microeconomics

1. INDIFFERENCE CURVES
Course: Seminar on Micro Economics
GROUP MEMBERS: ALKA SINGH
MAHAK ARORA
PARAS HANDA
PRIMAL SHARMA

2. Cardinal versus ordinal utility
 Early economists assumed that people are able to
assign meaningful utility numbers (utils) to their
satisfaction in one situation vis-à-vis their
satisfaction in an alternative situation.
 For example, the utils generated by each brownie you
eat or book you read would be recorded as if you
have utilometer imbedded in your system.
 Cardinal measurement of utility Satisfaction,
like temperature or distance, is assumed
measurable in meaningful, absolute numbers.

3. Ordinal Utility Genesis…
 Cardinal measures are possible when incremental units
are constant and reasonably objective, but utility is
roughly measurable at best. As there is no one born
equipped with a utilometer to precisely measure
satisfaction.
 In the 1930s, Nobel prize-winner Sir John Hicks followed
the leads of Vilfredo Pareto and Francis Y. Edgeworth to
develop indifference analysis, an underpinning for the
theory of consumer behavior that dispenses with
cardinally-measured utility. Hicks argued that ranking
our preferences is the best we can do.

4. INDIFFERENCE CURVES
 The technique of indifference curves was originated by
Francis Y. Edgeworth in England in 1881. It was then
refined by Vilfredo Pareto, an Italian economist in 1906.
This technique attained perfection and systematic
application in demand analysis at the hands of Prof. John
Richard Hicks and R.G.D. Allen in 1934.
 Hicks discarded the Marshallian assumption of cardinal
measurement of utility and suggested ordinal
measurement which implies comparison and ranking
without quantification of the magnitude of satisfaction
enjoyed by the consumer .

5. Assumptions:
 Rational behavior of the consumer
 Utility is ordinal
 Diminishing marginal rate of substitution
 Consistency in choice
 Transitivity in choice making
 Goods consumed are substitutable

6. Axioms of rational choice
• Completeness
– if A and B are any two situations, an individual
can always specify exactly one of these
possibilities:
• A is preferred to B
• B is preferred to A
• A and B are equally attractive

7. Axioms of rational choice
• Transitivity
– if A is preferred to B, and B is preferred to C,
then A is preferred to C
– assumes that the individual’s choices are
internally consistent

8. Axioms of rational choice
• Continuity
– if A is preferred to B, then situations suitably
“close to” A must also be preferred to B
– used to analyze individuals’ responses to
relatively small changes in income and prices

9. Definition
 An indifference curve is the locus of points
representing all the different combinations of two
goods which yield equal level of utility to the
consumer.
 Indifference schedule is a list of various
combinations of commodities which are equally
satisfactory to the consumer concerned.

10. Two Indifference Schedules
SCHEDULE 1 SCHEDULE2
Good X Good Y Good X Good Y
1 12 2 14
2 8 3 10
3 5 4 7
4 3 5 5
5 2 6 4
In Schedule 2,consumer has initially 2 units of goods X and 14 units of Y.So
questions arises how much of Y would consumer be ready to abandon for
succesive additions of X in his stock so that satisfaction remains equal as
compared to his intial one i.e 2X+14Y.

11. Schedule 1 or Schedule 2?
 Any combination in schedule 2 will give consumer
more satisfaction than in schedule 1.
 The reason for this is that more of a commodity is
preferable to less of it.
 In simple terms, greater quantity of a good gives an
individual more satisfaction than the smaller
quantity of it,the quantity of other goods with him
remaining the same.

12. Indifference Curves
 An indifference curve shows a set of consumption
among which the individual is indifferent
Quantity of Y
Combinations (X1, Y1) and (X2, Y2)
provide the same level of utility
Y1
Y2 U1
Quantity of X
X1 X2

13. Shape of Indifference Curve
 Indifference curve slope down and to the right, and
the slope becomes less steep the farther right you go
(this shape is sometimes described
as convex or convex to the origin). Why?
 The curves slope down to the right because any
combination on the curve would yield equal
satisfaction.

