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    Chapter 4

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    Keertana Murali

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    © All Rights Reserved
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    of IC Analysis as Different from Utility Analysis & Assumptions of ICAnalysis of Consumer's Equilibrium © Indifference Set and Indifference Curve f Features/Properties of Indifference Curves & Consumer's Budget (Budget Set and Budget Line) & Optimum Choice of the Consumer: Consumer's Equilibrium 1, IC ANALYSIS AS DIFFERENT FROM UTILITY ANALYSIS i In the previous chapter, we discussed consumer's equilibrium with reference to utility analysis. The basic limitation of utility analysis is that it is based on the assumption of cardinal measurement of utility: that utility can be expressed in terms of cardinal numbers like 1, 2, 3, etc. 1 The IC analysis of consumer's equilibrium discards this assumption. Instead, it is based on the concept of ordinal measurement of utility. According to this concept, utility is only ranked as high or low (more or Jess) It is never expressed in terms of units like 1, 2, 3, ete. 2. ASSUMPTIONS OF IC ANALYSIS OF CONSUMER'S EQUILIBRIUM IC analysis of consumer's equilibrium is based on the following sumptions: (i) Money income of the consumer is given and does not change. li) The consumer spends his income on such goods which can be substituted for each other, like apples and oranges. Scanned with CamScanner — (iii) The consumer's preference (or scale of preference) for the two goods is well defined. Generally speaking, his intensity of desire for a good would increase when he has less of it. Likewise, his intensity of desire for a good would decrease when he has more of it. (iv) More of a good always gives more satisfaction to the consumer. This is called ‘monotonic preference’ for a good. (The assumption is made to simplify the description of IC analysis.) (v) The consumer is rational, He always maximises his satisfaction. 3. INDIFFERENCE SET AND INDIFFERENCE CURVE Consider a situation when a consumer is spending his given income across goods A and B. Let Good-A be apples, and Good-B be oranges. Consider these goods as substitutes of each other. Tabular Presentation Consider Table 1, showing different combinations of apples and oranges. Table 1. Different Combinations of Apples and Oranges eon) Ney Number of Oranges Observations Note the following observations relating to Table 1; (i) Combinations A, B, C and D are specified by the consumer according to his scale of preferences for the two goods. (ii) Each combination offers the same level of satisfaction © the consumer. So that (in terms of the level of satisfaction) Combination A = Combination B = Combination C = Combination D- (iii) As there is no difference among combinations A, B, C and D, ¥* may say that the consumer is indifferent across these combination Together, these combinations form an ‘Indifference Set’ of thé consumer. ae Scanned with CamScanner (Vn Indifference set is a set of those combinations of two goods which offers the in isfacti indi FOCUS consumer the same level of ae. So that, the consumer is indifferent ZONE across all combinations in his indifference set. Diagrammatic Presentation Diagrammatic presentation of Table 1 gives the following curve: Indifference Curve (Diagrammatic presentation of Indifference Set) Cis anindifference curve. Each pointon the curve shows: ‘a combination of two goods, offering the same level of satisfaction to the consumer. Thus, level of satisfaction of | the consumer at point A’ as at points B,CorD. | Each point on the curve (like A, B, C, ...) shows one combination of two ‘goods (apples and oranges). Since each combination offers the same level ‘of satisfaction to a consumer, this curve is called indifference curve. wv) os Indifference curve is a diagrammatic presentation of an indifference set of a consumer. FOCUS shows different combinations of two commodities (like apples and oranges) offering = ZONE Same level of satisfaction to the consumer. FEATURES/PROPERTIES OF INDIFFERENCE CURVES S/YNN Following are the