Theory of Ordinal
Utility/Indifference Curve Analysis:
Introduction:
The indifference curve analysis approach was
first introduced by Slustsky, a Russian
Economist in 1915. Later it was developed by
J.R. Hicks and R.G.D. Allen in the year 1928.
In an article “ A Reconsideration of the theory
of value”. And in his value and capital in 1939.
It has been used to replace the neo-classical
cardinal utility concept.
Introduction cont---• These economist are the of view that it is wrong to
base the theory of consumption on two assumptions:
• (i) That there is only one commodity which a person
will buy at one time.
• (ii) The utility can be measured
• Their point of view is that utility is purely subjective
and is immeasurable. Moreover an individual is
interested in a combination of related goods and in the
purchase of one commodity at one time. So they base
the theory of consumption on the scale of preference
and the ordinal ranks or orders his preferences
Meaning of indifference curve &
definition
• The indifference curve indicates the various
combinations of two goods which yield equal
satisfaction to the consumer. By definition:
• "An indifference curve shows all the various
combinations of two goods that give an equal
amount of satisfaction to a consumer".
• An indifference curve is the locus of all
commodity bundles (combinations) that give the
consumer the same level of utility (ie, the
consumer is indifferent between these bundles.
Indifference Schedule
Example One
Suppose that each of the bundles A, B, C, and D as defined in the
following table will give Mary 100 units of satisfaction--in other words,
Mary is indifferent among them--then the graph of quantity of chocolate
against quantity of peanut butter is called an indifference curve.
To show hypothetical numerical
Bundle/combination
Quantity of
Quantity of
Peanut/X
Chocolate/Y
Utility
A
L
10
1
1
9
100
B
M
6
2
2
6
100
C
N
3
3
3
4
100
D
P
1
4
4
3
100
Indifference Schedule
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Example two :
For example, a person has a limited amount of income which he wishes to
spend on two commodities, rice and wheat. Let us suppose that the following
commodities are equally valued by him:
Various Combinations:
a) 16 Kilograms of Rice
Plus
2 Kilograms of Wheat
b) 12 Kilograms of Rice
Plus
5 Kilograms of Wheat
c) 11 Kilograms of Rice
Plus
7 Kilograms of Wheat
d) 10 Kilograms of Rice
Plus
10 Kilograms of Wheat
e) 9 Kilograms of Rice
Plus
15 Kilograms of Wheat
It is matter of indifference for the consumer as to which combination he
buys. He may buy 16 kilograms of rice and 2 kilograms of wheat or 9
kilograms of rice and 15 kilograms of wheat. All these combinations are
equally preferred by him.
An indifference curve thus is composed of a set of consumption alternatives
each of which yields the same total amount of satisfaction. These
combinations can also be shown by an indifference curve.
Diagram/Graph
Figure/Diagram of Indifference Curve:
• The consumer’s preferences can be shown in a
diagram with an indifference curve. The indifference
showing nothing about the absolute amounts of
satisfaction obtained. It merely indicates a set of
consumption bundles that the consumer views as
being equally satisfactory.
Cont-• In fig. 1 we measure the quantity of wheat along X-axis (in kilograms)
and along Y-axis, the quantity of rice (in kilograms). IC is an
indifference curve.
• It is shown in the diagram that a consumer may buy 12 kilograms of
rice and 5 kilograms of wheat or 9 kilograms of rice and 15 kilogram
of wheat. Both these combinations are equally preferred by him and
he is indifferent to these two combinations. When the scale of
preference of the consumer is graphed, by joining the points a, b, c, d,
e, we obtain an Indifference Curve IC.
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• Every point on indifference curve represents a different combination
of the two goods and the consumer is indifferent between any two
points on the indifference curve. All the combinations are equally
desirable to the consumer. The consumer is indifferent as to which
combination he receives. The Indifference Curve IC thus is a locus of
different combinations of two goods which yield the same level of
satisfaction.
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An Indifference Map:
• A graph showing a whole set of indifference curves is
called an indifference map. An indifference map, in
other words, is comprised of a set of indifference
curves. Each successive curve further from the original
curve indicates a higher level of total satisfaction.
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Assumptions:
The ordinal utility theory or the indifference curve analysis is based on four main assumptions
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(i) Rational behavior of the consumer: It is assumed that individuals are rational in making decisions from their
expenditures on consumer goods.
there are two goods X and Y
(ii) Utility is ordinal: Utility cannot be measured cardinally. It can be, however, expressed ordinally. In other
words, the consumer can rank the basket of goods according to the satisfaction or utility of each basket.
(iii) Diminishing marginal rate of substitution: In the indifference curve analysis, the principle of diminishing
marginal rate of substitution is assumed.
