INDIFFRENCE CURVE ANALYSIS OF CONSUMERS EQUILIBURIUM

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• We are all consumers. Right ?
• Who is a consumer ?
• Consumer: A consumer is a person who purchases and uses goods and services in order to satisfy his wants.�
• Why do we consume goods ?�
• It has utility in our life.�
• What is UTILITY ?�
• Utility is an economic term introduced by Daniel Bernoulli referring to the total satisfaction received from consuming a good or service.
• It is the want satisfying power of a commodity.�
• So in order to satisfy our needs we are consuming goods and services ???

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• Goods and services are brought by us in order to reach the highest level of satisfaction. That is called CONSUMERS EQUILIBRIUM.

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• (A point from where we won’t be willing to increase or reduce our consumption)

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• So in order to find out our equilibrium, first we have to decide what quantity of a good/goods we should buy at given price at a given point of time.

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• To understand consumer behaviour, there are three important theories…

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• Cardinal Utility Approach of Alfred Marshall

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• Ordinal Utility Approach of J R Hicks

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• Revealed Preference Theory of Paul A Samuelson

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CONSUMPTION BUNDLE

• As a consumer Is it possible for us to buy everything we wants ?
• Do you think so ???
• Since wants are unlimited and resources in our hand is limited, we have to make a choice.
• Normally we buy many goods. But for ease of analysis let us assume that there are only two goods.
• Any combination of the amount of these two goods is called a CONSUMPTION BUNDLE.
• For Example:- bundle (5,10) contains 5 units of good X and 10 units of good Y.

CONSUMER’S BUDGET

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• The consumer can spend his entire income either on good X or on good Y or a combination of both.
• Consumer’s budget is the money income of the consumer which he can use to buy goods and services.
• For Example:- To buy sugar and tea Sindhu has Rs.100 and Sethu has Rs 75.

So here, Sindhus budget is Rs.100 and Sethus budget is Rs.75.

BUDGET SET

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• A set of consumption bundles is known as BUDGET SET.

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• Refers to the attainable combinations of a set of two goods , given prices of goods and income of the consumer.

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• Budget set includes all combinations of goods X and Y (given their prices) on which the actual expenditure is equal to or less than the given income of the consumer.

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• It is also called budget constraint as it shows the limit (constraint) up to which the consumer can buy a set of two goods with his given income.

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BUDGET LINE

Slope of the Budget Line ???

• The slope of the budget line is equal to the ratio of the prices of two goods.

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L

B

L

(Attainable and Non-attainable Regions )

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x

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X

Y

O

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SHIFT IN BUDGET LINE

• The two determinants of the budget line are:
• Prices of goods,
• Consumer’s income spent on the goods.

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(i) PRICES OF GOODS :

1. When Price of Good X changes : (Py & income(M) remain unchanged)
1. When price of X increases :
1. Initial budget line BL
2. when price of X increases, budget line shifts left.
3. New budget line BL1

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• SLOPE – INCREASES( OB/OL1>OB/OL)

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Px’’.X+Py.Y=M

Px.X Py.Y=M

Px’. + X Py.Y=M

GOOD X

GOOD Y

L

L1

B

• When price of X decreases :
• Initial budget line BL
• when price of X decreases, budget line shifts right.
• New budget line BL1

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• SLOPE – DECREASES (OB/OL1<OB/OL)
• When price of Y increases : (Py’>Py)
• Initial budget line BL
• when price of Y increases, budget line shifts left.
• New budget line B1L

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• SLOPE – DECREASES (OB1/OL<OB/OL)

B

L

L1

Px.X + Py.Y=M

Px’.X + Py.Y=M

L

B

B1

Px.X + Py.Y=M

Px.X + Py’.Y=M

GOOD X

GOOD Y

GOOD X

GOOD Y

• When price of Y decreases : (Py’<Py)
• Initial budget line BL
• when price of Y increases, budget line shifts rightt.
• New budget line B1L

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• SLOPE – INCREASES( OB1/OL>OB/OL)

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B

B1

L

Px.X + Py.Y=M

Px.X + Py’.Y=M

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(ii) INCOME OF THE CONSUMER : (Px & Py remain unchanged)

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• Initial budget line BL.

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1. INCREASE IN INCOME :

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• BL shifts right to B1L1

• Slope remains SAME (Px/Py)
• As no change in Prices.

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(ii) DECREASE IN INCOME :

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• BL shifts left to B2L2

Slope remains SAME (Px/Py)

• As no change in Prices.

..\VIDEOS\budget line and its slope.mp4

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• Also known as Ordinal Utility Approach

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• Presented by Prof. Hicks in his work “VALUE AND CAPITAL” in 1939
• The concept of indifference curve analysis was first propounded by British economist Edgeworth was put into use by Italian economist Wilfredo Pareto during the early 20th century. However, it was brought into extensive use by economists J.R. Hicks and R.G.D Allen.
• Hicks and Allen criticized Marshallian cardinal approach of utility and developed indifference curve theory of consumer’s demand. Thus, this theory is also known as ordinal approach

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• Indifference curve is a geometrical device that has been used to replace the cardinal utility approach.

