Welcome to Scribd, the world's digital library. Read, publish, and share books and documents. See more ➡
Standard view
Full view
of .
×
0 of .
Results for:
P. 1
Indifference Curve

# Indifference Curve

Ratings: 0|Views: 1,498|Likes:

### Availability:

See More
See less

09/16/2010

pdf

text

original

Indifference Curve Analysis
The aim of indifference curve analysis is to analyse how a rational consumer chooses between two goods. In other words, how the change in the wage rate will affect the choice between leisure time and work time.Indifference analysis combines two concepts; indifference curves and budget lines(constraints)
The indifference curve
An indifference curve is a line that shows all the possible combinations of two goods between which a person is indifferent. In other words, it is a line that shows theconsumption of different combinations of two goods that will give the same utility(satisfaction) to the person.For instance, in Figure 1 the indifference curve is I1. A person would receive the sameutility (satisfaction) from consuming 4 hours of work and 6 hours of leisure, as they wouldif they consumed 7 hours of work and 3 hours of leisure.Figure 1: An indifference curve for work and leisureAn important point is to remember that the use of an indifference curve does not try to put a physical measure onto how much utility a person receives.
The shape of the indifference curve
Figure 1 highlights that the shape of the indifference curve is not a straight line. It isconventional to draw the curve as bowed. This is due to the concept of the diminishingmarginal rate of substitution between the two goods.The marginal rate of substitution is the amount of one good (i.e. work) that has to be givenup if the consumer is to obtain one extra unit of the other good (leisure).The equation is below
The marginal rate of substitution (MRS) = change in good X / change in good Y
Using Figure 1, the marginal rate of substitution between point A and Point B is;MRS = -3 / 3 = -1 = 1 Note, the convention is to ignore the sign.

The reason why the marginal rate of substitution diminishes is due to the principle of diminishing marginal utility. Where this principle states that the more units of a good areconsumed, then additional units will provide less additional satisfaction than the previousunits. Therefore, as a person consumes more of one good (i.e. work) then they will receivediminishing utility for that extra unit (satisfaction), hence, they will be willing to give upless of their leisure to obtain one more unit of work.The relationship between marginal utility and the marginal rate of substitution is oftensummarised with the following equation;MRS = Mu
x
/ Mu
y
It is possible to draw more than one indifference curve on the same diagram. If this occursthen it is termed an indifference curve map (Figure 2).Figure 2: An indifference mapThe general rule is that indifference curves further too the right (I4 and I5) showcombinations of the two goods that yield a higher utility, while curves to the left (I2 and I1)show combinations that yield lower levels of utility.
A Budget Line (budget constraints)
The budget line is an important component when analysing consumer behaviour. The budget line illustrates all the possible combinations of two goods that can be purchased atgiven prices and for a given consumer budget. Remember, that the amount of a good that a person can buy will depend upon their income and the price of the good.This discussion outlines the construction of a budget line and how the change in thedeterminants will affect the budget line.Figure 3 constructs a budget line for a given budget of £60, £2 per unit of x and £1 per unitof y.

With a limited budget the consumer can only consume a limited combination of x and y (themaximum combinations are on the actual budget line).A change in consumer income and the budget lineIf consumer income increases then the consumer will be able to purchase higher combinations of goods. Hence an increase in consumer income will result in a shift in the budget line. This is illustrated in Figure 4. Note that the prices of the two goods haveremained the same, therefore, the increase in income will result in a parallel shift in the budget line.Assume consumer income increased to £90.Figure 4: An increase in consumer incomeIf consumer income fell then there would be a corresponding parallel shift to the left torepresent a fall in the potential combinations of the two goods that can be purchased.A change in the price of a good and the budget lineIf income is held constant, and the price of one of the goods changes then the slope of thecurve will change. In other words, the curve will pivot. This is illustrated in Figure 5.

## Activity (20)

### Showing

AllMost RecentReviewsAll NotesLikes