Consumers Equilibrium Using Indifference

Curve Analysis
Avish | Bhavya | Diksha | Manik | Priyanka | Vedant
 Assumptions of the
Indifference Curve Approach
• 1. Rationality : The consumer is assumed to be
rational. He aims at maximising his benefits from
consumption, given his income and prices of the
goods.
• 2. Ordinality : Utility is expected satisfaction that a
consumer gets from a given market basket. In
indifference curve analysis, utility is an ordinal
concept. Consumer can order or rank the subjective
utilities derived from the commodities.

• 3. Diminishing Marginal Rate of Substitution : The slope of indifference curve is called Marginal Rate of Substitution
(MRS) of X for Y. MRS is defined as the amount of good Y the consumer is willing to give up to consume an additional
unit of good X, while leaving total utility unchanged.
• 4. Consistency of Choice : Consumer is consistent in his choice. It means that if good X
is preferred over good Y in one time period, then consumer will not prefer Y over X in another time period.
Assumptions of the Indifference Curve
Approach
• 5. Transitivity of Choice : Consumer’s choices are characterised by the
property of transitivity. If good X is preferred to good Y and good Y is
preferred to good Z, then good X is preferred to good Z or x > z.
• 6. Monotonic Preference : A consumer’s preferences are monotonic if and
only if between any two bundles, the consumer prefers the bundle which has
more of at least one of the goods and no less of the other good as compared
to the other bundle.
• Thus, monotonicity of preferences implies that (Fig 2.4) point M (which is
above the indifference curve) represent a bundle which is preferred to the
bundle on the indifference curve.
 Indifference Map & It’s Properties
• A family of indifference curves is called an Indifference Map. It gives a complete picture of a
consumer’s scale of preference for two goods.

• 1. Downward Sloping to the Right : It is because if the quantity of one good is reduced then the
quantity of the other good is increased. Thus, indifference curve must be downward sloping to
the right.
• 2. Convex to the Origin : An indifference curve is convex to the origin because of diminishing
marginal rate of substitution. The slope of an indifference curve is called Marginal Rate of
Substitution of X for Y, symbolically denoted as MRSXY. It is defined as the amount of Y that a
consumer is willing to substitute for an additional unit of X.

[Slope of Indifference Curve] = | Y/X | = MRSXY

MRSXY is the rate at which the consumer trades off Y for X. Diminishing Marginal Rate of

Substitution. MRSXY must be diminishing as consumer moves along the curve

to the right.

• 3. Two Curves do not Intersect each other :

 Budget Line or Income Line
• A budget line is a line which shows all possible combinations of two goods
that a consumer can buy with his given income and prices of the
commodities. The equation of a budget line is: PX * X + PY * Y = M where
• PX = Price of commodity X
• X = Quantity of Commodity X
• PY = Price of commodity X
• Y = Quantity of Commodity X
• M= Total income of consumer
• Budget Set : It is the collection or set of all the possible bundles or
combinations of two goods that the consumer can buy with his income and
prevailing prices of the commodities.
• Budget Constraint : The budget constraint shows that a consumer can choose
any bundle as long as it costs less or equal to the income she has, given
income and prices of goods. It can be written as:
Slope of Budget Line

• Slope of Budget Line : Slope of the budget line measures the

amount of change in good Y required per unit change in good X
along the budget line. Slope of budget line is also called Marginal
rate of exchange (MRE).
• The absolute slope of the budget line equals the PX /PY ratio.
The economic meaning of the slope is that, given these prices,
how much is the opportunity cost of X in terms of Y sacrificed
or given up.
 Assumptions of the Budget Line

• 1. Change in Income : Suppose income of consumer rises by 50 per

cent and prices of both commodities are constant then consumer’s
capacity to buy goods increases. He will buy more quantities of both
goods. As a result budget line shifts rightward to P1L1; and when
income decreases, it shifts leftward to P2L2
• 2. Change in Prices of Commodities :
(i) Change in Price of Commodity X. Suppose price of commodity X falls,
price of commodity Y and income of consumer remain constant. As a result,
consumer can buy more quantity of commodity X. The budget line shifts
rightward and new budget line becomes P1L1. When price of X rises, it
shifts leftward to P1L2 (See Fig. 2.10).

(ii) Change in Price of Commodity Y. Suppose price of commodity Y falls,

price of commodity X and income of consumer remain unchanged. As a
result, consumer can buy more quantity of commodity Y. There will be
rightward shift in budget line to P1L. When price of Y rises, it shifts
 Assumptions of the Budget Line

• (iii) With a Simultaneous Change in Price of Both Commodities :

by equal proportion and in same direction, income of consumer
remaining unchanged, will result is two possibilities:
(a) If PX and PY fall by equal proportion and in same direction then budget
line shifts rightward, it is because consumer is able to buy more
quantities of both goods with his given income
(b) (b) If PX and PY rise by equal proportion and in same direction then
budget line shifts leftward (See Fig. 2.12).
 Consumer’s Equilibrium or Optimal Choice
•Equilibrium is attained when the consumer reaches the highest possible indifference curve given his budget
•constraint.
•In other words, Consumer’s Equilibrium refers to the situation when a consumer is having maximum satisfaction
• with limited income and has no tendency to change his way ofexisting expenditure.
• Conditions of Consumer Equilibrium –
1. MUx/Px= MUy/Py
2. Diminishing Marginal Rate of Substitution

I1, I2, I3, I4 = These all different indifference curves.

AB = Budget constraint on budget line
The consumer’s budget line AB is tangent to Indifference Curve I2 at point E.
It is the point of consumer’s equilibrium.
At point E,
Slope of indifference curve = slope of budget line
Or MRSxy = Px/Py
 Consumer’s Equilibrium or Optimal Choice

Two Disequilibrium situations are:

1. MRSxy > Px/Py – It means that the customer is willing to pay more than the
current market price. As a result, the consumer buys more of X and less of Y.
MRS tends to fall and continues to fall till it becomes equal to the ratio of
prices of two goods and then equilibrium is established i.e.
MRSxy = Px/Py
2. MRSxy < Px/Py – It means that the customer is willing to pay less than the
current market price. As a result, the customer buys more of Y and less of X.
MRS tends to rise and continues to rise till it becomes equal to the ratio of
prices of two goods and then equilibrium is established i.e.
MRSxy = Px/Py