2. Indifference Curve Analysis
Indifference curve analysis does not
attempt to measure satisfaction in
cardinal numbers .
Instead , it is based on ranking consumer
satisfaction in order of preferences using
ordinal numbers.
3. Indifference Curve (IC)
● Graphical representation showing
different combinations of commodities
which yield to the consumer the same
level of satisfaction.
4. Indifference curve
● Thus , under indifference curve analysis,
the consumer considers all possible
combination of goods and service which he
/she can afford and subsequently chooses
the combination which is the most
preferred.
● This choice framework is represented by
indifference curves and the consumer
budget line.
5.
6. Explanation of the curve
● On the curve , point ABCD represent the
combination or consumption bundles.
● Point A bundle comprise of ,4 units of good X and 20
units of good Y. By definition, this combination would
yield the identical level of satisfaction represented by
B which comprises 8 units of goods x and 10 units
of good y. Thus, the consumer would have the
same preference for either combination A or B.
● The same thing applies to all the other consumption
bundles along this curve such as C and D.
7. Basic Assumptions of the IC
1. There are two goods X and Y.
2. The consumer acts rationally so as to
maximise satisfaction
3. Any combination of both goods yield
the same level of satisfaction.
4. The consumer’s tastes, habits and
income remain the same.
5. The rate of exchange between both
goods is called the marginal rate of
substitution
8. Indifference map
● A graph showing a whole set of
indifference curves. The further away a
particular curve is from the origin the
higher the level of satisfaction it
represents.
9. Indifference Map
IC5 represent the highest level of
welfare and IC 1 represent the
lowest level of welfare.
Ic5 > ic4 > ic3>ic2>ic1
Where > represent the
preferred level of welfare .
Any point along the same
indifference curve give the
same level of satisfaction.
11. Characteristics of Indifference
curves
1.All points on the same indifference curve give
the same level of satisfaction; therefore the
consumer is indifferent at any point along the IC.
1.Points to the right represent a higher level of
satisfaction than all points along a given IC
points to the left represent a lower level of
satisfaction.
12. Characteristics Cont’d
3. They are an infinite number of indifference
curves in welfare space ; collectively these are
called indifference map.
4.They are downward sloping which means you
have to give up more of a commodity to obtain
more of another commodity.
The slope measures the rate at which the
customer is willing to substitute good x for good
y so as to leave satisfaction unchanged .This is
called the marginal rate of substitution
13. Characteristics
5 .They are convex to the origin (showing
the diminishing marginal rate of
substitution) i.e. MRS = change in ’Y’/
change in ’X’.
6. They never cross / They do not intersect.
A point of intersection would exist only if
two or more curve have a common point.
14. Indifference curves
Indifference curves are plotted on what is
called an indifference map.
A consumer is indifferent or impartial
between the combinations indicated by
any two points on an indifference curve.
15. Activity
● There are two goods : pear and oranges. A consumers
indifference set would be as follows:
Bundles Pear Y Oranges X
A 50 10
B 40 20
C 35 30
D 30 40
E 25 50
Calculate MRS for
A-B
B-C=
C-D
D-F =
17. Indifference curve analysis
● Indifference curve analysis ranks utility
according to the combination of goods
the consumer prefers, therefore the
consumer can say whether he prefers
patty to bun but unable to say by how
much.
● Indifference curve analysis aims at
analyzing consumers without having to
measure utility (ordinalist approach).
18. IC is used to show:
• Changes in consumer income
● A change in the price of one good or both
goods
● It involves the use of IC and budget lines
to show when consumer is maximizing
his her utility.
● It can also be use to analyze the income
and substitution effect of a price change.
20. The Budget Line
● The budget line is used to
demonstrate the idea of the budget
constraints .It shows that all
consumers are constrained in what
they are able to buy because of their
income and the prices of the goods
they wish to buy.
21. Budget line
● This shows the various combination of
two goods which can be purchased with
a given income and the going price of
the good.
24. ● Good X cost $100
● Good Y cost $200
● Income $5 000
● Draw a diagram (budget line ) to
represent the data above .
25. Draw the diagram to represent
this data.