(iv) Consistency in choice: The consumer, it is assumed, is consistent in his behavior during a period of time. For
insistence, if the consumer prefers combinations of A of good to the combinations B of goods, he then remains
consistent in his choice. His preference, during another period of time does not change. Symbolically, it can be
expressed as:
If A > B, then B > A
(iv) Consumer’s preference not self contradictory: The consumer’s preferences are not self contradictory. It
means that if combinations A is preferred over combination B is preferred over C, then combination A is
preferred over combination A is preferred over C. Symbolically it can be expressed:
If A > B and B > C, then A > C
(v) Goods consumed are substitutable: The goods consumed by the consumer are substitutable. The utility can
be maintained at the same level by consuming more of some goods and less of the other. There are many
combinations of the two commodities which are equally preferred by a consumer and he is indifferent as to
which of the two he receives.
Marginal Rate of Substitution (MRS):
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Definition and Explanation
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The concept of marginal rate substitution (MRS) was introduced by Dr. J.R. Hicks and
Prof. R.G.D. Allen to take the place of the concept of diminishing marginal utility.
Allen and Hicks are of the opinion that it is unnecessary to measure the utility of a
commodity. The necessity is to study the behavior of the consumer as to how he
prefers one commodity to another and maintains the same level of satisfaction.
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For example, there are two goods X and Y which are not perfect substitute of each
other. The consumer is prepared to exchange goods X for Y. How many units of Y
should be given for one unit of X to the consumer so that his level of satisfaction
remains the same?
The rate or ratio at which goods X and Y are to be exchanged is known as the
marginal rate of substitution (MRS). In the words of Hicks:
“The marginal rate of substitution of X for Y measures the number of units of Y that
must be scarified for unit of X gained so as to maintain a constant level of
satisfaction”.
Marginal rate of substitution (MRS) can also be defined as:
“The ratio of exchange between small units of two commodities, which are equally
valued or preferred by a consumer”.
Formula:
• MRSxy = ∆Y
∆X
• It may here be noted that the marginal rate of
substitution (MRS) is the personal exchange
rate of the consumer in contrast to the market
exchange rate.
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Schedule:
• The concept of MRS can be easily explained
with the help of schedule given below:
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Marginal Rate of Substitution
Combination
Good X
Good Y
MRS of X for Y
1
1
13
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2
2
9
4:1
3
3
6
3:1
4
4
4
2:1
5
5
3
1:1
Schedule explanation
• In the table given above, all the five combinations of good X and good
Y give the same satisfaction to the consumer. If he chooses first
combination, he gets 1 unit of good X and 13 units of good Y.
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• In the second combination, he gets one more unit of good X and is
prepared to give 4 units of good Y for it to maintain the same level of
satisfaction. The MRS is therefore, 4:1.
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• In the third combination, the consumer is willing to sacrifice only 3
units of good Y for getting another unit of good X. The MRS is 3:1.
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• Likewise, when the consumer moves from 4th to 5th combination, the
MRS of good X for good Y falls to one (1:1). This illustrates the
diminishing marginal rate of substitution.
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Diminishing Marginal Rate of
Substitution:
• In the above schedule, we have seen that as the consumer moves
from combination first to fifth, the rate of substitution of good X for
good Y goes, down. In other words, as the consumer has more and
more units of good X, he is prepared to forego less and less of good
Y.
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• For instance, in the 2nd combination, the consumer is willing to give
4 units of good Y in exchange for one unit of good X, in the fifth
combination only one unit of Y is offered for obtaining one unit of
X.
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• This behavior showing falling MRS of good X for good Y and yet to
remain at the same level of satisfaction is known as diminishing
marginal rate of substitution
Diagram/Figure:
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The concept of marginal rate of substitution (MRS) can also be illustrated with the help of the diagram.
In the fig. 3 above as the consumer moves down from combination 1 to combination 2, the consumer is willing to give up 4
units of good Y (∆Y) to get an additional unit of good X (∆X).
When the consumer slides down from combinations 2, 3 and 4, the length of ∆Y becomes smaller and smaller, while the length
of ∆X is remain the same. This shows that as the stock of the consumer for good X increases, his stock of good Y decreases.
He, therefore, is willing to give less units of Y to obtain an additional unit of good X. In other words, the MRS of good X for good
Y falls as the consumer has more of good X and less of good Y. The indifference curve IC slopes downward from left to the right.
This means a negative and diminishing rate of substitution of one commodity for the other.
Importance of Marginal Rate of
Substitution (MRS):
• (i) Measures utility ordinally: The concept of MRS is
superior to that of utility concept because it is more
realistic and scientific than the theory of utility. It does not
measure the utility of a commodity in isolation without
reference to other commodities but takes into
consideration the combination of related goods to which a
consumer is interested to purchase.
