Indifference Curves

Dr.Usha Nori
Indifference Curves
A consumer is able to rank different combinations of
the commodity in order of preference or indifference
Indifference between two bundles of goods implies
equal preferences
IC- locus of points which show the different
combinations of two commodities a consumer is
indifferent about
Level of satisfaction remains the same at all points on
the same IC and consumer would be indifferent
between all such combinations of the two goods
consumed.
A curve that defines the combinations of two goods
that give a consumer the same level of satisfaction
Properties of IC
 The preference ordering is assumed to satisfy four basic properties:
completeness, more is better, diminishing marginal rate of
substitution, and transitivity.
 Property 1: Completeness. For any two bundles—say, A and B—either
A B, B A, or A B.
 we assume the consumer is capable of expressing a preference for, or
indifference among, all bundles.

 Property 2: More Is Better

 If bundle A has at least as much of every good as bundle B and more of
some good, bundle A is preferred to bundle B.
The shape of the indifference curve depends on the
consumer’s preferences.
One important way to summarize information about a
consumer’s preferences is in terms of the marginal rate
of substitution.
The marginal rate of substitution (MRS) is the
absolute value of the slope of an indifference curve.
The marginal rate of substitution between two goods
is the rate at which a consumer is willing to substitute
one good for the other and still maintain the same
level of satisfaction.
 Property 3: Diminishing Marginal Rate of Substitution. As a
consumer
 obtains more of good X, the amount of good Y he or she is willing to
give up to obtain another unit of good X decreases.
 Property 4: Transitivity. For any three bundles, A, B, and C, if A is
preferred to B and B to C, then A is preferred to C.
 The assumption of transitive preferences, together with the more-is-
better assumption, implies that indifference curves do not intersect
one another. It also eliminates the possibility that the consumer is
caught in a perpetual cycle in which she or he never makes a choice.
Characteristics of Indifference Curves
Basic Characteristics
Higher indifference curves are better.
Indifference curves do not intersect.
Indifference curves slope downward- due to
nonsatiation.
Indifference curves are concave to origin.
Perfect substitutes are products that satisfy the same
need, e.g., car models.
Perfect complements are products consumed together,
e.g., cars and tires.
© 2009, 2006 South-Western, a part of Cengage
Learning
 Bundles Conferring Equal Satisfaction

Bundle Clothing Food

A 30 5

B 18 10

C 13 15

D 10 20

E 8 25

F 7 30
 Bundles Conferring Equal Satisfaction

35
a
30
Quantity of clothing per

25
g
week

20 b

15
c
d
10 e
f
h
T
5

5 10 15 20 25 30 35
Quantity of food
 Bundles Conferring Equal Satisfaction

· None of the bundles in the table are obviously superior to any of

the others in the sense of having more of both commodities.
· Since each of the bundles shown in the table give the consumer
equal satisfaction, he is indifferent between them.
· The data in this table are plotted in the corresponding figure.
 An Indifference Map
Quantity of food per week

I5
I4
I3
I1 I2

0 Quantity of food per week

 An Indifference Map

· A set of indifference curves is called an indifference map.

