Indifference Curve Approach

Topic 3

Outline

• Concepts—definition/illustration• Indifference map• Slope of indifference Curve/MRTS• DMRTS/reasons• Assumptions of Indifference curve• Properties of Indifference Curve• Budget line• Equilibrium of the consumer• Income Consumption Curve/Engel Curve• Price Consumption Curve/Demand Curve• Income and Substitution Effect

Concepts and illustration

• Indifference curve as an ordinal measure of utility– Utility is a psychological feeling

• IC is the locus of all commodity combinations, from which the consumer derives the same level of satisfaction

Illustration

• IC Schedule • IC Graph

Indifference Map

Meaning of Indifference Map• A set or family of

indifference curve is IM.• A lower level of IC

represents a lower level of satisfaction

Indifference Map

Marginal Rate of Technical Substitution/Slope of IC

• (MRS) may be defined as the rate at which a consumer will exchange successive units of one commodity for another

• The MRS of good X for Y is given as:

Diminishing MRS

• The Principle of DMRTSXY States that: as the consumer has more and more of good X, he is prepared to forego less and less of good Y.

• Graphical Illustration

Reasons for DMRTS

• The want of a particular good is satiable—the more of a good consumer have, the less is the intensity of want

• The goods are imperfect substitutes to one another.

Assumptions of IC

• More of a good is better—the consumer has not reach the point of sateity.

• Preferences are transitive, i.e. consumer’s taste is consistent, A = B, B = C, then, A = C.

• Diminishing Marginal Rate of Substitution

Properties of Indifference Curve

• IC slopes downward to the right—when more of a good is increased, the other is reduced. (negative slope)

Property 2

• Indifference curve is convex to the origin—this is based on the principle of DMRS- Illustrate with diagram

• Graphical illustration

Property 3

• Indifference Curve cannot intersect

Property 4

• Higher level of indifference curve represents a higher level of satisfaction than a lower level of IC

Budget Line

• A budget line refers to the combinations of commodities that a consumer is able to purchase given his income and the prices of the commodities.

BL Continues

• From the budget constraint, Qx and Qy can be obtained as

The Slope of the Budget Line

• The slope of the budget line is the ratio of the prices of the two commodities. Geometrically the slope of the budget line is:

Slope of the Budget line Cont.

• Mathematically, the slope is the derivative of the budget line

Derivation of Equilibrium

• The necessary condition of maximum satisfaction is that the slope of the indifference curve (MRS) be equal to the ratio of commodity prices which is the slope of indifference curve.

Consumer Equilibrium

• Point of equilibrium

Effects of Changes in Income (ICC)

• Income Changes results in ICC

• ICC is the locus of points representing various combinations of two commodities purchased by the consumer as his income changes, all other things remaining constant

• Graphical Illustration

Engel Curve—derived from ICC

• An Engel curve is a schedule or function showing the relationship between equilibrium quantity purchased of a commodity and the levels of income.

• The shape of the Engel curve depens on the shape of the ICC

Effect of Changes in Price--PCC

• Price Consumption Curve (PCC) is a locus of points of equilibrium on indifference curves, resulting from the change in the price of a commodity

PCC and Demand Curve

Income and Substitution Effects

• Price Effect = Income Effect + Substitution Eff.• Income Effect = Increase in real income due to a

fall in the price of the commodity• Substitution Effect = tendency to substitute

cheaper goods for the more expensive one• Income effect causes a movement along the ICC

which has a positive slope• Substitution effect causes a movement along

the PCC which has a negative slope

Derivation of Income & Substitution Effect—Hicks Approach

• Substitution effect is the change in quantity demanded, resulting from a change in relative price after real-income effect of price change is eliminated

• Income effect is the change in quantity demanded resulting exclusively from change in real income, all other things remaining the same.

Derivation of Income and Substitution Effect Slutsky Approach