Introduction to Economics –ECO401 VU

Lesson 11

CONSUMER BEHAVIOR: CONSUMPTION SIDE ANALYSIS (CONTINUED)

THE INDIFFERENCE CURVE APPROACH OR ORDINAL APPROACH

This ordinal approach to utility consists in asking the question as to whether the consumer
prefers one combination or bundle of goods to another combination or bundle of goods.
Ordinal approaches do not require a “measurement” of the utility a person gains, rather, only a
ranking of the various bundles in order of preference.
An indifference curve is a line which charts out all the different points on which the consumer
is indifferent with respect to the utility he derives (in other words it is a combination of all equi-
utility points). It is drawn in goods space, i.e. a good Y on the vertical axis and a good X on the
horizontal axis.
Indifference curves are bowed in towards the origin. In other words its slope decreases (in
absolute terms) as we move down along the curve from left to right.

Good
Y

Indifference
curve

Good X
MARGINAL RATE OF SUBSTITUTION
The average slope of the indifference curve between any two points is given by the change in
the quantity of good Y divided by change in the quantity of good X. This is called the marginal
rate of substitution (MRS). MRS states how much unit of a good you have to give up in order
get an additional unit of another good.
A diminishing marginal rate of substitution (MRS) is related to the principle of diminishing
marginal utility. MRS is equal to the ratio of the marginal utility of X to the marginal utility of Y.

dY = MUX = MRS
dX MUY
The indifference curve for perfect substitutes is a straight line, while it is L-shaped for
perfect compliments.

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Introduction to Economics –ECO401 VU

Good
Y Indifference
Curve for
perfect
substitutes

Good X

Good
Y Indifference
Curve for perfect
compliments

Good X

An indifference map shows a number of indifference curves corresponding to different levels

of utility. A higher indifference curve corresponds to a higher level of utility. Indifference curves
never intersect.
The Budget Line and Indifference curves:
The budget line shows various combinations of 2 goods X & Y that can be purchased. Its
slope –Px/PY is called input price ratio.

Good
Y

Budget Line

Good X
EQUATION OF THE BUDGET LINE
Budget line in terms of Y = a + bX
kX + lY = M
lY = – kX + M
Y= –kX + M
l l
Where,
M = total amount of money
k & l = Prices of two goods
M = intercept

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Introduction to Economics –ECO401 VU

l
- K = Px = slope
l Py

The budget line can shift due to changes in total budget and the relative price ratio –Px/PY. If
money income rises, the budget line will shift outwards (parallel to the initial budget line). If the
relative price ratio changes, the slope of the budget line changes.

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