principal features/properties of indifference curves. e G)IC Slopes Downward © IC slopes downward from left to right. It means that IC has a negative slope. It implies that if the consumer decides to have more of one good, he must have less of the other. It is only then that the satisfaction level Would remain constant at different points of the IC. Scanned with CamScanner See Slope of IC: Algebraic Expression SI f IC = <— lope of AX AY AB L(y)2 =e 7 =(-)2 [Consumptionofoneadditional unit of Good-X involves a sacrifice of 2 units of Good-Y] Since consumption of two goods is inversely related, IC must have negative slope, or it must slope downward, @ Let us refer to Fig. 2. At point A on the IC, the consumer has 5 oranges and 2 apples. Moving from A to B, he has 3 apples (one more than before) and 3 oranges (2 less than before). @ When the consumer moves from point A to B, and he has 3 apples instead of 2, his satisfaction level from apples must rise. Since A = B (in terms of satisfaction level), he must consume less of oranges, so that the rise in satisfaction level (due to higher consumption of apples) is counter-balanced by the fall in satisfaction level (due to lower consumption of oranges). IC slopes downward, or it shows a negative slope Since consumption of two goods is inversely related, IC must have negative slope. Scanned with CamScanner Q, State the principal reason that leads to downward slope of IC. ‘Ans. It is monotonic preference of the consumer that leads to downward slope of IC. According to monotonic preference, more of a good always leads to higher satisfaction. Accordingly, more of one good must be combined with less of the other. So that, satisfaction level remains constant at all points of IC. (ii) IC is Convex to the Origin a ICis convex to the origin means that the'slope of IC tends to decline, as we move along the IC from left to right. “g The slope of IC is called marginal=rate of substitution (MRS). good forthe other. y should MRS decline? / uy m As more - by the consumer, z= his intensity of desire for Good-X tends to decline ine. Implying that Sst marginal utility of Good-X tends to fall (in accordance with the law of Penasco pak nes diminishing marginal utility). Beater g ae s, t r 2 2 = * = - On the other hand, as: more and more units of Good-Yaregivenup, eras his intensity of desire for Good-Y tends to rise ji inal MRS refers to the rate at "; oa Implying that marginal rich the consumer is utility of Good-Y tends to rise with every additional unit of it being nilling to sacrifice Good-Y sacrificed. (on Y-axis) for Good-X (on } 2 Haat sec It is because of this, for every successive unit of Good-X, the consumer is willing to give up less and less amount of Good-Y. Accordingl (sacrificing Y per unit of additional X) tends to fall as we move down the IC. Thus, IC is convex to the origin because MRS tends to decline. ig. 4 illustrates this point. Between points A and B, the consumer is willing to give up 1.5 units of Good-Y for 1 more unit of Good-X. So that, MRS =- (AY! =- 18. =-15. AX 1 7 - Read the statement But, as we move down the curve, we find that between points B and given pelea and answer C, the consumer is willing to give up 1.5 units of Good-Y only when ff the question that foltows: he gets 2 units of Good-X in return (or 0.75 units of Good-Y are given J ™ Convexity of a curve AY me implies that the slope of up for 1 more unit of Good-X). So that, MRS = - —— =- — the curve diminishes as Ax 2 = 70.75. Tone moves fromleft to Likewise, between points C and D, AY = 0.5 and AX = 2, so that AY_ 05 MRS = - ——=_—> ~~ AX 2 oe because of the diminishing MRS that IC is convex to the origin. Scanned with CamScanner wa 1Cisconvextothe origin implying diminishing MRS Sym (aM) Diminishing Mrs ee 3 as -Ad eas odd 5 3 7 Os 25 IC is Convex to the Origin Yes, IC is normally convex to the origin. It is because MRS move along the curve, left to right. AY. ‘ sx) tends to decline as we Note that x is identical with the slope of IC, So that declining MRS means that the slope of IC tends to decline as we move down this curve. ‘Also note that itis the declining MRS that makes indifference curve as convex to the