Introduction to Economics
Lecture# 5
Consumer behavior
Ordinal Approach/ Indifference Curve
Analysis
Indifference Curves
• Indifference analysis is an alternative way of
explaining consumer choice that does not require an
explicit discussion of utility.
• Indifferent: the consumer has no preference among
the choices.
• Indifference curve: a curve showing all the
combinations or bundle of two goods which yield the
same level satisfaction to the consumer so that he is
indifferent among these combination.
• We can say that these bundles of consumption make
the consumer equally happy.
Shape of Indifference Curve
• The indifference curves are not likely to be
vertical, horizontal, or upward sloping.
• 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 to remain
equally happy.
Shape of
Indifference
Curve
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Slope of Indifference Curve
• 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. It is known as
Marginal Rate of Substitution (MRS)
– This relationship changes according to diminishing
marginal utility—the more a consumer has of a good,
the less the consumer values an additional value of
that good. This is shown by an indifference curve that
bows in toward the origin. This notion is known as
Diminishing Marginal Rate of Substitution DMRS
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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. It means higher indifference curves will
be preferred to lower ones
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Indifference
Map
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Assumptions of Indifference Curve
Theory
• Rationality: it is assumed that consumer is rational _means has
•
full knowledge about market conditions and aware of his costs and
benefits.
Utility is Ordinal: this theory assumes that consumer can rank
all his preferences according to the level of satisfaction without
precisely quantifying the utility.
• Consistency: It is assumed that consumer is consistent in his
•
choice, if in one period he prefers bundle A over B he will never
choose B over A in another period if both bundles are available to
him
Transitivity: consumer choices should be transitive. If bundle A
is preferred to B , and b is preferred to , Then bundle A must be
preferred to C. Symbolically it means
If A > B ,and B >C , then A >C
Properties of Indifference Curve
• Higher indifference curves are preferred to lower
ones. As higher indifference curve represent larger
quantities of goods than the lower ones
• Indifference curves are downward sloping. If a
consumer wants to increase the quantity of one thing
he has to reduce the units of other products
• Indifference curves are bowed inward. The
diminishing marginal rate of substitution causes the
indifference curve to bow inward or convex to the
origin
Indifference curves do not cross
• 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. (C & B)
• 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
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.
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Numerical Example
suppose Px=2, Py=1, I=10
Combinations
Commodity X
Commodity Y
Income constraint
XPx+ YPy= I
A
0
10
0(2)+10(1)=10
B
1
8
1(2)+8(1)=10
C
2
6
2(2)+6(1)=10
D
3
4
3(2)+4(1)=10
E
4
2
4(2)+2(1)=10
F
5
0
5(2)+0(1)=10
Shifts in The
Budget Line
the slope of budget line is indicated as the
price ratios of both commodities can be
expressed as PX/PY
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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.
• It means consumer will be in equilibrium when higest
indifference curve will touch the lowest budget line or the
slopes of both curves is same. Symbolically this point of
tangency of both curves can be expressed as
MRS or Dy/Dx= Px/Py
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Consumer
Equilibrium
The consumer maximizes satisfaction by
purchasing the
combination of
goods that is on the
indifference curve
farthest from the
origin but attainable
given the
consumer’s budget.
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Deriving the
Individual 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.
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