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• IC analysis measures utility ordinally not cardinally.

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INDIFFERENCE CURVE ANALYSIS

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What is an Indifference Curve ???

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• IC is defined as the locus of points of combinations of two goods X and Y ( say apple and orange) which gives the consumer the same level of satisfaction.
• Indifference Curve shows the different combinations between two commodities which gives same level of satisfaction to a consumer.
• It is a graph showing the bundles that gives the consumer the same level of satisfaction.

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• An IC is drawn from the Indifference schedule of a consumer.

INDIFFERENCE SCHEDULE

• Simply, an indifference curve is a graphical representation of an indifference schedule.

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• �The above table shows the following:�

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• Combinations A, B, C, D and E are specified by the consumer according to his scale of preferences for the two goods.
• Each combinations offers the same level of satisfaction to the consumer so that (in terms of the level of satisfaction)

combination A= combination B= combination C= combination D= combination E.

• As there is no difference among the above five combinations (A, B, C, D, E), we may say that the consumer is indifferent across these combinations. Together, these combinations form an indifference set of the consumer.

• If these combinations are plotted on a diagram and are joined by a line this becomes an Indifference Curve.
• On a graph, an indifference curve is a link between the combinations of quantities which the consumer regards to yield equal utility.

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• The IC is the locus of the points A,B,C,D and E, showing the combinations of two goods which the consumer is indifferent.

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• Why is he indifferent ?????
• Because of SAME LEVEL OF SATISFACTION
• Also known as ISO-UTILITY CURVE. Because utility/satisfaction is same at all points (i.e.)

Utility of point A= utility of point B= utility of point C= utility of point D= utility of E

(1X+12Y) = (2X+8Y) = (3X+5Y) = (4X+3Y) = (5X+2Y)

• Since each combination on the diagram gives the same level of satisfaction to a consumer on which he is indifferent, this curve is called as “Indifference Curve”

ASSUMPTIONS OF INDIFFERENCE CURVES�

• i) Rationality: The consumer is assumed to be rational. He aims at maximising his benefits from given income & prices & does it.
• ii) Ordinarily: Consumer can rank or order the scale of preference as per the utility derived from the consumption of goods. In case of 3 goods there are 3 possibilities i) X is preferred to Y ii) Y is preferred to X iii) X & Y are equally preferred i.e. consumer is indifferent between two goods.
• iii) Diminishing marginal rate of substitution (MRSxy): Slope of indifference curve is called MRSxy Amount of good Y sacrificed in order to consume one additional unit of good X is Marginal Rate of Substitution of x & y. It is assumed that MRSxy diminishes with greater quantities of X. As consumption of good X increases, utility derived from it falls due to LDMU, so he is ready to sacrifice less of Y.
• iv) Consistency of choice: Consumer is consistent in his choice i.e. If X is preferred to Y in a time period then Y will not be preferred over X in another time period.

• v) Transitivity of choice: If X is preferred over Y & Y is preferred over Z then X will be preferred to Z also.
• vi) Monotonic Preference : A consumer’s choice is monotonic if between any two bundles the consumer prefers the bundle which has more of at least one of goods & no less of another good. Ex. A consumer with monotonic preference will prefer the bundle (2, 3) to bundle (2,2) (1,3) .
• Vii) Two commodities :
• It is assumed that the consumer has fixed amount of money, all of which is to be spent only on two goods. It is also assumed that prices of both the commodities are constant.
• Viii) Non satiety :
• Satiety means saturation and indifference curve theory assumes that the consumer not reached the point of satiety. It implies that the consumer still has the has willingness to consume more of both the goods. The consumer always tends to move to a higher indifference curve seeking for higher satisfaction.

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POINTS ON, ABOVE & BELOW INDIFFRENCE CURVE

SHAPE OF AN INDIFFRENCE CURVE

INDIFFERENCE MAP

• A set of indifference curves showing different levels of satisfaction to the consumer is called an “Indifference map”. Indifference curve to the right shows higher utility level because it represents more quantity of both the goods taken together and more quantity of goods means higher satisfaction.

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• In the above diagram, there are four indifference curves. IC4 represents highest level of satisfaction and IC1 represents lowest level of satisfaction.

• As the consumer moves along the IC from left to right, the amount of good X increases and the amount of good Y decreases. The MRS between good X and Y goes on deminishing. This is known as deminishing marginal rate of substitution.