14. Indifference Curve
 An indifference curve shows various combinations of
goods that yield the same utility, but different
indifference curves show different levels of utility.
 For instance, the green indifference curve on the graph
below indicates a higher level of utility than the red or
the blue indifference curves. Economists assume that
people want to attain the highest level of utility possible
(I3 is better than I2 which is better than I1)
 There are an infinite number of indifference curves in the
indifference map, and each person’s indifference map is
unique to that person.

16. Indifference Curve Map
• Each point must have an indifference curve through it
Quantity of y
Increasing utility
U3 U1 < U2 < U3
U2
U1
Quantity of x

17. Utility
 Given these assumptions, it is possible to show that
people are able to rank in order all possible
situations from least desirable to most
 Economists call this ranking utility
 if A is preferred to B, then the utility assigned to A exceeds the
utility assigned to B
U(A) > U(B)

18.  Utility is affected by the consumption of physical
commodities, psychological attitudes, peer group
pressures, personal experiences, and the general
cultural environment
 Economists generally devote attention to
quantifiable options while holding constant the
other things that affect utility
 ceteris paribus assumption

19. Preferences and Utility
• Marginal Rate of Substitution, MRSyx :
The rate at which a consumer is willing to sacrifice one
good (y) in return for more of another good (x).
• Principle of Diminishing Marginal Rate of
Substitution : A rule stating that, for any convex
indifference curve, when moving down the curve from the
top (northwest) to the bottom (southeast), the absolute
value of that curve’s slope must be continuously declining

20. Marginal Rate of Substitution
• MRS changes as x and y change
– reflects the individual’s willingness to trade y for x
Quantity of y At (x1, y1), the indifference curve is steeper.
The person would be willing to give up more
y to gain additional units of x
At (x2, y2), the indifference curve
is flatter. The person would be
y1 willing to give up less y to gain
additional units of x
y2 U1
Quantity of x
x1 x2

21. Marginal Rate of Substitution
• The negative of the slope of the
indifference curve at any point is called
the marginal rate of substitution (MRS)
Quantity of y
dy
MRS
dx U U1
y1
y2 U1
Quantity of x
x1 x2

22. Properties of Indifference Curves
• Higher indifference curves are
preferred to lower ones.
• Indifference curves are downward
sloping.
• Indifference curves do not cross.
• Indifference curves are bowed
inward.

23. Property 1: Higher indifference curves are
preferred to lower ones.
• Consumers usually prefer more of something
to less of it.
• Higher indifference curves represent larger
quantities of goods than do lower
indifference curves.

24. Property 2: Indifference curves are downward
sloping.
• A consumer is willing to give up one good only
if he or she gets more of the other good in
order to remain equally happy.
• If the quantity of one good is reduced, the
quantity of the other good must increase.
• For this reason, most indifference curves slope
downward.

25. Property 3: Indifference curves do not cross.
Quantity
of Pepsi
C
A
B
0 Quantity
of Pizza

26. Property 4: Indifference curves are bowed
inward.
 People are more willing to
Quantity
of Pepsi trade away goods that they
have in abundance and less
14
willing to trade away goods of
MRS = 6 which they have little.
8 A
1
4 MRS = 1 B
3 Indifference
1
curve
0 2 3 6 7 Quantity
of Pizza

27. Perfect Substitutes
Nickels
6
4
2
I1 I2 I3
0 1 2 3 Dimes

28. Perfect Complements
Left
Shoes
I2
7
5 I1
0 5 7 Right Shoes

29. Budget Line or Budget Constraint
 Essential for understanding the theory of
consumer’s equilibrium.
 The budget line shows all the different
combinations of two goods that a consumer can
purchase given his money income and price of two
commodities
 When a consumer attempts to maximize his
satisfaction, there are two constraints:
 Paying the prices for the goods
 Limited money income

30. Budget Equation
Px*X + Py*Y=M
M := Income of the consumer
Px := Price of good X
Py := Price of good Y
X := Quantity of good X
Y := Quantity of good Y

31. A budget line
30 a
Units of Units of Point on
good X good Y budget line
0 30 a
b
Units of good Y
20 5 20 b
10 10
15 0
10 Assumptions
PX = £2
PY = £1
Budget = £30
0
0 5 10 15 20
Units of good X

32. Budget Line Continued…
 Budget line graphically shows the budget constraint.
 The combination of commodities lying to the right of
the budget line are unattainable because income of
the consumer is not sufficient to buy those
combinations.
 The combinations of goods lying to the left of the
budget line are attainable.

