Indifference Curves

Indifference Curves
• Indifference analysis is an alternative way of
explaining consumer choice that does not require an
explicit discussion of utility.
• Ordinal Approach: It does not require quantification
of utility but ranking is sufficient
• Indifference curve: A curve showing all the
combinations of two goods (or classes of goods) that
yields same level of satisfaction. So the consumer is
indifferent among all combinations.

Copyright © Houghton Mifflin Company. All rights 2

reserved.
 Assumptions
• Consumer has a definite scale of preferences
• Full knowledge about prices and market
• Rational consumer maximizing satisfaction
• Income is constant and all income is spent on
consumption
• Consumer is interested in combination of
goods/services than single commodity
• Consumer possesses an indifference map
depicting scale of preferences

3
 Properties of Indifference curves
• Indifference curves for two “goods” are generally negatively
sloped
• The slope of an indifference curve reflects the degree of
substitutability of two goods i.e. one for another
• Indifference curves are generally convex

• Indifference curves never cross

• Indifference curves that are farther from the origin represent

higher levels of utility
• Indifference curves need not be parallel to each other
 Indifference Curves: Shape

• A common shape for an indifference curve is

downward sloping.
– For the consumer to be indifferent to the bundle
of goods chosen, as less of one good is consumed,
more of another must be consumed.

Copyright © Houghton Mifflin Company. All rights 5

reserved.
Points on and off an indifference
curve
 Indifference Curves: Shape (2)
• The indifference curves are not likely to be vertical, horizontal,
or upward sloping.
– A vertical or horizontal indifference curve holds the quantity of one of
the goods constant, implying that the consumer is indifferent to getting
more of one good without giving up any of the other good.

– An upward-sloping curve would mean that the consumer is indifferent

between a combination of goods that provides less of everything and
another that provides more of everything.
– Rational consumers usually prefer more to less.

Copyright © Houghton Mifflin Company. All rights 7

reserved.
Indifference Curve Shapes

Copyright © Houghton Mifflin Company. All rights 8

reserved.
 Indifference Curves: Slope

• The slope or steepness of indifference curves is

determined by consumer preferences.
– It reflects the amount of one good that a consumer must give up
to get an additional unit of the other good while remaining
equally satisfied.

Copyright © Houghton Mifflin Company. All rights 9

reserved.
 Bowed-in
Indifference
Curve

Copyright © Houghton Mifflin Company. All rights 10

reserved.
 Indifference Curves:
No Crossing Allowed
• Indifference curves cannot cross.

• If the curves crossed, it would mean that the same bundle of

goods would offer two different levels of satisfaction at the
same time.
• If we allow that the consumer is indifferent to all points on
both curves, then the consumer must not prefer more to less.
• There is no way to sort this out. The consumer could not do
this and remain a rational consumer.

Copyright © Houghton Mifflin Company. All rights 11

reserved.
 Indifference
Curves Cannot
Cross!

Copyright © Houghton Mifflin Company. All rights 12

reserved.
 Indifference Map
• An indifference map is a complete set of indifference
curves.
• It indicates the consumer’s preferences among all
combinations of goods and services.
• The farther from the origin the indifference curve is,
the more the combinations of goods along that curve
are preferred.

Copyright © Houghton Mifflin Company. All rights 13

reserved.
Indifference
Map

Copyright © Houghton Mifflin Company. All rights 14

reserved.
 Budget Constraint
• The indifference map only reveals the ordering of consumer
preferences among bundles of goods. It tells us what the
consumer is willing to buy.
• It does not tell us what the consumer is able to buy. It does
not tell us anything about the consumer’s buying power.

• The budget line shows all the combinations of goods that

can be purchased with a given level of income and prices.

Copyright © Houghton Mifflin Company. All rights 15

reserved.
 The
Budget Line

Copyright © Houghton Mifflin Company. All rights 16

reserved.
 Willingness to Substitute Between Goods

• marginal rate of substitution (MRS) - the

maximum amount of one good a consumer will
sacrifice to obtain one more unit of another good.

B
MRS 
Z
– The slope of the indifference curve!

4-17
 MRS along an Indifference curve
Indifference Curve Convex to the Origin
• The MRS from bundle a
B, Burritos per semester

to bundle b is -3.
a From bundle a to bundle – This
b, Lisa
is the same as the
8
slope in
is willing to give up 3 Burritos of the indifference
curve between those two
exchange for 1 more Pizza…
–3 points.
b
5
1 From
Frombundle
bundlecbtotobundle
bundled, c,
-2 Lisa willing•to
Lisaisiswilling toFrom
give
giveup b 1to
up 2 c,
3
c Burritos
Burritosininexchange – MRS
exchange for
for1=1-2.
1 more
morePizza…
Pizza…
-1 d – This is the same as the
2
1 slope of the indifference
I
curve between those two
0 3 4 5 6 points.
Z, Pizzas per semester

4-18
 Diminishing marginal rate of substitution

• The marginal rate of substitution approaches

zero as we move down and to the right along
an indifference curve.