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• (ii) A relative concept: The concept of marginal rate of
substitution has the advantage that it is relative and not
absolute like the utility concept given by Marshall. It is free
from any assumptions concerning the possibility of a
quantitative measurement of utility
Exceptions of DMRS Law
• 1. Straight line indifference curve
• L-shaped indifference curve
Properties/Characteristics of
Indifference Curve:
• Definition, Explanation and Diagram
• An indifference curve shows combination of
goods between which a person is indifferent.
The main attributes or properties or
characteristics of indifference curves are as
follows:
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• (1) Indifference Curves are Negatively Sloped:
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The indifference curves must slope down from left to right. This means that an
indifference curve is negatively sloped. It slopes downward because as the
consumer increases the consumption of X commodity, he has to give up certain
units of Y commodity in order to maintain the same level of satisfaction.
In fig. 6 the two combinations of commodity cooking oil and commodity wheat is
shown by the points a and b on the same indifference curve. The consumer is
indifferent towards points a and b as they represent equal level of satisfaction.
At point (a) on the indifference curve, the consumer is satisfied with OE units of
ghee and OD units of wheat. He is equally satisfied with OF units of ghee and OK
units of wheat shown by point b on the indifference curve. It is only on the
negatively sloped curve that different points representing different combinations
of goods X and Y give the same level of satisfaction to make the consumer
indifferent.
• (2) Higher Indifference Curve Represents Higher Level:
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• A higher indifference curve that lies above and to the
right of another indifference curve represents a higher
level of satisfaction and combination on a lower
indifference curve yields a lower satisfaction.
• In other words, we can say that the combination of
goods which lies on a higher indifference curve will be
preferred by a consumer to the combination which lies
on a lower indifference curve.
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(3) Indifference Curve are Convex to the Origin:
This is an important property of indifference curves. They are convex to the
origin (bowed inward). This is equivalent to saying that as the consumer
substitutes commodity X for commodity Y, the marginal rate of substitution
diminishes of X for Y along an indifference curve
In this figure (3.6) as the consumer moves from A to B to C to D, the
willingness to substitute good X for good Y diminishes. This means that as the
amount of good X is increased by equal amounts, that of good Y diminishes by
smaller amounts. The marginal rate of substitution of X for Y is the quantity of
Y good that the consumer is willing to give up to gain a marginal unit of good
X. The slope of IC is negative. It is convex to the origin.
• (4) Indifference Curve Cannot Intersect Each Other:
• Given the definition of indifference curve and the
assumptions behind it, the indifference curves cannot
intersect each other. It is because at the point of tangency, the
higher curve will give as much as of the two commodities as is
given by the lower indifference curve. This is absurd and
impossible.
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• In fig 3.7, two indifference curves are showing cutting each other at
point B. The combinations represented by points B and F given equal
satisfaction to the consumer because both lie on the same indifference
curve IC2. Similarly the combinations shows by points B and E on
indifference curve IC1 give equal satisfaction top the consumer.
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• If combination F is equal to combination B in terms of satisfaction and
combination E is equal to combination B in satisfaction. It follows that
the combination F will be equivalent to E in terms of satisfaction. This
conclusion looks quite funny because combination F on IC2 contains
more of good Y (wheat) than combination which gives more
satisfaction to the consumer. We, therefore, conclude that indifference
curves cannot cut each other.
• (5) Indifference Curves do not Touch the Horizontal or Vertical Axis:
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• One of the basic assumptions of indifference curves is that the
consumer purchases combinations of different commodities. He is not
supposed to purchase only one commodity. In that case indifference
curve will touch one axis. This violates the basic assumption of
indifference curves.
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In fig. 3.8, it is shown that the in difference IC touches Y axis at point C and X axis at point E.
At point C, the consumer purchase only OC commodity of rice and no commodity of wheat,
similarly at point E, he buys OE quantity of wheat and no amount of rice. Such indifference
curves are against our basic assumption. Our basic assumption is that the consumer buys
two goods in combination.
• Important properties of indifference curves.
• The above story suggests two important properties of indifference
curves
• Indifference curves are downward sloping (they have negative
sloped).
• Indifference curves are convex. That is the absolute value of their
slope declines as we obtain more X and less Y.
• The above indifference curve was for all the bundles that give Mary
a utility of 100. What about all commodity bundles that will give her
a utility of 150, 200, or any other number? There is an indifference
curve for each level of utility and the family of all possible
indifference curves is called an indifference map. The following
diagram is an example of an indifference map.