33. Budget Space
 A set of all combinations of the two commodities that can
be purchased by spending the whole or a part of the given
income.

34. Changes in Price and Shift in Budget
Line
 At the lower price of X,
the given income
purchases OL’ of X which
is greater than OL.
 At the higher price of X,
the given income
purchases OL” of X
which is less than OL.

35. Changes in Income and Shift in Budget
Line
 BL initial budget line
 If consumer’s income
increases while prices of
both X and Y remain
unaltered, the price line
shifts upwards i.e. B’L’
and is parallel to BL.
 Similarly it will shift
downward i.e. B”L”, if
income decreases.

36. Slope of Budget Line and Prices of two
goods
Slope of budget line BL is equal to the ratio of
prices of two goods.
Slope of budget line = OB/OL
= Px / Py

37. Consumer Equilibrium
 It refers to a situation in which a consumer with given
income and given prices purchases such a combination of
goods which gives him maximum satisfaction and he is
not willing to make any change in it.
 Assumptions:
1) The consumer has a given indifference map exhibiting
his scale of preferences for various combinations of two
goods, X and Y.
2) Fixed amount of money to spend and has to spend
whole of his money on two goods.
3) Prices of goods are given and constant for him. He
cannot influence those prices.
4) Goods are homogeneous and divisible.

39.  There are three indifference curves IC1, IC2 and IC3.
 The price line PT is tangent to the indifference curve
IC2 at point C.
 The consumer gets the maximum satisfaction or is in
equilibrium at point C by purchasing OE units of good
Y and OH units of good X with the given money
income.
 The consumer cannot be in equilibrium at any other
point on indifference curves.
 For instance, point R and S lie on lower indifference
curve IC1 but yield less satisfaction. As regards point U
on indifference curve IC3, the consumer no doubt gets
higher satisfaction but that is outside the budget line
and hence not achievable to the consumer.

40. Conditions
 A given price line must be tangent to an indifference
curve or marginal rate of satisfaction of good X for good
Y (MRSxy) must be equal to the price ratio of the two
goods. i.e. MRSxy = Px / Py
 The second order
condition is that indifference
curve must be convex to the
origin at the point of
tangency.

41. Income Effect : Income Consumption
Curve
 The income effect means the change in consumer’s
preferences of the goods as a result of a change in his
money income.
 Income consumption curve traces out the income effect on
the quantity consumed of the goods.
 Income effect for a good is said to be positive when with the
increase in income of the consumer, his consumption of
good also increases. (Normal Goods)
 Income effect for a good is said to be negative when with
the increase in income of the consumer, his consumption of
good decreases. (Inferior Goods)

42. Income Consumption Curve

43. Continued…
 With the given budget line P1L1, the consumer is
initially in equilibrium at point Q1 on the
indifference curve IC1 and is having OM1 of X
and ON1 of Y.
 As income increases budget line shifts upwards
i.e. from P1L1 to P1L2 to P3L3 and so on.
 With budget line P2L2, equilibrium is at Q2 on
IC2. Similarly it changes with next budget lines.
 If now various points Q1, Q2, Q3 and Q4
showing consumer’s equilibrium at various levels
of income are joined together, we will gwt
Income Consumption Curve.

44. Income Consumption Curve in Case of Good X
being Inferior Good

45. Income Consumption Curve in Case of Good Y
being Inferior Good

46. Income Consumption Curves of Normal
Goods

47. Income Consumption Curves of Inferior
Goods

48. Engel curve
 An Engel curve describes how household expenditure on
a particular good or service varies with household
income. There are two varieties of Engel Curves. Budget
share Engel Curves describe how the proportion of
household income spent on a good varies with income.
Alternatively, Engel curves can also describe how real
expenditure varies with household income. They are
named after the German statistician Ernst Engel (1821–
1896) who was the first to investigate this relationship
between goods expenditure and income systematically in
1857. The best-known single result from the article
is Engel’s Law which states that the poorer a family is,
the larger the budget share it spends on nourishment.