origin. Higher the MRS, greater the convexity. (iii) Higher IC shows Higher Level of Satisfaction Aset of ICs drawn in a graph is called Indifference Map. Fig, 5 shows a set of indifference curves one above the other. Indifference Map Ww Good-X Scanned with CamScanner Consumer's Equilibrium—lIndifference Curve Analysis ‘With reference to Fig. 5, following observations need to be carefully noted: p Higher IC (to the right and above another IC) indicates higher level of satisfaction. Thus, IC, indicates higher level of satisfaction than IC,; IC, indicates higher level of satisfaction than IC,, and IC, indicates Each IC in the indifference map corresponds to different level of consumer's income. Higher IC corresponds to higher level of income. Higher IC means higher level of satisfaction Ans. Refer to Fig. 6. Consider points R (on the lower IC) and $ (on the higher IC). © Both at R and S, consumer has OK (same) amount of Good-Y. But at S, the consumer has OL, amount of Good-X which is greater than OL (the amount of Good-X at point R). @ We know, more of a good means more satisfaction owing to monotonic preferences. Hence, the conclusion that IC, offers higher level of satisfaction than IC,. aradox or a contradiction. Fig. 7 illustrates how. Y =B (being on the same IC,) C (being on the same IC,) <. B=C.But this is not logical. +: AtC, consumption of Good-X is greater than at B, while the consumption of Good-Y Is the A same (at 8 and C). wok 1C2 1 Consider points A and B. These are on the same IC,. Therefore, these are equal in terms of the level of satisfaction. So that A = B. Likewise A=C,as these are on the same IC). hy i Band A = C, we can conclude that B = C. But this is not Bical. Because: at both B and C, the consumption of Good-Y is the Scanned with CamScanner same (= OK), But at C, the consumption of Good-X (= KC) is Breaty than at B (= KB). Implying that C must be offering higher level , satisfaction than B. (v) IC does not touch X-axis or Y-axis @ This is because [C’analysis considers the consumption of two goody, simultaneously. If IC touches Y-axis (as in Fig. 8), it would mean that the consumption, of Good-X is zero. Likewise, if IC touches X-axis (as in Fig. 8), it would mean that the consumption of Good-Y is zero. Y ‘© Touching Y-axis, IC would mean zero consumption of Good-X © Touching X-axis, IC would mean zero consumption of Good-¥ Q. The table given below shows Shyam’s preferences for Study (S) and Entertainment (EB), by! using various combinations of the two choices between which he is indifferent. Each of the three sets of bundles represent different utility level. Table showing Shyams preferences for Study (S) and Entertainment (E) He manarmoor> Scanned with CamScanner Consumer's Equilibrium—Indifference Curve Analysis Study the given table and answer the following questions: (i) Using the given information draw three indifference curves, plotting entertainment on the vertical axis and study on the horizontal axis. (ii) Which IC represents the highest level of satisfaction? (iii) Which IC represents the lowest level of satisfaction? » (iv) Consider the following bundles of goods: (a) 50(S), 8(E) (b) 45(S), 5 (E) (0) 12 (S), 45(E) (d) 25(S), 16(E) (e) 21(S), 11(E) Rank these five bundles in descending order of satisfaction. Ans yz ©) 12(5), 45(E) eA Entertainment (E) 5.6 G laa s 1G IG pe) 50(S), 8(E) Ic, (b) 45(S), 5(E) 15 20 25 30 35 40 45 50 Study (5) orto (d) 25(S), 16(E) © “el Bo : a4 ee (i) IC,, IC,, IC, (plotted as shown above). (ii) IC, represents highest level of satisfaction. (iii) IC, represents lowest level of satisfaction. (iv) Ranking bundles in descending order of satisfaction. (a) 21(S), 11 (E)—Rank 4 (b) 45(S), 5 (E)—Rank 3 (d) 25(S), 16 (E) & 50 (S), 8 (E) (same level of satisfaction) Rank 2 “(© 12(S), 45(E)—Rank 1 Scanned with CamScanner Introductory Microeconomics 5. CONSUMER'S BUDGET (BUDGET SET AND BUDGET LINE) Illustration m Let us assume that a consumer has a budget of ¥ 60 to be spent, Good-1 and Good-2. Also, assume that price of Good-1 is = 2 perur and price of Good-2 is € 1 per unit. Accordingly, we find the following budget set of the consumer. Thiss shows consumption possibilities