The Indifference Curve

Each point on the IC curve (e.g. point a or b) shows a combination of apples and mangoes which yields the same total satisfaction to the consumer.AMOICab15155

The Indifference Map

A set of indifference curves is called an Indifference Map

Higher indifference curve gives greater satisfaction i.e. it can not be said how much greater utility does IC2 represent than IC1 and IC3, than IC2, and so on.That is, the aggregate utilities are rankable but not measurable; increases in utility cannot be ranked. AMOIC1IC2IC3IC4MangoesApples

The Marginal Rate of SubstitutionHicks: We define marginal rate of substitution of X for Y as the quantity of Y which would just compensate the consumer for the loss of the marginal unit of X.

Causes of diminishing MRS: 1. particular want is satiable 2. Goods are imperfect substitutes

Slope of IC curve = MRSMA (next slide)

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CombinationApplesMangoesMRS of Mangoes for Apples

1151

2112

383

464

555

Properties of Indifference CurvesDownward Sloping to the RightConvex to the originAMAMAM4123abcab125IC1IC1IC61012ab00O000ICICICAMAMAM

.Non-intersectingIC1IC2MMangoesApples

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The Price Line (also called: Budget Line, Price Opportunity Line, Price-income Line, Budget-constraint Line): The line that shows all possible combinations of goods (in this case Apples and Mangoes) that the consumer can buy if he spends the whole of his given sum of money on his purchases at the given prices. The Price LineAMO105

Shifting of Price Line 1) Price change of one good 2) Income change10560AMAM0105168

The EquilibriumConsumers Equilibrium or Maximizing Satisfaction when money income is fixedAssumptions: Conditions:1) The consumer has an Indifference Map 1) Necessary condition: Price2) Money-income and Prices of goods are fixed Line should be tangent3) The consumer acts rationally 2) Sufficient condition: At the4) Each of the goods is homogeneous point of equilibrium an IC and divisible must be convex to the origin Graph of Equilibrium :

AMOIC1IC2IC3abcdeAMe IC4

The Income Effect:the effect on consumers equilibrium of a change in consumers income, relative prices of goods remaining the same. An Income Consumption Curve (ICC) traces out the Income Effect as the consumers income changes, with given relative prices of the two goods.ICC: relationship between income and consumption, while the prices of goods are fixedICC(45 degree line)AMICCAMInferior good AInferior good MICCAM(-) slope indicates inferiority of a good. After a certain point, as income rises, less of a particular good is bought.

The Price Effect:Price-Consumption Curve (which reflects the Price Effect) shows how the consumption of product M changes, as its prices changes, the consumers income and price of A remaining the same. Price Effect = Income Effect + Substitution EffectMA+SE+IEPCCIC1IC2For real income increaseFor relative change in prices of A and M

The Substitution Effect:the change in the quantity of a good purchased which is due only to the change in relative prices, money income remaining constant.The substitution effect is a change in the quantity demanded as a result of a change in relative price after the consumer has been compensated for a change in his real income. That is, there is a movement along the original indifference curve, real income remaining the same.QTAMOPRHBALNKIC1IC2ApplesMangoesBH or AP is the amount of money income that should be taken away from the consumer so that the gain in real income which results from the fall in the price of M is cancelled out.At point the T, the consumer gets the same satisfaction as at Q, because both Q and T are situated on the same indifference curve IC1 Movement from Q to T on the same indifference curve IC1 is due only to the relative fall in the price of M. At the point T, the consumer buys MK more of M than at Q as M is now relatively cheaper. This MK is the substitution effect which involves movement from Q to T. SE

Splitting the Price Effect:Normal good, Inferior good, and Giffen goodSplitting the Price EffectNormal good: SE + IE = + PEInferior good: SE - IE = + PEGiffen good: SE - IE = - PE+SE+IE+SE-IE+SE-IEMMMAAA0 00=+PEPCC+PE =PCC-PE=PCC

The Substitution Effect:Hicks vs. SlutskyHicksian Substitution Effect Slutsky Substitution Effect Eliminates the income-effect by reducing the consumers income (by way of taxation) so that he returns to his (original satisfaction i.e.) original indifference curve IC1, to an equilibrium point conforming to the new price ratio. This has been done by drawing an imaginary budget line parallel to the new budget line and tangent to original indifference curve (IC1)Eliminates the income-effect by reducing the consumers income so that he is still able to buy his original combination of the two goods (i.e. to his original indifference curve IC1 and also to his original equilibrium point) at the new price ratio. This is done by drawing an imaginary budget line through the original equilibrium point

The Substitution Effect:Hicks vs. SlutskyHicksian Substitution Effect Slutsky Substitution Effect Hicksian EffectPrice EffectPrice EffectHicksian EffectSlutsky EffectMMAAa

Drawing New budget line: for only food increase - instead of cash

cashfoodCash lost (for whatever the quantity of food from A to B)New budget line: as only food increased - not cash FoodCash sacrificed for food O to DAB0DC

Application of Indifference Curve techniqueCash or Food - which is better ?cashfoodFood wastageABCash lost