· The further the curve from the origin, the higher the level of
satisfaction it represents.
· Moving along the arrow is moving to ever-higher utility levels.
Indifference Curves and Risk Preferences
Investing in risky financial assets- consumers
behaviour
Option A is the safest investment, but it offers the
lowest return (2.94 percent);
option B is of medium safety, with a moderate return
(4.49 percent); and
fund C is the least safe, but it carries the highest
potential return (6.00 percent).
Investors view safety and the level of the return on an
investment as “goods”
Investments with higher returns and higher levels of
safety are preferred to investments with lower returns
and lower levels of safety.
Investors would be willing to substitute between the
level of return and the level of safety.
Given the three options, from an investor’s viewpoint,
there is a tradeoff between a higher reward (return)
and the level of safety of the investment
1. Steep indifference curves- describe an investor who
has a high marginal rate of substitution between
return and safety;
She or he must receive a large return to be induced to
give up a small amount of safety.
2. The relatively flat indifference curves - indicate an
investor with a low marginal rate of substitution
between return and safety. This individual is willing to
give up a lot of safety to get a slightly higher return.
Budget constraints
Budget set
The bundles of goods a consumer can afford.
Let M represent the consumer’s income, which can be any
amount.
Px and Py represent the prices of goods X and Y,
respectively. Given this notation, the opportunity set (also
called the budget set) may be expressed mathematically as
 PxX + PyY = M
Budget line
The bundles of goods that exhaust a consumer’s income.
Px /Py * X + Y = M/ Py
Solving for Y yields
Y = M/Py- Px/Py* X
Note that Y is a linear function of X with a vertical
intercept of M/Py and a slope of Px /Py.
The slope of the budget line is given by Px /Py and
represents the market rate of substitution between
goods X and Y.
A budget line for a consumer who has $10 in income
and faces a price of $1 for good X and a price of $2 for
good Y.
If we substitute these values of Px, Py, and M into the
formula for the budget line, we observe that the
vertical intercept of the budget line (the maximum
amount of good Y that is affordable) is M/Py 10/2 5.
The horizontal intercept is M/Px 10/1 10 and
represents the maximum amount of good X that can
be purchased. The slope of the budget line is Px
/Py(1/2).
The reason the slope of the budget line represents the
market rate of substitution between the two goods is as
follows.
Suppose a consumer purchased bundle A in Figure 4–4,
which represents the situation where the consumer
purchases 3 units of good Y and 4 units of good X.
If the consumer purchased bundle B instead of bundle A,
she would gain one additional unit of good Y. But to afford
this, she must give up 2 units (4 2 2) of good X.
For every unit of good Y the consumer purchases, she must
give up 2 units of good X in order to be able to afford the
additional unit of good Y. Thus the market rate of
substitution is Y/X (4 3)/(2 4) 1/2, which is the slope of the
budget line.
Different IC curves
Perfect substitutes- consumer would be willing to substitute
one type of product for the other at a rate of one for one.
Perfect Complements- No rate at which one will be
substituted for other.
Imperfect substitutes- A good that gives zero utility
Absolute necessity – ex: water if it falls to say w0, increasingly
large amounts of other goods are necessary to persuade the
consumer to cut down on his water consumption. MRS for an
absolute necessity approaches infinity as consumption falls
towards the amount that is absolutely necessary.
Good that confers negative utility after some level of
consumption
A good that is not consumed.
 Shapes of Indifference Curves

Perfect Substitutes Perfect Complements A good that gives zero

utility

Left hand gloves

Vegetables
I2
I2
I2 I1
I1
I1
0 0 0
[i]. Packs of green pins [ii]. Right hand gloves [iii]. Meat
 Shapes of Indifference Curves

A good that confers a negative A good that is

An absolute necessity utility after some level of not consumed
consumption
I2 I1
a

All other goods

All other goods

All other goods

I2
I1 0 I2
w f0 0 b I1
0
[iv]. Water [v]. Food [vi]. Good X
 The Equilibrium of a Consumer

35
Quantity of clothing per week

30

25

20

15

10

5 10 15 20 25 30 35

Quantity of food per week

 The Equilibrium of a Consumer
Quantity of clothing per week

30

a b
25
c

20
E

15

10 I5
d
I4
5 e
I3
f I2
I1
5 10 15 20 25 30 35

Quantity of food per week

Consumer equilibrium
The equilibrium consumption bundle is the affordable
bundle that yields the greatest satisfaction to the
consumer.
An important property of consumer equilibrium is
that at the equilibrium consumption bundle, the slope
of the indifference curve is equal to the slope of the
budget line.
MRS = Px/Py
 The Equilibrium of a Consumer