for the consumer, given his incor and prices of Good-1 and Good-2. Tabular Presentation Table 2. Budget Set of the Consumer Trea Ket) Units of Good-1 Poca scott Pe eat 2x0+1x60=0+60=60 2x10 +140 = 20+ 40=60 2%20+1x20=40+20=60 2%30+1x0=604+0=60 [Note: This budget set is drawn on the assumptions that consumer's incomé budget = % 60; Pgoog.1 = & 2 per unit and Pgggy.2 = € 1 per unit.) Observations m Ifaconsumer spends his entire income on Good-1, he can buy 30 unit of it. @ On the other hand, if he spends his entire income on Good-2, he gt 60 units of it. @ Alternatively, a consumer can buy 10 units of Good-1 (spendit, 10 x& 2 =F 20 on it) and 40 units of Good-2 (spending 40 x €1=%4 on it), Also, he can buy 20 units of Good-1 (spending 20 x ¥ 2 = = 40° it) and 20 units of Good-2 (spending 20 x 1 = 20 onit). @ Likewise, you can think of various other combinations that a consum™ can buy, given his income and prices of Good-1 and Good-2. , Budget set refers to attainable combinations of a set of two goods, given prices of gooh FOCUS and Income of the consumer. The budget set equation (briefly called ‘Budget Equation’: ZONE PX,+ PX) SY Here, P, = Price of Good-l; X, = Quantity of Good-l; P, = Price of Good?! X= Quantity of Good-2; Y = Total expenditure or total budget. Budget Set is also called Budget Constraint as it shows the limit (constraint) up to which consumer can buy a set of two goods with his given income. Scanned with CamScanner Q. What can lead toa change in budget set? ‘Ans. Budget set depends on P, (Price of Good-1), P, (Price of Good-2), and Y (Consumer's income). Change in any of these variables will lead to a change in budget set. grammatic Presentation prammatic presentation of the data-set of Table 2 offers a budget line, Fig, 10. Budget Line of the Consumer Pudost One This budget line corresponds to the of following equation, called Budget Line Price Line Equation: PAX, +P2X2=¥ Y:: Total expenditure or total budget. ab, h point on the line ab indicates one combination of Good-1 and -2 which a consumer can buy with his given income, and given prices of Good-1 and Good-2. et Une is a line showing different possible combinations of Good-1 and Good-2, h a consumer can buy, given his budget and the prices of Good-1 and Good-2. FOCUS efe, on the budget Une, a consumer is spending his entire income either on Good- INE ‘Good-2 or on both Good-l and Good-2. Scanned with CamScanner Why is line ab (in Fig. 10) called Price Line? @ Because line ab shows that 30 units of Good-1 are equal to 60 units of Good-2 in the market. So that, Price of 1 unit of Good-1 = Price of 2 units of Good-2. R60 _2 Thus, 307 T i Thus, price line shows price ratio between Good-1 and Good-2. It shows that '2' units of Good-2 are to be sacrificed for getting ‘t’ unit of Good-1. Budget Line and Attainable & Non-attainable Combinations um Budget line is a line that separates attainable combinations (also called feasible combinations) from the non-attainable (non-feasible) combinations. = Can a consumer go beyond the budget line? Certainly not, given his budget (income) and the prices of Good-1 & Good-2 Thus, any point beyond the budget line shows a non-attainable combination or a non-feasible combination. Fig, 11 illustrates this point. (Note: The diagram shows budget line when: consumer's budget = & 60; price o! Good-1 = 2 per unit; price of Good-2 = @ 1 per unit. ] @ A consumer can only afford to buy combinations that fall along his budget line (ab in Fig. 11) or inside it. This region is known as feasiblé region. = A consumer cannot afford to buy combinations that are beyond hit: budget line. This region is called non-feasible Tegion. Scanned with CamScanner Tan sleew (Oe er Os difference Curve Analysis is budget line different from budget set? Budget Set Budget Line Budget line is defined in terms of this equation: P,X, + P,X, = Y. Q.How Ans. Basis of Difference 1, Meaning Budget set is defined in terms of this equation: P,X, + PX, Y. Budget line includes only such combinations of goods X and Y (given their prices) on which the actual expenditure by the consumer is exactly equal to his given income. Specifically, it does not include such combinations which are attainable but where: consumer's expenditure < consumer's income. 