• We can understand this diagram by looking at
the point shown on the indifference curves.
For example, our consumer is indifferent
between bundles A and C but she prefers
bundle B to both A and C. Also, whereas she is
indifferent between E and D, she prefers both
to B, A and C. As we talked earlier, with ordinal
utility, the only relationships of interest are
preference and indifference. The consumer
prefers bundles on higher indifference curves
to those on the lower curves and she is
indifferent between bundles on the same
curves.
Price Line or Budget Line:
• Definition and Explanation:
• The understanding of the concept of budget line is essential for
knowing the theory of consumer’s equilibrium.
• "A budget line or price line represents the various combinations
of two goods which can be purchased with a given money
income and assumed prices of goods".
• The budget line is an important element analysis of consumer
behavior. The indifference map shows people’s preferences for
the combination of two goods. The actual choices they will make,
however, depends on their income. The budget line is drawn as a
continuous line. It identifies the options from which
the consumer can choose the combination of goods.
• For example, a consumer has weekly income of $60. He
purchases only two goods, packets of biscuits and packets of
coffee. The price of each packet of biscuits is $6 and the price of
each packet of coffee is $12. Given the assumed income and the
price, of the two goods, the consumer can purchase various
combination of goods or market combination of goods weekly.
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Price Line or Budget Line cont---• Budget line is the locus of all commodity combinations the
consumer can purchase spending all of her budget. To develop the
idea of the budget line once again assume that there are only two
goods, say X and Y. let us denote price of X by PX and price of Y by
PY. If x is the quantity of goods X and y is the quantity of good Y
purchased by the consumer, then l
• I = PX.X + PY. Y
• When I is constant, in a two-dimensional Y-X, diagram this
represents the equation of the budget line. If we write the equation
explicitly (that is y in terms of x) we have,
• Y = (I/PY) - (PX / PY) X
• This means that the slope of the budget line is - PX / PY and the yintercept of the line is I/PY. The X intercept of the line (that is the
point where Y=0) can be easily found to be I/PX. The following is the
graph of the budget line.
Schedule:
• The various alternative market baskets
(combinations of goods) are shown in the table
below:
Market Basket
Packets of Biscuits Per Week
Packets of Coffee Per Week
A
10
0
B
8
1
C
6
2
D
4
3
E
2
4
F
0
5
Income $60 Per Week = Packets of Biscuits Costs $6 = Packets of Coffee is Priced $12 Each
Schedule Cont---• (i) Market basket A in the table above shows that if the
whole amounts of $60 is spent on the purchase of biscuits,
then the consumer buys 10 packets of biscuits at a price of
$6 each and nothing is left to purchase coffee.
• (ii) Market basket F shows the other extreme. If the
consumer spends the entire amount of $60 on the purchase
of coffee, a maximum of 5 packets of coffee can be
purchased with it at a price of $12 each with nothing left
over for the purchase of biscuits.
• (iii) The intermediate market baskets B to E shows the mixes
of packets of biscuits and packets of coffee that the cost a
total of $60. For example, in combination of market basket
C, the consumer can purchase 6 packets of biscuits and 2
packets of coffee with a total cost of $60.
Diagram/Figure:
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In the fig. 3.9 the line AF shows the various combinations of goods the consumer can
purchase. This line is called the budget line.
It shows 6 possible combinations of packets of biscuits and packets if coffee which a
consumer can purchase weekly. These combinations are indicated by points A, B, C, D,
E and. Point A indicates that 10 packet of biscuits can be purchased if the entire
income of $60 is devoted to the purchase of biscuits. Similarly, point F shows the
purchase of 5 packets of coffee for the entire income of $60 per week.
The budget line AF indicates all the combinations of packets of biscuits and packets of
coffee which a consumer can buy given the assumed prices and income. In case, a
consumer decides to purchase combination of goods inside the budget line such as G,
then it involves a total outlay that is smaller then the amount of $60 per week. Any
point outside the budget line such as H requires an outlay larger than the consumer’s
weekly income of $60.
The slope of the budget line indicates how many packets of biscuits a purchaser must
give up to buy one more packet of coffee. For example, the slope at point B on the
budget line is ∆Y / ∆X or two packets of biscuits 1 = packet of coffee. This indicates that
a move from B to C involves sacrificing two packets of biscuits to gain an additional one
packet of coffee. Since AF budget line is straight, the slope is constant at -2 packets of
biscuits per one packet of coffee at all points along the line.
Shifts in Budget Line:
• The price line is determined by the income of the consumer
and the prices of goods in the market. If there is a change in
the income of the consumer or in the prices of goods, the price
line shifts in response to a exchange in these two factors.
