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Indifference Curve Analysis and Demand Curve

# Indifference Curve Analysis and Demand Curve

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12/05/2012

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Assignment on Consumer Equilibrium and Demand Curve
Assignment:
Explain on the basis of
Indifference Curve Analysis
, how a consumer attains equilibriumin his purchase decision? Derive the
Demand Curve
from that analysis.
Solution:
An
Indifference Curve
reveals the various combinations of two products or services towhich the customer is indifferent at a particular level of income. Any combination of products or services on an indifference curve will give the same level of utility. Theindifference curve is based on the following assumptions:
Indifference curves have a negative slope
Indifference curve slopes downward to the right, which reveals that the consumer prefers more of a particular product. Given the choice between two products in anindifference curve, if the consumer displays decreased demand for one product,naturally the demand for the other product goes up.
Indifference curves cannot intersect each other
If indifference curves intersect each other, it means that a consumer has twodifferent levels of utility for the two products. Higher level of indifference curve showshigher levels of utility.This concept can be explained with the help of Marginal Rate of substitution:The
Marginal Rate of Substitution
(MRS) is the rate at which a customer is willing tosubstitute one product for the other maintaining the same level of utility.The Ratio of the Marginal Utility of the two products and the rate at which a consumer iswilling to trade one product for another can be derived by measuring the marginal rate of substitution between them keeping the Total Utility constant.To explain the concept better, let’s take the example of two products – pastry and patties.Consuming an additional unit of patties causes total utility to increase while the marginalutility is positive. On the other hand, reducing the consumption of pastries causes totalutility to decrease, marginal utility being negative. For total utility to remain unchanged, thegain in total utility due to the increased consumption of patties must exactly offset thereduction in total utility due to the reduced consumption of pastries.
Consumption of two Products that yield same level of utilityUtilityQuantity of Pastries ConsumedQuantity of Patties Consumed
201122096206920211
Sujeet Kumar MBA 1
st
SemesterRoll No. 25

Assignment on Consumer Equilibrium and Demand Curve
The change in total utility is equal to the change in the number of units consumed multipliedby the marginal utility of each of those units. The consumption of additional units of pattiesand reduced consumption for pastries, keeping the total utility constant can be expressedas
Pd pastries * MU pastries +Pd Pastries * MU Patties = 0 BecausePdS is negative, the previous equation can be written asPd pastries * MU pastries =Pd Pastries * MU Patties The above equation can be also expressed as:MU pastries / MU Patties =Pd patties /Pd Pastries
The left-hand side of the above equation finds the ratio of the Marginal Utility of pastriesdivided by the marginal utility of patties or the marginal rate of substitution of pastries for patties. The right-hand side of the equation tells us the number of patties the consumer iswilling to give up to purchase an additional unit of pastries.
Budget Constraint
The term Budget Constraint implies that the income of consumer is limited and he/shespent total money or maximum amount of money on consuming the products.The budget constraint can be expressed for the above mentioned products as:
Available money income for consumption >= Price of pastries * Quantity of pastries +Price of patties * Quantity of pattiesConsumer Equilibrium
A consumer is said to be in equilibrium when he maximizes his satisfaction with theavailable money income. Individuals maximizing utility subject to their budget constraintattain the highest possible level of utility at a point of tangency between their budgetconstraint and an indifference curve. The budget line represents the fixed income availableto the consumer to spend on two products. The intercepts of this budget constraint on eachaxis (X and Y) equals income divided by the price of the product. Here, consumer satisfaction is measured in terms of the preference or ranking he gives for the consumptionof products and services. Preference is represented in the form of indifference curve. Theconsumer can reach his equilibrium level when the indifference curve is tangential tobudget line.This can be represented graphically as:
Sujeet Kumar MBA 1
st
SemesterRoll No. 25

Assignment on Consumer Equilibrium and Demand Curve
The equilibrium point is reached when the consumer consumes X* units of product X andY* units of product Y. other points on the budget constraint, such as point A and B arefeasible, but not optimum, even through Point B provides a higher level of utility withregards to Product X, and A with regard to Product Y.
Derivation of Demand Curve:
From the above discussion the demand curve can be derived graphically as:
Sujeet Kumar MBA 1
st
SemesterRoll No. 25