● The slope of the line gives the ratio of prices of two
goods which depicts the rate at which the consumer is
able to substitute X for Y.
● Slope :
● Change in Y / Change in X =
● C and D
● 5/10 = ½ OR 0.5
● The ratio of price of 0.5 implies that the price of
good x is half the price of good Y. This
26. Notes on the graph
1. Any points along the budget line
represents a consumption bundle which
can be afforded by the consumer.
1. Any point within the budget line would
represent consumption bundles which are
also affordable but would not exhaust the
consumer’s entire income.
30. Changes in budget line
● Since the budget line represents the
consumer’s income level and the
combination of good x and y obtainable
with the income at given prices, then a
change in any of these variables
would lead to a change in the budget
line.
31. Question
● What do you think could be
the two main changes that
can affect the budget line?
1.Changes in income
2.Changes in Prices
32. Dayna
Changes in the Budget Line
● Changes in price – cause the budget
line to pivot
● Changes in income – cause the budget
line to shift
33. Changes in Income
❖ A change in income cause the BL to shift (holding
price remains constant).
❖ An increase in income cause the curve to shift to the
right (outwards).This means more of both goods
are affordable.
❖ A decrease in income cause the curve to shift to the
left (inwards) so fewer of both goods will be
affordable.
35. Changes in price
● As the price of good x or good y
changes , the quantity which the
consumer is able to afford would vary.
These changes in the purchasing
power of consumer’s income would
therefore result in a change in the
budget line.
36. Changes in price
Prices fall so more goods become
available. Hence ,more can be bought,
but if prices increases, goods become
more expensive so less is bought.
38. Class work
● Plot the budget lines when income is
assumed to be $10 and also when
income increases to $20.
● Assume also that the price of food is
$2 per unit and $1 per unit for clothes.
● Hint :Prepare the Budget set , then
plot
● Plot on same graph and label
properly………….
42. IC and Consumer Equilibrium
I1 to I4 represents a consumer
indifference map. In order to determine
which of the affordable consumption
bundles represented by the budget line
yields the highest level of satisfaction, a
budget line is superimposed unto the
indifference map.
43. Explanation
● Point E represents consumer
equilibrium since this is where the
budget line is tangential to (or just
touches) an indifference curve. The
point E represents the consumption
bundle which is the most preferred
among the affordable combinations of
good x and y.
44. ExplanatioN
● Any other points along the budget
line which represents other affordable
consumption bundles lie on lower
indifference curves and would
therefore yield a lower level of
satisfaction.
45. Explanation
● According to Indifference Curve
Analysis , the consumer obtains
equilibrium where the slope of the BL
is equal to the marginal rate of
substitution ( the rate at which the
consumer is willing to substitute good
x for good y.
46. Deriving the demand
curve using Indifference
Curve Analysis/Using
Ordinalist approach to
derive the demand curve
47. Deriving the demand curve using Indifference Curve Analysis/Using
ordinalist approach to derive demand curve
● Let us try doing this step by step …
● You need this ….
● Let's go… listen for the steps
48.
49. Explanation of Graph
● As the price of good x falls the budget
line will pivots from BL1 to BL2.
● As this happens, the consumer moves
from consuming x1 to x2 , i.e. ,(he
consumes more of x (due to the
income effect).
50. Explanation for Ordinalist
approach to derive the demand
curve
● As his consumption of x increases , he
moves to a higher indifference curve
illustrating greater satisfaction. At the
same time , consumption of y falls
from y1 to y2 (the substitution effect).
51. Explanation continues
● As the price of x falls further , the
budget line pivots again to BL3 and
the consumer moves to indifference
curve 3.
● Hence, consumer equilibrium moves
from E1 to E2 to E3.
52. Deriving the demand curve
● If good y on the y axis is substituted
with price and the equilibrium
quantities of good x are plotted
against the corresponding prices , then
the consumer demand curve is
obtained.
53. Home work
● Explain what is meant by the :
1. Income Effect
2. Substitution Effect
54. The Income Consumption
Curve/Line
● A line showing how a person’s optimal
consumption of two goods change as
income changes (assuming price is
constant)
56. Price consumption curve/line
● The flatter the curve is the lower the
price. Each curve represents an optimal
consumption point. The lines that
connect these is called the PCC.