2. Combinations Budget set includes all combinations of included goods X and Y (given their prices) on which the actual expenditure is equal to or less than the given income of the consumer, ice of X = units of Y to be sacrificed to obtain one unit of X. Likewise, Price of Y = units of X to be sacrificed to obtain a unit of Y.] / Read the statement ‘given below and answer — ‘the question that follows: _ |m Slope of Budget Line) | Price Line shows the rate | atwhich market price allows the consumer to ‘Slope of a budget line is i expressed as__. | lars x ; The figure shows that AY = 10 when AX = 5. AY —— =— =2. Ax So that the slope of price line = Scanned with CamScanner Unteaetertateiny terete eS It shows that to obtain 1 more unit of Good-X, the consumer Mus, sacrifice 2 units of Good-Y, Thus, the price of Good-X is expressed jn terms of the sacrifice of Good-Y for obtaining every additional unit of Good-X. So that: z= AY “Ax showing how much of Good-Y is to be sacrificed for obtaining one, more unit of Good-X. @ It must be noted that the slope of price line is constant, simply because price line is a straight line (we know, a straight line has a constant) slope). Further, price line is drawn as a straight line, because prices of) Good-X and Good-Y are taken as given in the market. Why does Budget Line Slope Downward? @ Budget line slopes downward. Because, given consumers’ income and) prices of goods X and Y, the consumer can buy more of Good-X only when he buys less of Good-Y (Refer to Table 2 for details). Changes in Budget Set Changes in budget set are indicated by: (i) Shifts in budget line, and (ii) Rotation of budget line. Following isa brief description of these change: (i) Shifts in Budget Line © Py, Py, Y increases, Budget line shifts © Py, Py, Y decreases. Budget line | forward (without changing its slope) shifts backward (without changing | | when income of the consumer itsslope) whenincome ofthe increases. Prices are assumed as consumer decreases. Prices are constant. assumed as constant. * Y, Px and Py decrease. Budget line © Y,Px and Py increase. Budget line shifts forward (and parallel) when Y shifts backward (and parallel) is constant, but both Px and Py fall in when ¥ is constant, but both Px and “thesameratio. 7. Py rise in the same ratio. we Both these situations are illustrated through Table 3 and Fig. 13. Scanned with CamScanner UN SLBE MHS LHINUISAUR Eee LICH emett/ em New Hindget Set when TRON ok aL) Eke veka Coole Ce) Shift in Budget Line Budget line shifts forward when: consumers’ income increases from % 60 to F 120 (P;, Pz remaining constant) Existing budget line when: consumers’ income = 60, Py =%2,P2= 2&1 Budget line shifts backward when: consumer's income decreases from d %60 to ® 30 (P;,P2 remaining constant) x 60 s, as in Fig. 14 and Fig. 15, Px L PLY Py LBL When Py falls ab-+ab, When Py falls ab--apb Scanned with CamScanner @ InFig. 14, Px falls and budget line rotates to the right starting fron) the Y-axis. m In Fig, 15, Py falls and budget line rotates to the right starting fron the X-axis. (b) Leftward Rotation: Budget line rotates to the left when: P, or Be rises, as in Fig. 16 and Fig. 17. xT PY —_ «TP Y Py T RT a * 34 & When Py rises When Py rises ab--a,b ab--ab x ¢ : +x Good-X In Fig. 16, Py rises and budget line rotates to the left starting fro the Y-axis. In Fig. 17, Py rises and budget line rotates to the left starting fra, the X-axis. (Ss TEST YOUR UNDERSTANDING Q. Consumers’ income is % 400. He spends it on purchase of goods X and Y. Prices of X and Yan % 40 and 50 per unit respectively. Answer the following questions: (i) State the equation of budget line and slope of budget line for the above data, (ii) State two such combinations of X and Y which lie on the budget line. State two such combinations of X and Y which lie outside the budget line. (iv) How many units of Good-¥ can a consumer buy if all his income is spent on Good-Y. (v) What type of change will be experienced in the budget line if Py falls from 250 to 240. Ans. (i) Budget Line Equation: PyQy + PyQy = 40X + 50Y = 400 