4-19
 Consumer Equilibrium
• The indifference map in combination with the budget line
allows us to determine the one combination of goods and
services that the consumer most wants and is able to
purchase. This is the consumer equilibrium.

• The demand curve for a good can be derived from

indifference curves and budget lines by changing the price
of one of the goods (leaving everything else the same) and
finding the equilibrium points.
Copyright © Houghton Mifflin Company. All rights 20
reserved.
 Consumer
Equilibrium

The consumer maxi-

mizes satisfaction by
purchasing the
combination of
goods that is on the
indifference curve
farthest from the
origin but attainable
given the
consumer’s budget.

Copyright © Houghton Mifflin Company. All rights 21

reserved.
 Two Normal Goods
•As income increases, the
budget constraint shifts out &
we are able to reach higher &
Y
IC3 higher IC’s.
IC2
•The points of tangency are at
IC1
higher & higher levels of
C
Y3
consumption of both goods.
B
Y2
A

Y1

X1 X2 X
X3
 Income-Consumption Curve
•The curve that traces out
these points is called the
income-consumption curve.
Y IC2
IC3
•For two normal goods, the
curve slopes upward.
IC1
C
•It may be convex (as drawn
Y3 here), concave, or linear.
B
Y2
A

Y1

X1 X2 X
X3
 We can also look at consumption levels of two
goods when the price of one of them changes.
•Suppose there is an increase in the price of
the 1st good (the good on the X-axis).
Y •The budget constraint pivots inward.
• Here we see X drop & Y increase.
•

Y3
Y2
Y1

X3 X2 X1
X
 If we connect the points, we have the
price consumption curve.

•It shows the utility-maximizing

Y points when the price of a good
changes.

Y3
Y2
Y1

X3 X2 X1
X
 Separating Income and Substitution
Effects: THE HICKSIAN METHOD
Optimal bundle is Ea, on indifference curve I1.
X2

Ea

I1

xa
X1
 THE HICKSIAN METHOD
A fall in the price of X1
X2 The budget line pivots out from P

P *

Ea

I1

xa
X1
 THE HICKSIAN METHOD
The new optimum is Eb on I2.
X2 The Total Price Effect is xa to xb

Eb
Ea I2

I1

xa xb
X1
 THE HICKSIAN METHOD
• To isolate the substitution effect we ask….
“what would the consumer’s optimal bundle be if
s/he faced the new lower price for X1 but
experienced no change in real income?”
• This amounts to returning the consumer to the
original indifference curve (I1)
 THE HICKSIAN METHOD
The new optimum is Eb on I2.
X2 The Total Price Effect is xa to xb

Eb
Ea I2

I1

xa xb
X1
 THE HICKSIAN METHOD
Draw a line parallel to the new budget line
X2 and tangent to the old indifference curve

Eb
Ea I2

I1

xa xb
X1
 THE HICKSIAN METHOD
The new optimum on I1 is at Ec. The movement
X2 from Ea to Ec (the increase in quantity
demanded from Xa to Xc) is solely in response
to a change in relative prices

Eb
Ea I2
Ec I1

xa xc xb
X1
 THE HICKSIAN METHOD
This is the substitution effect.
X2

Eb
Ea I2
Ec
I1

X1
Xa Substitution Effect Xc
 THE HICKSIAN METHOD
• To isolate the income effect …
• Look at the remainder of the total price effect
• This is due to a change in real income.
 THE HICKSIAN METHOD
The remainder of the total effect is due to a
change in real income. The increase in real
X2 income is evidenced by the movement from I1
to I2

Eb
Ea I2
Ec
I1

X1
Xc Income Effect
Xb
 THE HICKSIAN METHOD
X2

Eb
Ea I2
Ec
I1

xa xc xb
X1
Sub IncomeEf
Effect fect
 Deriving the
Demand Curve

By changing the price of

one of the goods and
leaving everything else
the same, we can derive
the demand curve.

In (a), the price of a gallon

of gasoline doubles,
rotating the budget line
from Y1 to Y2. The
consumer equilibrium
moves from point C to E,
and the quantity
demanded of gasoline
falls from 3 to 2. Copyright © Houghton Mifflin Company. All rights 37
reserved.