INDIFFERENCE CURVES AND UTILITY
MAXIMIZATION
• Indifference curve – A curve that shows
combinations of goods which gives the same
level of satisfaction to the consumers so that
an individual is indifferent.
Pears
Constructing an indifference curve
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
0
a
Pears Oranges
30
24
20
14
10
8
6
0
2
4
6
8
10
12
Oranges
14
a
b
c
d
e
f
g
6
7
8
10
13
15
20
16
Point
18
20
22
Assumption
• More of a commodity is better than less
• Preference of a consumer are transitive
• Diminishing marginal rate of substitution
More of a commodity is better than
less
Preference of a consumer are
transitive
Marginal rate of substitution
• Marginal rate of substitution – The rate at
which consumer is prepared to exchange
goods X and Y is known as MRS ie the rate at
which one good must be added when the
other is taken away in order to keep the
individual indifferent between the two
combinations without changing total
satisfaction .
Deriving the marginal rate of substitution (MRS)
30
a
b
Units of good Y
26
20
10
0
0
67
10
Units of good X
20
Deriving the marginal rate of substitution (MRS)
30
a
MRS = 4
b
DY = 4
26
Units of good Y
DX = 1
20
10
0
0
67
10
Units of good X
20
Deriving the marginal rate of substitution (MRS)
30
a
MRS = 4
b
DY = 4
26
Units of good Y
DX = 1
20
10
9
DY = 1
c
MRS = 1
d
DX = 1
0
0
67
10
13 14
Units of good X
20
Indifference schedule
• Indifference schedule
Combina Good X
tion
A
1
B
2
Good Y
MRS
12
8
4
C
D
3
4
5
3
3
2
E
5
2
1
Marginal Rate of Substitution
• MRS declines as we move downward to the
right along an indifference curve.
• Indifference curves with diminishing MRS are
thus convex.
• Convexity illustrates that people like variety.
Law of diminishing marginal rate of substitution
• Law of diminishing marginal rate of
substitution – As you get more and more of a
good X , one is prepared to forego less and
less of Y, that is MRS of X for Y diminishes as
more and more of good X is substituted for
good Y.
DMRS
An indifference map
Units of good Y
30
20
10
I5
I4
I1
0
0
10
Units of good X
I2
20
I3
Properties of Indifference Curve
– Indifference curves are downward sloping to the
right
– Indifference curves are convex to the origin
– Indifference curves cannot intersect each other
– A higher Indifference curves represents a higher
satisfaction
BUDGET LINE
• Budget line graphically shows the budget
constraint.
• The combination of commodities lying to the
right of the budget line are unattainable because
the income of the consumer is not sufficient to
be able to buy those combinations.
• The combination of commodities lying to the left
of the budget line are attainable because the
income of the consumer is sufficient to be able
to buy those combinations
What is a Budget Constraint?
• A budget constraint shows the consumer’s
purchase opportunities as every
combination of two goods that can be
bought at given prices using a given amount
of income.
• The budget constraint measures the
combinations of purchases that a person can
afford to make with a given amount of
monetary income.
A budget line
a
30
Units of good Y
Units of
good X
0
5
10
15
b
20
Units of Point on
good Y budget line
30
20
10
0
a
b
Assumptions
10
PX = £2
PY = £1
Budget = £30
0
0
5
10
Units of good X
15
20
Effect of an increase in income on the budget line
40
Assumptions
PX = £2
PY = £1
Budget = £40
Units of good Y
30
n
20
m
16
10
Budget
= £40
Budget
= £30
0
0
5
7
10
Units of good X
15
20
Effect on the budget line of a fall in the price of good X
a
30
Units of good Y
Assumptions
PX = £1
PY = £1
Budget = £30
20
10
B2
B1
c
b
0
0
5
10
15
20
Units of good X
25
30
The Best Feasible Bundle
• Tools needed to determine how consumers
should allocate their income between 2 goods
:
– Budget Constraint
– Indifference Curves
• Consumer’s strategy is to keep moving to
higher and higher indifference curves until he
reaches the highest one that is still affordable.
How to Find the Best Combination
• Utility is maximized when:
–the indifference curve is just tangent
to the budget line.
Consumer Equilibrium
The Best Affordable Bundle
Units of good Y
Finding the optimum consumption
Budget line
I5
I4
I1
O
Units of good X
I2
I3
indifference curve and budget line
r
Units of good Y
s
Y1
t
u
I5
I4
v
I1
O
X1
Units of good X
I2
I3
Units of good Y
Effect on consumption of a change in income
B1
O
Units of good X
I1
Units of good Y
Effect on consumption of a change in income
B1
B2
O
Units of good X
I2
I1
Units of good Y
Effect on consumption of a change in income
I4
I3
B1
B2
B3
O
Units of good X
B4
I2
I1
Units of good Y
Effect on consumption of a change in income
Income–consumption curve
I4
I3
B1
B2
B3
O
Units of good X
B4
I2
I1