1.

Indifference Curve: An Indifference curve is the locus of points , each representing

particular combination of two goods which yields same level of satisfaction(utility) to
the consumer, so that he is indifferent as to the particular combination of goods he
consumes.
 When thsese combinations are plotted on the graph, the resulting curve is
known as Indifference curve.
 This curve is also known as iso-utility curve or equal utility curve.

Assumptions of Indifference Curve:

Assumptions of Indifference Curve are:
1. Rationality
2. Utility is Ordinal
3. Diminishing Marginal Rate of Substitution
4. Consistency and Transitivity of Choice
5. Non-Satiety

Rationality
The consumer is assumed to be rational.He aims to maximize his satisfaction(utility) out of his
income, given market price and other factors. It is assumed that the consumer has full
knowledge of all relevant information.

Utility is Ordinal
It is assumed that the consumer ranks his preferences according to the satisfaction he gets from
various combination of goods.He does not know the amout of satisfaction but he expresses his
preferences for the various bundles of commodities. Hence ordinal utility measurement is
necessary not cardinal measurement.

Diminishing Marginal Rate of Substitution

Indifference curves are assumed to be convex to origin. The negative of the slope of an
indifference curve at any point is known as marginal rate of substitution of two commodities.
Thus, it denotes that indifference curve theory is based on the axiom of diminishing marginal
rate of substitution.
Consistency and Transitivity of Choice
It is assumed that the consumer is consistent in his choice, that is, if in one period he chooses
combination A, over B, he will not choose B over A in another period if both the combinations
are available to him.

Symbolically,

A  B, then B ≯ A

Similarly, it is assumed that consumer’s choices are characterized by transitivity: if combination

A is preferred to B, and B is preferred to C, then combination A, is preferred to C.
Symbolically,

A  B, and B  C, then A  C

Non-Satiety
It is assumed that total utility of the consumer depends on the quantities of the commodities
consumed.

Indifference Curve Analysis:

Assume that a consumer consumes two commodities X and Y and makes five combinations for
the two commodities a,b,c,d and e, which is shown in the Table 1:

Combination Units of Units of Total Utility

Commodity Y Commodity X
a 25 3 U
b 15 5 U

c 8 9 U
d 4 17 U

e 2 30 U

Table 1: Indifference Schedule For Substitues X and Y

When the Indifference schedule for X and Y is plotted on a graph, Indifference curve is
obtained, which is shown in figure 1.

 On the Indifference Curve (IC) curve, there can be several other points between a, b, c, d
and e, which yield the same level of satisfaction to the consumer. Therefore, consumer
remains indifferent towards any combinations of two substitute goods which yield the
same level of satisfaction.

Indifference Map: All the indifference curves which ranks the preferences of the consumer is
known as the Indifference map.

 Combinations of goods situated on the indifference curve yields same level of

satisfaction(utility) to the consumer.
 Combinations of goods on a lower indifference curve yields lower satisfaction.
 Combinations of goods lying on the higher indifference curve yields higher level of
satisfaction and are preferred.
Indifference Map is shown in figure 2.

 The negative of the slope of an indifference curve at any point is known as

marginal rate of substitution (MRS X,Y)for the two commodities X and Y.
 And it is Given by the slope of the tangent at that point.

𝑑𝑦
Slope of the Indifference Curve = − 𝑑𝑥 = MRS X,Y

Marginal Rate of Substitution: Marginal Rate of Substitution (MRS) of X for Y is defined as the
no of units of commodity Y must be sacrificed for an additional unit of commodity X, so that the
consumer remains on the same level of satisfaction.

Properties of Indifference Curve:

The Indifference Curve (IC) has certain definite properties, which are as follows:

Indifference Curve (IC) properties are as follows:

1. Indifference Curves are negatively sloped

2. Higher IC curve represents higher level of satisfaction.
3. Indifference curves are convex to origin
4. Indifference curves do not intersect each other
Indifference Curves are negatively sloped:
An indifference curves slopes downward to the right, which shows that if the quantity of one
commodity (Y) decreases, the quantity of the other commodity (X) must increase, if the
consumer is to stay on the same level of satisfaction.

