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Indifference curve analysis/ Ordinalist approach

The marginal utility theory approach to consumer behaviour has been criticised in that it is not
possible to measure utility, which in any case can be viewed as a rather abstract and subjective
idea.The idea was that although the consumer could not measure utility, they could order or
rank their preferences eg preferring bundle of products A to bundle of products B and so on.

Indifference curves

These are Lines representing different combinations of commodities that yield a same level of
utility or satisfaction to the consumer.

Assume two products, x and y, it is possible to produce an indifference schedule which is a

table which shows different combinations of the two products which yield the same level of
satisfaction.

An indifference schedule

Combination. Units of product x. Units of product y

A 10 30

B 20 16

C 30 9

D 40. 5

Information in Table can be represented diagrammatically producing an indifference curve and

at point A, B, C or D the consumer obtains same utility.
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Properties of indifference curves

1. They are convex to the origin which means they slope downwards and their slope represents
Marginal rate of substitution (MRS) which is the rate at which a consumer gives up
consumption of one good for another but still enjoying same utility. (MRS = MUx/MUy)

2 a construction of many indifference curves to the right produces an indifference map as shown
below.
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3. They never cross each other as this would suggest inconsistent and irrational consumer

behavior.

The Budget line/ consumption possibility line

It's a line that describes the various combinations of two (or more) products that can be
purchased if the whole household income is spent on these products.

It reveals all combinations of the two products that are obtainable, given the individual’s income
and the prices of the two products.

Example,

A consumer has $100 to spend on the two products X and Y per week. Table below shows the
possible combinations of the two products assuming the individual spends all of the $100 with
the price of product X being $20 and that of product U being $10.

The budget constraint with income equal to $100

Quantity of product X Quantity of product Y

Price =$20 Price = $10

A 0 10

B 1 8

C 2 6

D 3 4

E 4 2

F 5 0

The individual can be at point A purchasing 10 of product y but unable to buy any of product x,
or at point F purchasing 5 of product x but none of product y, or alternatively the consumer
could be at a point between A and F on the budget line.

Assuming that a consumer must spend all of his income on one or two goods X and Y, it will
therefore produce a budget constraint:
Q x Px + Qy Py = Income
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This is an equation of a straight line, which can be represented by the following graph.

Good Y

10. A

8 B. * Unattainable

6. C

4 * Attainable. D

2. E

0. F
good X

Points outside the budget line, that is, points to the right of the boundary represent
combinations of the two goods that are not affordable given the consumer’ s income and
the slope of the budget line depends upon the relative prices(Px/Py) of the two products.
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On the other hand, points inside the boundary are attainable but the consumer will not be
spending all his income. Only points along the boundary represent combinations of the
two goods when the consumer is spending all his income.

NB The location of the budget line varies with money income and price levels. Any
changes in money income and or prices will change the position of the budget line.
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CONSUMER EQUILIBRIUM

- The consumer is in equilibrium, reaching the highest level of satisfaction that his or
her income allows, where the budget line is tangential to the indifference curve
furthest from the origin.

- At this tangency the slope of the budget line (relative prices of the two products) is
equal to the slope of the indifference curve (marginal rate of substitution) as shown
below.

- The individual is at the highest level of satisfaction possible, given income level and
the price of the two products, where the indifference curve IC 2 is tangential to the
budget line AB. This is represented by point E which is where the marginal rate of
substitution (MRS) is equal to the relative prices of the two products.

A change in income

- An increase in income, assuming the price of the two products remains unchanged,
will lead to a parallel shift of the budget line to the right, allowing the consumer to
buy more of both products.
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- Shift of the budget line from AB to CD, allows the consumer to move onto a higher
indifference curve IC 2 with a new equilibrium of E2 . The line through the equilibrium
positions is called the income–consumption curve and it shows how the
consumption of the two products responds to an income change.

- If there had been a fall in income the budget line would have shifted parallel and to
the left.

A change in price

- If there is a change in price of one of the goods, with income remaining unchanged,
the budget line will pivot.

- The initial budget line is AB and the consumer is in equilibrium at E1 , where the
budget line is tangential to the indifference curve. Following a fall in the price of
product X the budget line pivots to AC, thus allowing the consumer to move onto a
higher indifference curve (IC 2 ) resulting in a new equilibrium of E2 .

- A line that joins all of the points of consumer equilibrium is called the price–
consumption curve.

- As the price of product X has fallen the quantity demanded has expanded from X1 to
X2 .

- There are two reasons which explain for the increase in quantity demanded after a
price fall which are substitution and income effect.
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SUBSTITUTION AND INCOME EFFECT

- As the price of product X falls it becomes cheaper relative to product Y and for this
reason the consumer will substitute product Y for product X. This is called the
substitution effect of a price change.

- It will always be the case that the consumer will substitute towards the product which
has become relatively cheaper.

- As the price of product X falls it also means that the consumer has more money to
spend on other products. It can be said that the consumer’s real income has increased
since it costs less to buy a given quantity of goods.

- This may mean that the consumer buys more of product X and this is called the
income effect of a price change

- AB is the original budget line with the consumer in equilibrium at point a. If the price
of product X falls this will lead to a pivot in the budget line to AC, allowing the
consumer to reach a higher indifference curve (IC 2 ) and a new equilibrium of point c.

- The result of this is that the quantity of product X bought has risen from X1 to X3 .
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- We establish a compensating/ hypothetical budget line A'C' tangent to the original

indifference curve and parallel to the indifference curve AC. We therefore restore the
level of income by shifting the compensating budget line parallel until we come to the
budget line AC.
- The movement from a to b is the substitution effect and the movement from point b to
c is the income effect.

NB in the case of a Normal good the substitution and income effect reinforce each other
and will be both positive (work in same direction) and in the case of Inferior good the
substitution effect will be positive and greater than the income effect which will be
negative.

DERIVATION OF DEMAND CURVE

- As the price of product X falls, it leads to budget line pivoting from AB to AC to AD
and the quantity of product X demanded rises from X1 to X2 to X3 thus giving a
downward sloping demand curve as below.