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DEMINISHING MARGINAL RATE OF SUBSITUTION

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• We can clearly see that the rate of decrease in consumption of Good Y is not the same as rate of increase in consumption of Good X. Similarly, rate of decrease in consumption of Good Y has gradually decreased ∆Y1 < ∆Y2< ∆Y3 <∆Y4 even with constant increase in consumption of Good X.
• when the consumer moves from bundle A to B, B to C, C to D, D to E, Marginal Rate Of Substitution goes on decreasing…

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∆Y1

∆Y2

∆Y3

∆Y4

CAUSES OF DEMISHING MARGINAL RATE OF SUBSTITUTION

• Goods are not perfectly substitutable :
• If one good can perfectly substitute another good, both the goods are regarded as same. and, thus, increase or decrease in amount of any good will not cause effect in marginal substitution.
• Increase in one good does not increase the want satisfying power of another good :
• Since two goods cannot be perfectly substitutable, an increase in one good cannot fully satisfy the consumer as the other good.
• For an instance, cigarette and coffee cannot be perfect substitutes to each other. Thus, giving up 4 cups of coffee increases cigarette consumption by only 1 unit, rather than 4 units.

• The want for a particular commodity can be satiable :
• According to marginal rate of substitution, a person can sacrifice certain amount of one commodity (y) in order to increase the stock of other commodity (X). He keeps on sacrificing Y for X until the point of satiety, after which his demand for X starts declining.

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• Also, trading off Y more and more causes decrease in stock of Y, to maintain which he is now willing to forego lesser and lesser of that good with each successive increment of X.

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• 1. Indifference Curve slopes downwards from left to right. Why ?????
• When a consumer wants to have more of a commodity, he/she will have to give up some of the other commodity, given that the consumer remains on the same level of utility at constant income. As a result, the indifference curve slopes downward from left to right.

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PROPERTIES OF INDIFFRENCE CURVE

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• 2. IC curves are convex to the origin. Why ?????

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• The convexity rule implies that as the consumer substitutes X for Y, MRS deminishes. This means that the amount of X is increased by equal amount that of Y deminishes by smaller amounts. The slope of the curve becomes SMALLER as we move to the right.
• rate of decrease in consumption of Good Y

has gradually decreased from 4 to 1 (i.e.)

∆Y1 < ∆Y2 < ∆Y3 < ∆Y4 even with constant

increase in consumption of Good X.

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• Due to DMRS Indifference curve became

CONVEX

∆Y1

∆Y4

∆Y3

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∆Y2

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• 3. A higher IC to the right of another represents a higher level of satisfaction and preferable combination of goods.
• Combination at point Q contains more of both the goods (X and Y) than that of the combination at point S.
• Total utility of commodity tends to increase

with increase in stock of the commodity.

Thus, utility at point Q is greater than utility

at point S.

• i.e. satisfaction yielded from higher curve

is greater than satisfaction yielded from a

lower curve.

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4. IC curves can neither touch nor intersect each other.

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• Point A on the IC1 curve shows a higher level of satisfaction than point B on the IC2 curve, as it lies farther away from the origin. But point C lies on both the curves which yields the same level of satisfaction as point A & B. Thus;

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On the curve IC1 A=C (1)

On the curve IC2 B=C (2)

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Therefore…. A=B

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• This is absurd because A and B are two different points on two different indifference curve . Thus, A# B. So, Two ICs cant intersect each other.

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• An IC curve cannot touch either axis.

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• If it touches X axis , the consumer will be having OM quantity of good X and none of Y.

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• Similarly , if an IC curve touches Y axis, the consumer will have only OL amount of good Y and no amount of good X.

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• Such curves are in contradiction to the assumption that the consumer buys two goods in combinations.

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• According to KOUTSAYIANNIS “ the consumer is in equilibrium when he maximizes his utility , given his income and market prices”

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• A consumer is said to have attained equilibrium when he spends given income or budget in such a way as to yield optimum satisfaction, given the prices of two goods and the consumer’s preference.
• In simple words, a consumer is said to be in equilibrium when he is getting maximum satisfaction out of his limited income.

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• It is the position of MAXIMUM SATISFACTION.

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• According to IC approach, a consumer attains equilibrium at the point where budget line is tangent to IC.

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CONSUMER’S EQUILIBRIUM IN INDIFFRENCE CURVE APPROACH

ASSUMPTIONS

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• The consumer is rational and seeks to maximize his satisfaction through the purchase of goods.
• The consumer consumes only two goods (X and Y).
• The goods are homogenous and perfectly divisible.
• Prices of the goods remain constant.
• The indifference map for goods X and Y are given. The indifference map is based on the consumer’s preferences for the goods.
• The preference or habit of the consumer does not change throughout the analysis.
• The income of consumer is given and constant.

CONDITIONS OF CONSUMERS EQUILIBRIUM :

• three indifference curves IC¹, IC² and IC³.
• the price line PT is tangent to the indifference curve IC² at point C.
• point R and S lie on lower indifference curve IC¹ but yield less satisfaction.
• point U on indifference curve IC³, gets higher satisfaction but that is outside the budget line not achievable to the consumer
• 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.

In this diagram, point E on IC1 which is of concave shape is not stable equilibrium for the consumer as point G or H is preferable to E.

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..\VIDEOS\consumers eq IC analysis.mp4

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THANK YOU