Higher IC Curve represents higher level of satisfaction:

A higher IC lying above and to the right of another IC represents higher level of satisfaction and
vice versa. In other words, combination of goods on higher indifference curves are preferred by
the rational consumer.

Indifference curves are convex to origin:

ICs are inwards. This implies that the slopes of an Indifference curve decreases as we move
along the curve from the left downwards to the right i.e., Marginal rate of substitution of X for Y
diminishes as we move along the indifference curve. The rate gives the convex shape to the
indifference curve. However, there are two extreme scenarios:

1. Two commodities are perfect substitute for each other – In this case, the
indifference curve is straight line, where MRS is constant.
2. Two goods are perfect complementary goods – In such cases indifference curve will
be of L- shaped and convex to origin. An example of such goods would be gasoline
and water in a car.

Indifference Curves do not intersect each other:

Two ICs will never intersect each other. Also, they need not be parallel to each other either.
Look at the following diagram:
Figure 3, shows two ICs intersecting each other at point A. Since point A and B lies on the IC1,
they give the same level of satisfaction to the consumer. Similarly, points A and C give the same
satisfaction level as the lies on IC2. Therefore, we can imply that point B and C offer the same
satisfaction level to the consumer which violates the basic assumption of indifference curve.

An Indifference Curve do not touch the axis:

This is not possible because of assumption that a consumer considers different combination of
two goods and wants both of them. If the curve touches either of the axes, then it means that
he is satisfied with only one commodity and does not want the other, which violates the basic
assumption of IC theory.

Criticism of Indifference Curve:

Although, indifference curve analysis has been a major advance in the field of consumer’s
demand, it is criticized on various ground.

The main points of criticism of indifference curve are given below:

1. Two commodities model

2. Ignorant towards market behavior
3. Ignorant towards demonstration effect
4. Ignorant towards risks and uncertainties
5. Unrealistic assumptions
Two commodities model:
Indifference curve analysis is based on combinations of two commodities. Considering more
than two commodities in the analysis makes the calculations complex. This may further make
the prediction of consumer behavior difficult.

Ignorant towards market behavior:

Indifference curve analysis considers only two commodities in the market. However, market is
full of a large number of commodities. Thus, this theory ignores the market behavior in the
analysis.

Ignorant towards demonstration effect:

The demonstration effect states that an individual’s consumption pattern is affected by the
others consumption behavior. This is ignored by the indifference curve analysis.

Ignorant towards Risks and Uncertainties:

The market and individual’s life are full of risks and uncertainties, which has been ignored by
the indifference curve analysis.

Unrealistic Assumptions:
Indifference curve theory assumes that the consumer is fully aware about his/her preference
for various commodities. However, this is unrealistic assumption as humans have their
limitations.

Percentage Change in Quantity demanded

2. Price elasticity of demand =
Percentage change in price

Where,
Percentage change in quantity demanded =
New Quantity demanded−Original Quantity demanded (∆Q)
Original Quantity demanded (Q)

Percentage change in price =

New price−Original Price (∆P)
Original Price (P)

∆𝑄 𝑃
𝑒𝑝 = ×
∆𝑃 𝑄

Where,

ep= Price elasticity of demand

Q = Original quantity demanded

Q1 = New quantity demanded

∆𝑄 = Change in quantity demanded (Q1 – Q)

𝑃 = Original Price

𝑃1 = New Price

∆𝑃 = Change in Price (P1 – P)

Given that,

P = Rs 4
P1 = Rs 5

∆P = Rs 1 (5-4)

Q = 25 Units

Q1 = 20 Units
 ∆Q = -5 (20-25)
By substituting these values in the above formula, we get:

−5 4
𝑒𝑝 = ×
1 25

−20
𝑒𝑝 =
25

𝒆𝒑 = -0.8
Thus, the absolute value of price elasticity of demand is less than 1.

As elasticity is less than 1, the demand is less elastic. This indicates an inverse relationship
between the quantity demanded and price.