49. The Shape of Engel Curves
 The shape of Engel curves depend on many demographic
variables and other consumer characteristics. A good’s
Engel curve reflects its income elasticity and indicates
whether the good is an inferior, normal, or luxury good.
Empirical Engel curves are close to linear for some
goods, and highly nonlinear for others.
 Graphically, the Engel curve is represented in the first-
quadrant of the Cartesian coordinate system. Income is
shown on the Y-axis and the quantity demanded for the
selected good or service is shown on the X-axis.

50. The Shape of Engel Curves
(Contd.)
 For normal goods, the Engel curve has a positive
gradient. That is, as income increases, the quantity
demanded increases. Amongst normal goods, there
are two possibilities. Although the Engel curve
remains upward sloping in both cases, it bends
toward the y-axis for necessities and towards the x-
axis for luxury goods.

52. The Shape of Engel Curves
(Contd.)
 For inferior goods, the Engel curve has a negative
gradient. That means that as the consumer has more
income, they will buy less of the inferior good
because they are able to purchase better goods.

54. Applications Of Engel Curves
 In microeconomics Engel curves are used for equivalence scale
calculations and related welfare comparisons, and determine
properties of demand systems such as aggregability and rank.
 Engel curves have also been used to study how the changing
industrial composition of growing economies are linked to the
changes in the composition of household demand
 In trade theory, one explanation inter-industry trade has been the
hypothesis that countries with similar income levels possess similar
preferences for goods and services (the Lindner hypothesis), which
suggests that understanding how the composition of household
demand changes with income may play an important role in
determining global trade patterns.
 Engel curves are also of great relevance in the measurement of
inflation and tax policy

55. Substitution Effect
 It is the change in the quantity of good.
purchased due to change in their relative
prices alone, while real income of the
consumer remains the same.

56. Substitution Effect(Contd.)

57. Substitution Effect (Contd.)
 In this diagram the consumer with given money income
and given prices of two goods represented by price line
PL is in equilibrium at point Q on the indifference curve
IC. He buys ON quantity of good Y and OM of good X.
 We suppose now that the price of good X has fallen and
the price of good Y remains the same. With the fall in the
price line shifts from PL to PL/. Consumer’s real income
is raised because commodity X is cheaper now. This
increase in the real income of the consumer is to be
wiped out for finding out the substitution effect. The
reduction in the money income of the consumer is to be
made by so much amount which keeps him on the same
indifference curve IC.

58. Indifference Curve Analysis - Price Effect
 When there is no change in the income of the
consumer, no change in the price of one commodity,
and there is a change in the price of another
commodity, there will be a change in the
consumption made by the consumer. This change in
consumption is known as the Price Effect. Though
money income does not increase, the real income
increases, generating more purchasing power.

59. Indifference Curve Analysis - Price Effect
(Contd.)
 Under the Price Effect, there will be a
change in the equilibrium position of
the consumer. This can be shown in
the following diagram.
 In this diagram PCC is the Price
Consumption Curve. It is sloping
downwards to the right. Any point on
the Price Consumption Curve will
indicate the equilibrium position of the
consumer under the Price Effect. In
this diagram when the price of X
falls, the consumer purchases
more of X and less of Y.

60. Indifference Curve Analysis - Price Effect
(Contd.)
 Shapes of Price Consumption Curve
 With a fall in the price of one commodity there will be some
extra income with the consumer. It can distribute this real
extra income on the two commodities in different ways. So
the Price Consumption Curve will have different shapes.
Below we draw the different shapes of the Price
Consumption Curve.

61. Indifference Curve Analysis - Price Effect
(Contd.)
 In the above
diagram PCC is the
price consumption
curve. It is a
horizontal straight
line. It indicates
that with a fall in
the price of X, the
consumer
purchases more of
X and the same
quantity of Y

62. Indifference Curve Analysis - Price Effect
(Contd.)
 In the above diagram
PCC, the price
consumption curve, is
sloping upwards to the
right. This indicates
that with a fall in the
price of X the
consumer purchases
more of X and more of
Y.

63. Indifference Curve Analysis - Price Effect
(Contd.)
 In this diagram the
price consumption
curve is sloping
upwards to the left.
This indicates that
with a fall in the
price of X, the
consumer purchases
less of X. This is
applicable in case of
Giffen goods.

64. Questions