Slope of Budget Line = é = 4 =08 (ii) 40X + 50Y = 400 Any combination with spending equal to 400 will lie on the budget line. Example: Combinations: (a) 5X + 4Y (b) 10% + 0¥ i will lie on the budger line, Scanned with CamScanner Consumers Equilibrium— Indifference Curve Analysis: 40 (5) + 50 (4) =400 40 (10) + 50 (0) =400 (iii) 40X + 50Y = 400 Any combination with spending greater than 400 will lie outside the budget line. Example: Combinations: (a) 6X + SY (b) 6X + 6Y will lie outside the budget line. Derivation: 40 (6) + 50 (5) =490 > 400 40 (6) + 50 (6) =540 > 400 (iv) 40X + SOY = 400; given consumption of Good-X = 0 40 (0) + 50Y =400 400 Y =o =Sunits. (v) If Py falls from & 50 to 40, budget line rotates to the rig OPTIMUM CHOICE OF THE CONSUMER: ONSUMER’S EQUILIBRIUM nsumer’s equilibrium refers to optimum choice of the consumer. It eached when he maximises his satisfaction. In terms of indifference ve analysis, the consumer reaches his optimum choice when two itions are satisfi Note: The terms budget line/price line are used interchangeably. These are synonyms of each other. © Slope of IC Slope of Price Line/Budget Line So that, in a state of equilibrium, IC and price line are tangent to each other. i) IC is convex to the origin at the point of equilibrium. 18 offers diagrammatic illustration of consumer's equilibrium. It n on the assumption that the consumer is spending his given e (€ 60) across Good-X and Good-Y only, & Py and Py are given %2,and Py =%1). diagram, E is the point of equilibrium. Here, both the conditions quilibrium are satisfied: ii) 1C is convex to the origin at the point of equilibrium. Scanned with CamScanner Soe | Ina state of equilibrium, the consumer is buying 15 units of Good-X ang 30 units of Good-Y, He is maximising his satisfaction. Consumer's Equilibrium: Diagrammatic Presentation E: Point of equilibrium Here, p Px MRSyy=-5 Or, Slope of IC = Slope of Price Line To the left of point E, MRSyy >t Y To the right of point E, MRSxy RE ? ¥ Ans. The consumer should move downward to the right along the IC. Convexity of the IC ensures that as the consumer moves downward to the right along his IC, MRSyzy tends to fall. Implying that the consumer should start consuming more of X in place of Y. Q.2. How will a consumer adjust his consumption of goods X and Y in a situation when P, MRSxy< pe? Y ns. The consumer should start consuming more of Y in place of X. That is, he should move upward to the left along the IC. Convexity of the IC ensures that as the consumer moves upward to the left along his IC, 4 Px _ MRSyxy tends to rise. He should stop at a point when MRSyy = pR Y =] TEST YOUR UNDERSTANDING A consumer consumes only two goods X and Y & the prices of goods X and Y are < 8 and? 4 _ respectively. What will be MRS,y when consumer is in equilibrium? P, At equilibrium, MRSyy = 7 Substituting Py = 8 and Py = 4, MRSxy = 7 2 MRS yy = 2. Q.2. Rohan is choosing how to allocate this spending between chocolates and toffees. The figure alongside shows his budget line and indifference curve. Identify the point as mentioned in the diagram and match it with the appropriate statement given below: (i) The point at which Rohan maximises his satisfaction. (ii) The point at which he buys only chocolates and no toffees. (iii) A consumption bundle which would not exhaust his budget for these goods. Chocolates _ (iv) A point yielding the same satisfaction as at ‘D' but which Rohan’s budget can’t afford. (v) The point at which he buys only toffees and no chocolates. (vi) A consumption bundle preferred to point ‘D’ but which Rohan can’t afford. Ans. (i) D, (ii) C, (iii) A, (iv) E, (v) B, (vi) F Scanned with CamScanner Introductory Microeconomics Rt x Q.1. How will the consumer move along his IC in a situation when MRSyy > PR ? Y Ans. The consumer should move downward to the right along the IC, Convexity of the IC ensures that as the consumer moves downward to the right along his IC, MRSyy tends to fall. Implying that the consumer should start consuming more of X in place of Y. Q.2. How will a consumer adjust his consumption of goods X and Y in a situation when Py MRSyy

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