3a.
Cross Elasticity of demand is defined as the proportionate change in the quantity demanded of
good X as a result of change in the price of related good Y.

Percentage change in quantity demanded of good X

𝑒𝑐 =
Percentage change in price of good Y

𝑑𝑄𝑋 𝑃𝑌
ec = × 𝑄𝑋
𝑑𝑃𝑌
Here,

ec = Cross elasticity of demand

QX = Original quantity demanded of good X

dQX = Change in the quantity demanded of good X

PY = Original price of good Y

dPY = Change in the price of good Y

Cross elasticity of demand can be of three types:

  Positive Cross Elasticity of demand: When an increase in the price of good Y results in
the increase in the quantity demanded of good X and vice versa, the cross elasticity of
demand is said to be positive.
o Cross elasticity of demand is positive in case of substitute goods.
o If cross elasticity of good is greater than zero, the good is substitute

𝑑𝑄𝑋 𝑃𝑌
ec = × 𝑄𝑋  0
𝑑𝑃𝑌
For example, increase in the quantity demanded for the tea with the increase in the price of
coffee.

 Negative Cross Elasticity of demand: When an increase in the price of good Y results in
the decrease in the quantity demanded of good X and vice versa, the cross elasticity of
demand is said to be negative.
o Cross elasticity of demand is negative in case of complementary goods.
o If cross elasticity of good is less than zero, the good is complementary
𝑑𝑄𝑋 𝑃𝑌
ec = × 𝑄𝑋  0
𝑑𝑃𝑌
For example, decrease in the quantity demanded of butter/jam with the increase in the price of
bread.

 Zero Cross Elasticity of demand: When a proportionate change in the price of good Y
does not bring any change in the quantity demanded of good X, the cross elasticity of
demand is said to be zero.
o Cross elasticity of demand is zero in case of independent goods.
o If cross elasticity of good is equal to zero, the good is independent.

a) Here, given cross elasticity of demand of two goods is +1.2: If cross elasticity of
demand for good is positive and greater than zero, then good is substitute good.
Hence, two goods are substitutes.

b) Since the two goods are substitutes, there exists a positive cross elasticity of demand
between them. If the price of one good is rises by 5%, then, quantity demanded for the
other good will increase, holding the other factors constant.

Percentage change in quantity demanded of good X

𝑒𝑐 =
Percentage change in price of good Y
 Percentage change in the price of good Y = 5%
Hence,

Percentage change in quantity demanded of good X

1.2 =
5
By solving we get,
% Change in demand of good X = 1.2*5

% Change in demand of good X = 6%.

The percentage change of demand for good X increases by 6% when good Y has increase in
price by 5% at cross-price elasticity of demand +1.2.

3b.

 Marginal Utility: Marginal utility of a commodity is defined as change in the total utility,
attained from consumption of an additional unit of commodity.

Change in Total utility

Marginal Utility =
Change in quantity

Symbolically,
 ∆TU
MU =
∆Q

Where,
MU - Marginal Utility

TU - Total Utility
∆ - Change

Q - Unit of Commodity

Marginal Utility = TUn – TUn – 1

 Average Utility: Average Utility is defined as the utility obtained by the consumer from
per unit commodity consumed.

Total Utility
Average Utility =
Quantity

Symbolically,
TU
AU =
Q

Where,
AU – Average Utility

TU - Total Utility
Q - Unit of Commodity

Quantity Consumed Total Utility (TU) Average Utility Marginal Utility

(Q) 𝐓𝐔 (TUn – TUn-1)
( )
𝐐
 1 20 20/1 = 20 =20-0 = 20
2 35 35/2 = 17.5 =35-20 = 15
3 47 47/3 = 15.666 = =47-35 = 12
15.67
4 55 55/4 = 13.5 =55-47 = 8
5 60 60/5 = 12 =60-55 = 5

Reference:
1. D N Dwivedi, Managerial Economics, 8th ed, Vikas Publishing House
2. A. Koutsoyiannis, Modern Microeconomics, 2nd ed, St. Martin's Press, Inc.
3. Petersen, Lewis & Jain, Managerial Economics, 4e, Pearson Education India