● PCC is a line showing how a person’s
optimum level of consumption of 2 goods
changes as the price of one of them
changes
59. Income and substitution
effects of a price change
● Using indifference curve analysis, further inferences
could be made about the inverse relationship
between price and quantity demanded of a good.
Specifically two distinct reasons why a consumer
increases consumption of a good as it price fall
are revealed. These are :
1. The substitution effect
2. The income effect
60. Income and substitution effect
● The substitution effect refers to the change in
consumption patterns where the consumer
purchases more of the good which experiences a
price cut and less of the other good.
● The income effect arises from the increase in
purchasing power of the consumer’s disposable
income as the price of one of the good has
fallen. The increase in real income motivates the
consumer to increase consumption of both goods.
61. ● Two approaches which utilizes
indifference curve analysis to
distinguish between the substitution
effects . These are :
1. Hicksian income and substitution
effect
2. Slutsky income and substitution
effects
64. Do together Steps for Isolating
income and substitution effects
1. Draw a budget line , showing equilibrium
EA…. Label good x and Y. Label
indifference curve Ic 1 and the quantity of good
x
xA.
What if the price of good Xfall , what will
happen?
1. Show a fall in the price of good x and a
new level equilibrium EB and indifference
curve ic2 and where quantity of good
demanded rises to XB.
65. Isolating the Substitution effect
● Insert an imaginary budget line parallel to the
new indifference curve and tangent to the old
indifference curve .
● Label it Ec, BL3 and the quantity xc.The movement
from EA to Equilibrium Ec( increase in quantity from
XA-XC IS solely in response to the fall in price of X.
this is the substitution effect. As the consumer is
simple substituting more of good x which is
cheaper ,in place of less unit of good y so as to
remain indifferent .
67. Explanation of graph
● In the Hicksian approach, in order to
distinguish between the income and
substitution effects of the fall in price
of good x , an imaginary budget line is
inserted as shown by BL3 .
● This imaginary budget line BL3 is
inserted on the basis of two
conditions.
68. ● Firstly , it is drawn parallel to the new budget line
BL2 in order to reflect the new ratio of prices after
the fall in price of good x(remember the slope of
the budget line gives the price ratio).
● Secondly , it is tangential to the indifference curve
i1 which passes through the initial equilibrium at
point A. The point of tangency between IC1 and
the imaginary budget line BL3 is shown by point
C.
69. ● Point C represents the combination the consumer
would have chosen after the price of good X has
fallen , if he or she wanted to keep the total
level of satisfaction equivalent to that attained at
point A.
● Thus ,moving from point A to C, the consumer is
simple substituting more of good x, which is now
cheaper , in place of less unit of good y so as to
remain indifference. The substitution effect is
therefore shown by the distance Xa to Xc.
70. ● The movement from point C, which is the
imaginary equilibrium , to point B which is the final
equilibrium , after the fall in the price of good x ,
is the income effect .
● This is because point B lies on the budget line to the
right of the imaginary budget line through C. This means
the shift from C to B represents a rise in income. This
increase in income is the increase in purchasing power made
possible by the fall in price of good x and the corresponding
increase in consumption attributable to the income effect is
the distance XC to XB.
71. Income and substitution effects of a price
change
Types of goods:
1.Normal goods
2.Inferior goods
3.Giffen goods
72. Normal Goods
● The demand for normal goods increases
as income increases. There is a positive
income effect.
73. Inferior Goods
● The demand for these goods decrease
as income increases. They have a
negative income effect
74. Giffen Goods
● This is an inferior good, demand
increases as price increases. These
goods are considered necessary.
76. Explanation
● Good Y is a normal good since the
amount purchased increases from Y1 to
Y2 as the budget constraint shifts from
BC1 to the higher income BC2. Good X
is an inferior good since the amount
bought decreases from X1 to X2 as
income increases.
78. Explanation of Graph
● As the price decreases the budget line
pivots outwards, consumers will have
less of the Giffen good and more of the
normal goods.
79. Income and substitution effect
of a price change:
The Hicksian approach
Decrease in the price of
goods ….