· Paul has an income of £150 a week and faces prices of £5 a unit for
clothing and £6 a unit for food.
· A bundle of clothing and food indicated by point a is attainable.
· But by moving along the budget line to points such as b and c,
higher indifference curves can be reached.
· At E, where the indifference curve I4 is tangent to the budget line,
Paul cannot reach a higher curve by moving along the budget line.
· If he did alter his consumption bundle by moving, for example,
from E to d, he would move to the lower indifference curve I3 and
thus to a lower level of satisfaction.
Consumer equilibrium
Budget line: Shows all combinations of the goods that
are just obtainable given a consumer’s income and the
prices of the products that he/she buys.
A consumer is in equilibrium when, given his or her
income and commodity prices, the consumer
maximizes the utility or satisfaction from his/her
expenditures.
Sum of money spent on goods must be less than or
equal to the total income available.
I > PyQy + PxQx
Qy = I/Py – Px/Py . Qx
Therefore slope = -Px/Py
If a consumer spent her or his entire income on good X, the
expenditures on good X would exactly equal the
consumer’s income:
 Px X = M
 X = M/Px
horizontal intercept of the budget line is M/Px

Similarly, if the consumer spent his or her entire income on

good Y, expenditures on Y would exactly equal income
 PyY = M
 Y = M/Py
The slope of the budget line is given by Px /Py and
represents the market rate of substitution between
goods X and Y.
The rate at which one good may be traded for another
in the market; slope of the budget line.
Income change
When income increases from M0 to M1, the budget
line shifts to the right in a parallel fashion.
This reflects an increase in the consumer’s
opportunity set, because more goods are affordable
after the increase in income than before.
The vertical and horizontal intercepts of the budget
line both increase as the consumer’s income increases,
because more of each good can be purchased at the
higher income.
Similarly, if income decreases to M2 from M0, the
budget line shifts toward the origin and the slope of
the budget line remains unchanged.
Change in Prices
Now suppose the consumer’s income remains fixed at
M, but the price of good X decreases to P1x < P0x .
Furthermore, suppose the price of good Y remains
constant
the reduction in the price of good X changes the slope,
making it flatter than before.
the ultimate effect of a reduction in the price of good
X is to rotate the budget line counterclockwise.
Similarly, an increase in the price of good X leads to a
clockwise rotation of the budget line.
 BUDGET CONSTRAINTS
 The Budget Line

A Budget Line

A budget line describes the

combinations of goods that can be
purchased given the consumer’s
income and the prices of the goods.
Line AG (which passes through
points B, D, and E) shows the
budget associated with an income
of $80, a price of food of PF = $1
per unit, and a price of clothing of
PC = $2 per unit.
The slope of the budget line
(measured between points B and D)
is −PF/PC = −10/20 = −1/2.

C  ( I / PC )  ( PF / PC ) F (3.2)
 BUDGET CONSTRAINTS
 The Effects of Changes in Income and Prices

Effects of a Change in Income on the

Budget Line

Income Changes A
change in income (with
prices unchanged) causes
the budget line to shift
parallel to the original line
(L1).
When the income of $80 (on
L1) is increased to $160, the
budget line shifts outward to
L2.
If the income falls to $40,
the line shifts inward to L3.
 BUDGET CONSTRAINTS
 The Effects of Changes in Income and Prices

Effects of a Change in Price on the

Budget Line

Price Changes A change

in the price of one good
(with income unchanged)
causes the budget line to
rotate about one intercept.
When the price of food falls
from $1.00 to $0.50, the
budget line rotates outward
from L1 to L2.
However, when the price
increases from $1.00 to
$2.00, the line rotates
inward from L1 to L3.
 CONSUMER CHOICE
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination
of goods and services.
Maximizing Consumer Satisfaction

