substitutes

Y

X o

Perfect Complements

X

Derivation of the Demand Curve through Indifference Curve Through Price Consumption Curve PCC represents successive points of tangency between the different budget lines and the indifference curves.

Income Consumption Curve Income consumption curve shows how the consumption of two goods is affected by changes in income when prices of both the goods are given and constant. ICC shows the effect of the changes in income on the equilibrium quantities purchased of two commodities. The commodity is said to be normal if the consumer consumes more units of the commodity as his income increases, prices remaining the same (ICC will be upward sloping) If consumer purchases less units of one of the commodity as his income increases, the commodity is said to be inferior (ICC will be backward bending)

Income Effect Income effect is change in the consumption of a good arising out of the change in the purchasing power of money, which occurs due to price change.

Substitution Effect The substitution effect measures the change in the purchase ofa good, which arises out of the changes in its relative prices alone. The Slutsky measure of substitution effect Budget line is shifted in such a way that the consumer can purchase, if he likes to purchase, the previous combination New budget line passes through the initial equilibrium point

Price Effect Price Effect = Substitution Effect+ income effect Y

Price Effect = M1M3 Substitution Effect = M1M2

A

Income Effect = M2M3

D P R

S IC3 IC2

0

M1

M2

B M3

E

IC1

CX