80. Recap definition
for……eVERYONE……
❑ The substitution effect is defined as the
change in the combination of goods
purchased due to a change in the relative
prices.
❑ The income effect refers to the change in
combinations of good due to a change in
the level of real income, where real income is
defined as the purchasing power of money.
81. Income and sub effects from a fall in price of
normal , inferior and Giffen goods
82. Explanation
● The substitution and income effects work in the same direction when good X is a
normal good. The final price effect is then positive. The consumer tends to
increase consumption of Good X with fall in its price.
● When good X is an inferior good, then the substitution and income effects work in
opposite directions. When price of good X (Px)falls, the consumer tends to
increase consumption of good X as a result of substitution effect. However,
income effect here is negative. The price effect then depends on relative magnitude
of the two effects. The final price effect is positive for inferior goods, as change in
the consumption of good X as a result of the substitution effect is greater than the
income effect.
● When good X is a Giffen good then also substitution and income effects work in
opposite directions. When price of good X (Px)falls, the consumer tends to
increase consumption of good X as a result of substitution effect. However,
income effect here is negative. Further, the magnitude of change in units of good X
on account of the substitution effect is less than the income effect. The price effect,
the final outcome, is therefore negative.
84. Explanation
● Let us see what figure 2 depicts. The consumer’s original
equilibrium is E1. At this point, the budget line M1N1 is tangent to
the indifference curve IC1. Suppose the price of commodity X
(normal goods) decreases and other things remain the same. The
price decline shifts the budget line to M1N3. Consequently, the
consumer moves to new equilibrium point E3. Consumer’s
movement from E1 to E3 is the total price effect. Let us eliminate
the income effect from the price effect by following Hicks’ version.
To do so, we draw an imaginary budget line M2N2, which is
tangent to IC1 at E2. E2 equilibrium point after the elimination of
the income effect.
● Hence, total price effect = X1X3
● Substitution effect = X1 -X2
● Income effect =X2- X3
85. Normal Good - Price Increase
●If the price of good x increases the
budget line will pivot inwards as people
real income will decrease
●Draw a diagram showing a price increase
in normal good
87. Explanation
● In figure 3, X-axis represents inferior goods (commodity X) and Y-axis
denotes superior goods (commodity Y). The consumer’s original
equilibrium point is E1. At this equilibrium point, the budget line M1N1
is tangent to indifference curve IC1. If price of commodity X is reduced,
new budget line M1N2 is formed and the consumer moves to the new
equilibrium point E2. At E2, the budget line M1N2 is tangent to
indifference curve IC2.
● Here, consumer’s movement from equilibrium point E1 to equilibrium
point E2 is the total price effect. We follow Hicks’ version to eliminate
the income effect from the price effect. To accomplish this, an
imaginary budget line M2N3 is drawn in such a way that it is parallel to
budget line M1N2 and tangent to the original indifference curve IC1 at
E3. Hence, E3 is the equilibrium point after the elimination of income
effect.
89. Graph : Explanation
● In figure 1, the consumer’s initial equilibrium point is E1, where original
budget line M1N1 is tangent to the indifference curve IC1 . X-axis
represent Giffen goods (commodity X) and Y-axis denotes superior
goods (commodity Y).
● Assume that price of Giffen goods decreases. This causes the budget
line to shift outward and forms a new budget line M1N3. The consumer
moves to the new equilibrium point E3.
● At this new equilibrium point the quantity demanded of commodity X
decreases by X2X1. This movement represents the total price effect.
Total price effect consists of income effect and substitution effect. By
drawing a parallel budget line M2N2, we are eliminating the income
effect.
● Hence, the consumer again moves to another equilibrium point E2. At
E2, the quantity demanded of commodity X increases by X1X3.
90. Usefulness of ICAs
● It demonstrates the logics of rational
consumer choice, the derivation of the
individual indifference curve and the
income and substitution effect without
having to measure utility.
91. Limitation of its usefulness
● 1. Consumer choice may be influenced by
advertisement. They may be disappointed or
surprised by their choice. Therefore, the
optimal consumption choice may not in
practice give consumers maximum
satisfaction. Consumers may not have perfect
knowledge.
● 2. Consumers are not always rational