A consumer maximizes
satisfaction by choosing market
basket A. At this point, the
budget line and indifference
curve U2 are tangent.
No higher level of satisfaction
(e.g., market basket D) can be
attained.
At A, the point of maximization,
the MRS between the two
goods equals the price ratio. At
B, however, because the MRS
[− (−10/10) = 1] is greater than
the price ratio (1/2), satisfaction
is not maximized.
Consumer Choice: Designing New Automobiles

Consumer Choice of Automobile Attributes

The consumers in (a) are willing to trade off a considerable amount of interior space
for some additional acceleration. Given a budget constraint, they will choose a car
that emphasizes acceleration. The opposite is true for consumers in (b).
 An Income-consumption Line

Income-consumption line
Quantity of clothing per week

E3

E2

E1

I3

I2

I1

0 Quantity of food per week

 An Income-consumption Line

· This line shows how a consumer’s purchases react to changes in

income with relative prices held constant.
· Increases in income shift the budget line out parallel to itself,
moving the equilibrium from E1 to E2 to E3.
· The blue income-consumption line joins all these points of
equilibrium.
 The Price-consumption Line
a

Price-consumption
Quantity of clothing per week

line

E1

E2 E3

I3

I2
I1
b c d

Quantity of food per week

 The Price-consumption Line

· This line shows how a consumer’s purchases react to a change

in one price, with money income and other prices held
constant.
· Decreases in the price of food (with money income and the
price of clothing constant) pivot the budget line from ab to ac
to ad.
· The equilibrium position moves from E1, to E2 to E3.
· The blue price-consumption line joins all such equilibrium
points.
 Derivation of an Individual’s Demand Curve
Value of all other goods

Price-consumption line
[£ per month]

E2
E1
E0
I2
I0 I1

0 60 120 220 267 400 800

Price of petrol [£ per month]

[i] Petrol [litres per month]

0.75 x

y
0.50 Demand curve

0.25 z

0 60 120 220
 Derivation of an Individual’s Demand Curve

· The points on a price-consumption line provide the

information needed to draw a demand curve.
· In part (i) Phillip has an income of £200 per month and
alternatively faces prices of £0.75, £0.50, and, £0.25 per litre of
petrol, choosing positions E0, E1, and E2.
· The information for the number of litres he demands at each
price is then plotted in part (ii) to yield his demand curve.
· The three points x, y, and z in (ii) correspond to the three
equilibrium positions E0, E1 and E2 in part (i).
substitution effect
The movement along a given indifference curve that
results from a change in the relative prices of goods,
holding real income constant.
Income effect
The movement from one indifference curve to another
that results from the change in real income caused by
a price change.
 The Income and Substitution Effects
Value of all other goods [£ per week]

a1
E0

E1

Substi
I1
tution
effect

0 b q j1 Quantity of petrol [litres per week]

q0 q1 2
Law of diminishing marginal utility
 A consumer increases the consumption of a product, the utility gained
from successive units goes on decreasing. That means the rate of
increase of total utility decreases as more and more units are consumed.
 A consumer will continue consuming the commodity and exchanging
money income as long as
 MU1 > P1.Mum
 He thus attain equilibrium when
 MU1/P1 = Mum
 MU2/P2 =Mum