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• (i) Income changes: When there is change in the income of the
consumer, the prices of goods remaining the same, the price
line shifts from the original position. It shifts upward or to the
right hand side in a parallel position with the rise in income.
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• A fall in the level of income, product prices remaining
unchanged, the price line shifts left side from the original
position. With a higher income, the consumer can purchase
more of both goods than before but the cost of one good in
terms of the other remains the same.
In the fig. 3.10 (a), a change in income is shown when product prices remain
unchanged. The rise in income results in a parallel upward shifts in the budget line
from L/ M/ to L2M2. The consumer is able to purchase more of both the goods A and
B.
(ii) Price changes. Now let us consider that there is a
change in the price of one good. The income of the
consumer and price of other good is held constant.
When there is a fall in the price of one good say
commodity A, the consumer purchases more of that
good than before. A price change causes the budget
line to rotate about point L fig. 3.10 (b).
Consumer's Equilibrium Through
Indifference Curve Analysis:
• Definition:
• "The term consumer’s equilibrium refers to the
amount of goods and services which the consumer
may buy in the market given his income and given
prices of goods in the market".
• The aim of the consumer is to get maximum
satisfaction from his money income. Given the price
line or budget line and the indifference map:
• "A consumer is said to be in equilibrium at a point
where the price line is touching the highest attainable
indifference curve from below".
Conditions:
• Thus the consumer’s equilibrium under the
indifference curve theory must meet the
following two conditions:
• First: A given price line should be tangent to an
indifference curve or marginal rate of
satisfaction of good X for good Y (MRSxy) must
be equal to the price ratio of the two goods.
i.e.
• MRSxy = Px / Py
• Second: The second order condition is that
indifference curve must be convex to the origin
at the point of tangency.
Assumptions:
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The following assumptions are made to determine the consumer’s equilibrium
position.
(i) Rationality: The consumer is rational. He wants to obtain maximum satisfaction
given his income and prices.
(ii) Utility is ordinal: It is assumed that the consumer can rank his preference
according to the satisfaction of each combination of goods.
(iii) Consistency of choice: It is also assumed that the consumer is consistent in the
choice of goods.
(iv) Perfect competition: There is perfect competition in the market from where the
consumer is purchasing the goods.
(v) Total utility: The total utility of the consumer depends on the quantities of the
good consumed.
Explanation:
The consumer’s consumption decision is explained by combining the budget line
and the indifference map. The consumer’s equilibrium position is only at a point
where the price line is tangent to the highest attainable indifference curve from
below.
Diagram/Figure:
• (1) Budget Line Should be Tangent to the
Indifference Curve:
The consumer’s equilibrium in explained by
combining the budget line and the indifference
map.
Diagram
• In the diagram 3.11, there are three indifference curves
IC1, IC2 and IC3. The price line PT is tangent to the
indifference curve IC2 at point C. The consumer gets the
maximum satisfaction or is in equilibrium at point C by
purchasing OE units of good Y and OH units of good X
with the given money income.
• The consumer cannot be in equilibrium at any other point
on indifference curves. For instance, point R and S lie on
lower indifference curve IC1 but yield less satisfaction. As
regards point U on indifference curve IC3, the consumer
no doubt gets higher satisfaction but that is outside the
budget line and hence not achievable to the consumer.
The consumer’s equilibrium position is only at point C
where the price line is tangent to the highest attainable
indifference curve IC2 from below.
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(2) Slope of the Price Line to be Equal to the Slope of Indifference Curve:
The second condition for the consumer to be in equilibrium and get the
maximum possible satisfaction is only at a point where the price line is a
tangent to the highest possible indifference curve from below. In fig. 3.11, the
price line PT is touching the highest possible indifferent curve IC2 at point C.
The point C shows the combination of the two commodities which the
consumer is maximized when he buys OH units of good X and OE units of good
Y.
Geometrically, at tangency point C, the consumer’s substitution ratio is equal
to price ratio Px / Py. It implies that at point C, what the consumer is willing to
pay i.e., his personal exchange rate between X and Y (MRSxy) is equal to what
he actually pays i.e., the market exchange rate. So the equilibrium condition
being Px / Py being satisfied at the point C is:
Price of X / Price of Y = MRS of X for Y
The equilibrium conditions given above states that the rate at which the
individual is willing to substitute commodity X for commodity Y must equal
the ratio at which he can substitute X for Y in the market at a given price.
