Consumer Theory of

Demand
INDIFFERENCE CURVE ANALYSIS
FACILITATOR
Indifference Curve Analysis

 The ordinal approach otherwise called the indifference curve analysis states that
utility cannot be measured and there is no need to measure utility.

 What is needed is the ability to rank different combinations of goods or market

basket of goods based on one’s order of preferences.
Indifference Curve Analysis

For example, we prefer a BMW car to a Nissan car, but we don’t say by how
much. It is argued this is more relevant in the real world. When deciding where to go
for lunch, we may just decide I prefer an Italian restaurant to Chinese. We don’t
calculate the exact levels of utility.
Indifference Curve Analysis

Indifference curve or the ordinal approach is a graph showing the various

combinations of two goods from which a consumer derives equal amount of
satisfaction. Each consumer is said to be indifferent among the different
combinations.
Indifference Curve Analysis
The Shape of the Indifference Curve

An indifference curve has two main features:

 Its downward sloping

 It has a convex shape
The Shape of the Indifference Curve

 Downward sloping nature – indicates that there is a tradeoff between good Y and good X.
As the amount of goods X consumed increases, the amount of good y must decrease if the
consumer is to obtain the same level of satisfaction and remain on the same indifference
curve.

 The rate at which Y is given up for X is known as the marginal rate of

substitution. The marginal rate of substitution shows the amount of good Y that must be given
up for good X to increase by 1 unit.

 The formula for marginal rate of substitution is:

MRS = ∆ Y
∆X
The Shape of the Indifference Curve

The convex shape – states that the indifference curve is initially steep but gets taller
or more gently sloping as one moves downwards along the curve.

This is based on the law of diminishing marginal utility. When the household is
consuming 20 patties, she is willing to give up 6 patties for another slice of pizza.
The Shape of the Indifference Curve

As the number of slices of pizza increases, its marginal utility decreases, and as less
patties are consumed, its marginal utility (MU) increases.

 The consumer is willing to give up less patties for an additional slice of pizza.

The slope of the indifference curve is the marginal rate of substitution. This means the
slope or the MRS is decreasing.
Indifference Curve Analysis

Pizza (x) Patty (y) Marginal Rate of Substitution

1 20 -

2 14 6

3 10 4

4 7 3

5 6 1
Question

Peter has 1 unit of food and 12 units of clothing. Now, we ask Peter how many
units of clothing is he willing to give up in exchange for an additional unit of food so
that his level of satisfaction remains unchanged.
CALCULATE THE MARGINAL RATE
OF SUBSTITUTION
Combination Food (x) Clothing (y) Marginal Rate of
Substitution

A 1 12

B 2 6

C 3 4

D 4 3
Indifference Curve Analysis
Properties of the Indifference Curve

 Completeness – consumer is able to determine the price of the product and can
rank their preferences of different combinations so that they may prefer A to B, B
to A or they are indifferent between the combinations.

 Transitivity – ensure that the consumer’s behaviour is rational and consistent so

that if the consumer prefers A to B and B to C, then A must be preferred to C.
Properties of the Indifference Curve
More is preferred to less – this principle states that the typical consumer prefers more to less given the utility maximizing
principle. This principle is based on the assumption that the consumer is not fully satisfied
 

Two indifference curves cannot intersect - two ICs will never intersect each other. Also, they need not be parallel to each
other either. Look at the following diagram:
Indifference Map

An Indifference Map is a set of Indifference Curves. The curve that is farthest to the
right, offers the highest level of satisfaction since it contains the highest combination
of both x and y.
Indifference Map
We know that a consumer is indifferent among the combinations lying on the same
indifference curve.

However, it is important to note that he prefers the combinations on the higher

indifference curves to those on the lower ones.

This is because a higher indifference curve implies a higher level of satisfaction.

Therefore, all combinations on IC1 offer the same satisfaction, but all combinations on
IC2 give greater satisfaction than those on IC1.
Overview
The Budget Line

The budget line is a graph that shows the maximum combination of two goods that
a consumer can purchase given his nominal income and the price of the goods or
service purchased, this is alluding to real income which is purchasing power of the
consumer.
The Budget Line

The budget line will shift to the right if:

a) the nominal income increases and the price of x and y remains constant (ceteris
paribus)
b) the price of x and y decreases and nominal income remains constant.

Nominal income is the amount of money the consumer possesses while real income
is the purchasing power of the consumer.
The Budget Line

Pivoting of the budget line

If the price of x falls and the price of y remains constant, the budget line will pivot to
the right or outwards. This means that the consumer can purchase more of good x and the
same amount of y.

If the price of y fall and x remains constant, the budget line will pivot to the left or
inwards. This means that the consumer can purchase more of y and the same amount of x.
The Budget Line
ACTIVITY

 Create a scenario that would depict the following;

 Outward shift of the budget line

 Outward pivot of the budget line on the x axis
 Inward pivot of the budget line on the y axis
 Inward pivot of the budget line on the x axis
 Outward pivot of the budget line on the y axis
 Inward shift of the budget line
Slope of the Budget Line

The slope of the line gives the ratio of prices of the two goods, which depicts the
rate at which the consumer is able to substitute good x for good y.

 To calculate the slope of the budget line: - Px / PY

Slope of the Budget Line

Combinations Quantity of good x Quantity of good y

A 0 25

B 10 20

C 20 15

D 30 10

E 40 5

F 50 0
Slope of the Budget Line

 Plot the budget line for the data in the table.

 Calculate the slope of the budget line.

Consumer Equilibrium
Consumer Equilibrium

 The budget line identifies all the consumption bundles which the consumer
bundles yield the highest level of satisfaction. This is done by superimposing the
budget line onto the indifference map.

 A single point is identified where the budget line is just tangential to an

indifference curve.

 This represents the consumption bundle which is the most preferred affordable
combination.
Consumer Equilibrium

 The point of tangency between the budget line and the indifference curve
identifies the affordable consumption bundle which gives the highest level of
satisfaction.

 According to the indifference curve analysis, the consumer attains equilibrium

where the slope of the budget line is equal to slope of the indifference curve.
Consumer Equilibrium

 Slope of the budget line = Slope of the indifference curve

 Price Ratio= Marginal Rate of Substitution

Activity

 Impose your constructed budget line on an indifference map of good X and good
y.

 Identify the point of equilibrium. Give a reason for your answer.

 If there is an increase in the price of good x, illustrate the change that would
occur(Share screen to illustrate).
Activity continued…

 If there is a reduction in the price of good y, illustrate the change that would occur
(Share screen to illustrate).

 If there is a reduction in the price of good x, illustrate the change that would occur
(Share screen to illustrate).

 If there is a price increase for good y, illustrate the change that would occur(Share
screen to illustrate).