 Law of equimarginal utility- a consumer maximizes his total utility by

distributing his entire income optimally among the various
commodities consumed by him.
 Marginal utility derived per unit of expenditure i.e, per rupee is same for
all commodities.
Slope = -Px/Py
MRS = -Px/Py = Utility Maximizing point
The price ratio represents the rate at which the market
requires consumers to substitute the two goods.
The MRS is the rate at which the individual desires to
substitute the goods.
Utility Maximization occurs where the rate at which
the consumer wants to substitute is just equal to the
rate at which he/she must substitute.
Diminishing Marginal Rate of Substitution
 The less of one product that is presently being used by a consumer, the
smaller the amount of it that the consumer will be willing to forgo in
order to increase consumption of a second product.
 The rate of substitution tells how much more of one product we need
to compensate for successive lost units of the other.
Budget Constraints
Basic Characteristics
Show affordable combinations of X and Y.
Slope of –PX/PY reflects relative prices.
Effects of Changing Income and Prices
Budget increase (decrease) causes parallel outward
(inward) shift.
Relative price change alters budget slope.
Income and Substitution Effects
Income effect changes overall consumption.
Substitution effect alters relative consumption.
Optimal Consumption
Marginal Rate of Substitution (MRS)
The amount of Y that the individual would be willing
to give up for an additional unit of X is called the MRS.
MRSXY = -MUX/MUY and equals indifference curve slope.
MRSXY shows tradeoff between X and Y consumption,
holding utility constant.
MRSXY diminishes as substitution of X for Y increases.
Utility maximization requires
PX/PY = MUX/MUY, or
MUX/PX = MUY/PY.
© 2009, 2006 South-Western, a part of Cengage
Learning
© 2009, 2006 South-Western, a part of Cengage
Learning
Consumer choice and changes in demand
Changes in prices
If price increases, the change causes the budget
constraint to rotate clockwise. The consumer will have
a new utility-maximising point where the highest IC is
tangent to the budget constraint.
Higher the price of X reduce purchasing power and
increase the opportunity cost of X relative to Y.
The theory can be used to explain changes in demand
(i.e. shifts in demand curve). Such shifts result from a
change in tastes and preferences, a change in Income,
or a change in the price of other goods.
A. Increase in income- when income increases, the
budget constraint shifts outward. The new budget
constraint is parallel to the initial budget constraint.
Changes in tastes and preferences
If suppose there is a change in tastes and preferences
due to environmental concerns in the consumption of
X, then there will be a shift in IC to IC2 where the new
utility maximizing point will be different. Change in
preferences reduces the demand for X and therefore
there would be a leftward shift of demand curve.
Decrease in Price of X
This results in counter clock wise rotation of budget
constraint.
The new utility maximizing point is Z where IC2 is tangent
to the new budget constraint. This point specifies more of X
than before. This is because the opportunity cost of buying
X has declined.
Thus the price change depicts a movement from one point
to another along the demand curve for X.
Also point z involves less Y than before. That means
decrease in price of X resulted in decrease in demand for Y.
Apparently, these are substitutes.
In the case of complements- opposite occurs.
Substitution effect and Income effect
The substitution effect postulates that when the price
of X falls, the consumer will substitute X for Y in
consumption
On the other hand, the income effect arises because
when Px falls but money income (M) and Py do not
change, the individual’s real income increases, and so
he or she purchases more of X.
An application of indifference curve analysis
 Will tax cuts provide an incentive for people to work more?
 This question can be analyzed using indifference curves . It is assumed
that individuals can choose how many hours a day to work.
 The budget line shows the various combinations of leisure and income
open to an individual at a given wage rate.
 The indifference curves show all the combinations of income and
leisure that give the person equal satisfaction. The optimum
combination of income and leisure is at Y* and L* where the individual
is on the highest possible indifference curve: point a.
Tax has following features
Up to an income of Y1 no tax is paid: Y1 is the individual’s
personal allowance.
From Y1 to Y2 the basic rate of tax is paid. The budget
line is flatter, since less extra income is earned for each
extra hour of leisure sacrificed.
Above Y2 the higher rate of tax is paid. The budget line
becomes flatter still.
The individual illustrated in the diagram will now choose
to earn a take-home pay of Y** and have L** hours of
leisure: point b. Note that this is more leisure than in the
no-tax situation (point a). In this diagram, then, the tax
has acted as a disincentive. The substitution effect has
outweighed the income effect.
 Designing New Automobiles

Preferences for Automobile Attributes

Preferences for automobile attributes can be described by

indifference curves. Each curve shows the combination of
acceleration and interior space that give the same
satisfaction.

Owners of Ford Mustang coupes (a) are The opposite is true for owners of
willing to give up considerable interior Ford Explorers (b). They prefer
space for additional acceleration. interior space to acceleration.