• (3) Indifference Curve Should be Convex to the Origin:
• The third condition for the stable consumer equilibrium
is that the indifference curve must be convex to the
origin at the point of equilibrium. In other words, we can
say that the MRS of X for Y must be diminishing at the
point of equilibrium. It may be noticed that in fig. 3.11,
the indifference curve IC2 is convex to the origin at point
C. So at point C, all three conditions for the stableconsumer’s equilibrium are satisfied.
• Summing up, the consumer is in equilibrium at point C
where the budget line PT is tangent to the indifference
IC2. The market basket OH of good X and OE of good Y
yields the greatest satisfaction because it is on the
highest attainable indifference curve. At point C:
• MRSxy = Px / Py
(1) Changes in Consumer's
Equilibrium (Income Effect):
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Definition and Explanation:
We now describe in brief as to how indifference curves and budget lines can be used
to analysis the effects on consumption due to (a) changes in the income of a
consumer (b) changes in the price of a commodity.
In the consumer’s equilibrium analysis, it is primarily assumed that the price of the
goods X and Y and the income of the consumer remains constant. We now examine
as to how the consumer reacts as regards to his purchases of good when his income
changes within the indifference curve frameworks. Income is one of the most
important factors affecting the purchase of commodities.
If the prices of goods, tastes and preferences of the consumer remains constant and
there a change in his income, it will directly affect consumer’s demand. This effect
on the purchase due to change in income is called the income effect.
A rise in consumer’s income will shift the price line or budget line upward to the
right and he goes on to higher point of equilibrium. A fall in the income, will shift the
price line downward to the left and the consumer attains lower (tangency) points of
equilibrium. The shift of the price line is parallel as the prices of the goods are
assumed to remain the same. The income effect is explained with the help of
following diagram.
Diagram/Figure:
In the diagram (3.12) wheat is measured along OX and rise along OY. When the price line or budget line
is BB/ , the consumer gets maximum satisfaction or is in equilibrium position at point K where it touches
the indifference curve IC1. The consumer buys OS quantity of wheat and ON quantity of rice. We
suppose now that the income of the consumer has increased and the price line is now CC1. Which shifts
in a parallel fashion to the right.
The consumer is in equilibrium at a level at point L which is its equilibrium point. If there is further
increase in income: shift of the price line now will be DD1, and the consumer is in equilibrium at point T
and will be purchasing OZ quantity of wheat and OE quantity of rice. If these, equilibrium points K, L, T
are joined together by a dotted line passing through the origin, we get income consumption curve ICC.
This shows that with the rise in income, the consumer generally buys more quantities of the two
commodities rice and wheat. The income consumer is now better off at T on indifference curve IC3 as
compared to L at a lower indifference curve IC2 . The income effect is positive in case of both the goods
rice and wheat as these are normal goods. The income consumption curve ICC which is derived by
joining the successive equilibrium positions has a positive slope.
Diagram/Figure:
• Example:
• Income Effect When Wheat is an Inferior Good:
• Sometimes it also happens that with the rise in
income, the consumer buys more of one
commodity and less of another. For instance, he
may buy less of wheat and more of rice as is,
illustrated in figures 3.13.
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• In diagram 3.13, the income consumption
curve bends back on itself. With the rise in
income, the consumer buys more of rice and
less of wheat. The price effect for rice is
positive and for wheat is negative. The good
which is purchased less with the increase in
income is called inferior good.
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Income Effect When Rice is an Inferior
Good:
In the figure 3.14, it is shown that with the rise in money income, the purchase of wheat has
increased from M1 to M4 indicating positive income effect on the purchase of normal good
wheat. The income effect on inferior good is negative. The income consumption curve ICC is
starts bending towards the horizontal axis which shows that wheat is a normal good and rice
is inferior good.
(2) Changes in Consumer’s
Equilibrium (Price Effect):
• Price Effect on the Consumption of a Normal Good:
• We now discuss the reaction of the consumer to the changes in
the price of a good while his money income, tastes, preferences
and prices of other goods remain unchanged. When there is
change in the price of a good shown on the two axes of an
indifference map, there takes place a change in demand in
response to a change in price of a commodity, other things
remaining the same, is called price effect.
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(2) Changes in Consumer’s
Equilibrium (Price Effect):
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For example in fig. 3.15, AB is the initial budget line. It is assumed that the
price of wheat has fallen and the price of rice and the income of the
consumer remains unchanged. The price line takes a new position AC and
the equilibrium point shifts from P to U.
The consumer buys now OT quantity of wheat (the amount demanded
rises from OE to OT and OZ quantity of rice. With further fall in the price of
wheat, the consumer is in equilibrium at point S, where the budget line AD
is tangent to a higher indifference curve AC3. He buys now OF quantity of
wheat and OR quantity of rice.
