Module No.

3
Managerial Economics
Theory of Consumption
By

Abhishek Mukherjee
M.Phil., UGC NET, MBA, BBA
 Points of Discussion

• Ordinal approach – Hicks and Allen model.

• Indifference Curve
• Properties of Indifference Curve
• Marginal Rate of Substitution
• Budget Line
• Consumer’s Equilibrium
• Engle’s Curve

2
Ordinal approach – Hicks and Allen model

• The concept of indifference curve was originally developed by F.Y. Edge worth
and later elaborated by J.R. Hicks and Allen.

• Indifference curve analysis measures utility ordinals.

• It says, consumer compares the utility of different combinations of goods

within the constraints of his income.

• A consumer assesses a definite scale of preferences for products and services.

• Each scale of preference consists of a number of substitute combinations of

two or more products, which give the consumer same level of satisfaction.

• Therefore, the consumer is indifferent towards these combinations.

3
 Assumptions

• Satisfaction is not measurable, but only comparable. It is based on ordinal

analysis.

• The prices of goods are given in the market and they remain constant.

• It assumes that the consumer is not interested in any one commodity at a

particular time, but in a combination of goods .

• It assumes the diminishing marginal rate of substitution.

• The consumer aims at maximisation of his utility

4
 Indifference Curves

• An indifference curve may be defined as the locus of points, each

representing a different combination of two substitutes, which yield the
same utility or level of satisfaction to the consumer.

• Therefore he is indifferent between any two combinations of goods when it

comes to making a choice between them.

• If a consumer is faced with such combinations, he would be indifferent

between the combinations. When such combinations are plotted
graphically , the testing curve is called indifference curve.

• An indifference curve is also called Isoutility curve or Equal Utility

curve.

5
Indifference Schedule of Commodities Tea and
Biscuits

Combination Biscuits Bananas Total Utility Rate of

Substitution
A 1 + 12 = U -
B 2 + 8 = U 1:4
C 3 + 5 = U 1:3
D 4 + 3 = U 1:2
E 5 + 2 = U 1:1

6
Indifference Curve

7
 Properties of Indifference Curve

Indifference Curves have the following four basic properties:

1. Indifference Curves have a negative slope.
2. Indifference Curves are convex to the origin.
3. Indifference Curves do not intersect nor are they tangent to
one another.
4. Upper Indifference Curve indicate a higher level of
satisfaction.

8
Indifference Curves have a negative slope.

9
Indifference Curves are convex to the origin

10
Indifference Curves never Intersect

11
Upper Indifference Curve indicate a higher level of
satisfaction.

12
 Exercise

Q1. Which of the following statements is NOT TRUE of indifference curves?

(a) They are convex to the origin
(b) They could intersect
(c) They exhibit higher levels of utility as you move from the origin
(d) They are downward sloping

13
 Exercise

Q1. Which of the following statements is NOT TRUE of indifference curves?

(a) They are convex to the origin
(b) They could intersect
(c) They exhibit higher levels of utility as you move from the origin
(d) They are downward sloping

Answer: (b) They could intersect.

14
 Exercise

Q2. Two ICs never intersect each other because

(a) They can’t be close to each other
(b) They represent different levels of satisfaction
(c) Both
(d) None

15
 Exercise

Q2. Two ICs never intersect each other because

(a) They can’t be close to each other
(b) They represent different levels of satisfaction
(c) Both
(d) None

Answer: (b) They represent different levels of satisfaction

16
 Exercise

Q3. An indifference curve is always:

(a) Concave to the origin
(b) Convex to the origin
(c) L-shaped
(d) A vertical straight line

17
 Exercise

Q3. An indifference curve is always:

(a) Concave to the origin
(b) Convex to the origin
(c) L-shaped
(d) A vertical straight line

Answer: (b) Convex to the origin.

18
 Exercise

Q4. Indifference curves never intersect each other due to:

(a) Different levels of satisfaction
(b) Same levels of satisfaction
(c) Convex to origin
(d) Concave to origin

19
 Exercise

Q4. Indifference curves never intersect each other due to:

(a) Different levels of satisfaction
(b) Same levels of satisfaction
(c) Convex to origin
(d) Concave to origin

Answer: (a) Different levels of Satisfaction

20
Marginal Rate of Substitution

21
 Budget Line

• Budget line shows combination of two commodities that a consumer can

afford with level of income.

• All the combinations within and on the budget line are affordable,
whereas, all the combinations beyond the budget line are unaffordable.

22
Budget Line

23
 Budget Line

• To draw a budget line, we should take the consumer’s income and price of
both the commodities per unit.
• Let us suppose the consumer’s income is `50,000 and price of X commodity
is `10,000 per unit, and the price of Y commodity is 5000 per unit.
• Let us understand how to draw a budget line with above information.
• If the consumer spends the entire income only to buy X commodity, he can
buy 5 units.
• Whereas, if consumer spends the entire income only to buy Y commodity,
he can buy 10 units.
• When these two points are joined, we get a budget line.

24
 Shift in Budget Line

• In case income of the consumer changes with of the prices of the two
goods remaining the same, there would be a parallel shift in the budget
line as in the above diagram.

• Let us take BL as the original budget line.

• When income increases, the budget line would shift to right and the new
budget line would be B1 L1.

25
 Consumer’s Equilibrium

• Consumer’s equilibrium is at the point where the budget line is tangent to

the highest attainable indifference curve by the consumer, subject to
budget constraint.

• A consumer behaves rationally and would always aim to maximise utility

with the given money, income, and prices of goods in the consumption
basket.

• However, in this upward movement for a higher indifference curve, the

consumer is limited by budget constraint.

26
Consumer’s Equilibrium

27
 Consumer’s Equilibrium

• Consumer’s equilibrium is also known as least cost combination because

the consumer would be in equilibrium when he is able to get maximum
satisfaction with his given level of income.

• In the above diagram, the budget line shows the income of the consumer
and various indifference curves show the levels of satisfaction of the
consumer.

• We can see the combination Q on IC3, which is the highest indifference

curve and shows the highest satisfaction level, but the consumer cannot
reach there as this curve falls in the unaffordable area of budget line.

28
 Consumer’s Equilibrium

• The combinations R, S, and E are affordable, so the consumer has to decide

on the combination he wants to settle with.

• Consumer would be in equilibrium at point E as it is the combination he

would be able to buy and be at the highest possible indifference curve.

• Though combinations R and S are affordable, they are not in equilibrium

as they fall on the lower indifference curve and provide the consumer
lesser satisfaction than E.

• Consumer’s equilibrium is where the indifference curve and budget line

are tangent to each other.

29
 Engle’s Curve

• An Engel curve describes how household expenditure on a particular

good or service 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.

• According to the German statistician remembered for the “Engel curve,”

or “Engel’s law, which states that lower a family’s income, the greater
is the proportion of it spent on food.”

• His conclusion was based on a budget study of 153 Belgian families

and was later verified by a number of other statistical inquiries into
consumer behaviour.

30
 THANK YOU

HAVE A GREAT DAY AHEAD!!!

31