The rise in amount purchased of wheat (OE to OF) as a result of a fall in its
price is called price effect. The price effect on the consumption of a
normal good is negative. If we join the equilibrium points PUS, we get
price consumption curve (PCC) of the consumer for the commodity wheat
Price Effect When Commodity X is a
Giffen Good:
• Giffen good is a particular type of inferior good. When there is a
decrease in the quantity demanded of a good with a fall in its price,
the good is called Giffen good after the name of Robert Giffen.
•
• A British Economist Robert Giffen (1837-1910), observed that
sometimes it so happens that a decrease in the price of a particular
good causes its quantity demanded to fall. The consumer spends the
money he saves (by curtailing the demand) on the purchase of
increased quantity of the other good. The decease in the price of
Giffen good has an effect similar to an an increase in the income of a
buyer. This particular type of behavior of the consumer to decrease
demanded of good when its price falls is called Giffen Paradox.
• The price effect on the consumption of the Giffen good X is now
explained with the help of diagram below:
•
In fig. 3.16, the consumer is in equilibrium at point E where the budget line AB is
tangent to the indifference curve IC1. The consumer purchases OX1 quantity of Giffen
good X and OY1 quantity of good Y.
When there is a reduction in the price of good X but no change in the price of good Y,
the budget line AB/ will showing upward. The consumer is in equilibrium at point E/
where the budget line AB/ is a tangent to the indifference curve IC2. In the new
equilibrium position, the consumer purchases only OX2 units of Giffen good X and OY2
units of good Y.
We find that the decrease in the price of Giffen good X, its quantity purchased has fallen from OX1 to OX2 and
the quantity demanded of Y commodity goes up from OY1 to OY2. The price effect on the consumption of Giffen
good is positive. If is indicated by the backward bending PCC in the case of X as a Giffen good.
3) Consumer’s Equilibrium and the
Substitution (Effect of Price Change):
• In the economic literature, there are two slightly
different methods for explaining the impact of a price
change on the quantity demanded of the two the two
goods by the consumer. The first method is attributed to
Hicks and Allen and is named as Hicks-Allen Substitution
Effect.
•
• The second put forward by S. Slutsky, a Russian
Economist, is known as Slutsky Substitution Effect.
•
• The two concept differ in the way in which real income
of the consumer is to be maintained constant when the
substitution effect is to be observed. We explain the
Hicks-Allen Method of tracing the substitution effect.
•
Hicks-Allen Substitution Effect:
• In the Hicksian method, price changes is accompanied by so much
change in money income that the consumer is neither better off nor
worse off than before. The money income is changed by an amount
which keeps the consumer on the same indifference curve.
•
• For instance, the price of good say X falls, and that of good Y remains
unchanged. With this fall in the price of good X, then the real income
of the consumer would increase. This increase in the real income of the
consumer is so withdrawn that he is neither better off nor worse off
than above. The amount by which the money income is reduced is
called compensating variation in income.
•
• Substitution effect thus means the change in its relative price alone,
real income of the consumer remaining constant. The Hicksian
substitution effect in now explained with the help of diagram below.
•
In this diagram 3.17 the consumer with given money income and given prices of two goods
represented by price line PL is in equilibrium at point Q on the indifference curve IC. He buys ON
quantity of good Y and OM of good X.
We suppose now that the price of good X has fallen and the price of good Y remains the same. With
the fall in the price line shifts from PL to PL/. Consumer’s real income is raised because commodity X is
cheaper now. This increase in the real income of the consumer is to be wiped out for finding out the
substitution effect. The reduction in the money income of the consumer is to be made by so much
amount which keeps him on the same indifference curve IC.
In case, consumer’s income is reduced by PA (interims of Y) or LB (in terms of X), the consumer will
remain on the same indifference curve IC. PA or L/B is the compensating variation in income. At the
new price line AB, the consume is in equilibrium at point T. He now buys OM/ of good X and ON/ of
good Y.
The increase in the purchase of good X by MM/ and decrease in the purchase of good Y by NN/ is due
to the fall in the price of good X. The consumer has rearranged his purchase of good X and good Y as
good X is now relatively cheaper and good Y is relatively dearer than before.
The consumer has moved on the same indifference curve IC from Q to point T substituting the
commodity that has become relatively cheaper for the one that has relatively become more
expensive because of price change. The type of movement from point Q to T on the same indifference
represents the substitution effect.
Comparison Between Indifference
Curve Analysis and Marginal Utility
Analysis:
• There is difference of opinion among economists about the superiority
of indifference analysis over cardinal utility analysis.
• Professor Hicks is of the opinion that the indifference analysis is more
objective and scientific.
• Professor D.H. Rebertson is of the view that the Hicksian indifference
curve technique is simply “old wine in new bottle”.
•
• We give in brief the main points of similarly between these two types
of analysis and then discuss the superiority of Hicksian indifference
curve analysis over the Marshallian Utility Approach.
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Similarities Between the Two
Approaches:
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(i) Rationality assumption: In the two approaches, it is assumed that the consumer behaves rationality for
obtaining satisfaction from his expenditure on consumer goods. Marshall uses the term utility, and Hicks
satisfaction.
(ii) Proportionality rule: The equilibrium condition of the consumer in both the analysis is the
proportionality rule. In cardinal utility analysis , the equilibrium condition of the consumer is:
MUa / Pa = MUb / Pb = MUc / Pc …………. = MUn / Pn
In the Hicksian analysis, this ratio of marginal utility has been substituted by marginal rate of substitution is:
MRSxy = Px / Py
(iii) Diminishing MU and MRS: Another similarity between the two types of analysis is that both assume
that as the consumer gets more and more of a commodity, there is diminishing satisfaction to the
consumer.
(iv) Same conclusion: The cardinal utility analysis and the Hicksian indifference curve analysis both reach at
the same conclusion about the consumer behavior. There is nothing new in the indifference approach.
•
Superiority of Hicksian Indifference
Curve
Analysis:
i) It dispenses with cardinal measurement of utility: Professor R.G.D. Allen and J.R Hicks claims
that the indifference curve technique is scientific and more realistic than the Marshall’s utility
analysis. The foundation of utility analysis is based, they say, on the cardinal utility function
which assumes that the utility is measurable; whereas utility is purely subjective phenomena
and cannot be exactly measured. It varies from person to person and time to time. Any effort to
measure it precisely will be a futile one.
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On the the other hand, the indifference approach is based on ordinal utility function, i.e., it does
not assign any number to a commodity , representing the amount of the utility. It simply
assumes that the consumer weighs in his mind the relative desirability of the different
combinations of goods and services.
(ii) It explains the income effect and price effect: Marshall assumes that the marginal utility of
money remains constant whereas the fact is that with a rise or fall in income, the marginal
utility of the money changes. The indifference curve approach, however, takes into
consideration the income effect changes in price of the commodity.
(iii) It studies combination of two goods: It assumed in the Marshallian utility analysis that a
consumer can measure the utility of a commodity in isolation from other commodities, i.e., it
confines itself to a single commodity model. The indifference curve approach, on the other
hand; studies combinations of two goods commodity and analysis the relationship of
substitutable and complementarily.
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(iv) Application of the principle of MRS: The law of diminishing marginal utility
has now been replaced by the principle of diminishing marginal rate of
substitution. This law is more scientific and realistic and is well applicable in
the field of consumption, production and distribution.
(v) Popularity of indifference curve technique for the analysis of welfare
economies: The indifference curve technique is more popular among the
British economists and is mostly used for the analysis of welfare economies.
For instance,
the indifference curve approach helps us to explain that the direct tax imposes
a lesser burden than an indirect tax upon the consumer.
(a) The indifference curve approach helps us to explain that the direct tax
imposes a lesser burden than an indirect tax upon the consumer.
(b) The Hicksian indifference approach is also used for constructing the supply
curve of labor in the country. We can explain with the help of indifference
technique that when the wages of the workers rise, they begin to prefer
leisure. For example, if wife and husband both work and the wages of the
husband increases, wife often leaves the service and begins to do the domestic
work.
(c) The indifference curve technique is also used for illustrating the concept of
consumer's surplus.
(d) In case of rationing in the country, the indifference approach tells us that as
the income and preferences of consumers differ, therefore, the goods should
not be distributed equally. The income and tastes of the consumers should
always be kept in view.
Criticism of Indifference Curve
Approach:
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The indifference curve approach has been criticized on the following grounds:
(i) Old wine in new bottle: Professor D.H. Roberson is of the view that the difference between Marshallian
utility analysis and the indifference approach is that an old wine has been put in a new bottle. The only
change which Hicks and Allen has made is that they have used the words marginal rate of substitution
instead, of marginal utility.
(ii) Away from reality: The indifference curve technique is away from reality as the indifference hypothesis
are more complicated.
(iii) Midway house: Schumpeter describes indifference analysis as a midway house as it particularly no
better than the utility analysis.
(iii) The consumer is not rational: The consumer is not rational as he acts under various social, economic
and legal disabilities.
(iv) Two goods model unrealistic: Two goods model unrealistic because a consumer buys large number of
commodities to satisfy his unlimited wants.
(v) All commodities are not divisible: There is no doubt that indifference curve technique is not without
defects, but when we take into consideration the position as a whole, we find that the indifference
approach is superior to that of utility approach because it is more realistic and less restrictive.