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1. Lecture 3
Theory of Demand
Indifference Curve

2. Indifference Curve Technique
• In view of the shortcomings of the utility analysis, modern
economists have adopted a new technique called the
indifference curve technique for the analysis of demand
• All desires of consumers are not of equal urgency or
importance. Resources are limited therefore, he has to
choose more important desires for satisfaction. Ability to
arrange preferences in order of urgency or importance is
inherent in human nature
• The consumer’s scale of preferences is independent of the
prices ruling in the market. On the basis of scale of
preferences he knows that one combination of goods yields
him the same satisfaction as another

3. Assumptions
• Completeness
– It is assumed that consumer’s scale of preference is so complete that
he is able to choose any one of the two combinations of commodities
presented to him or is indifferent between them
• Non-satiation
– A consumer prefers more to less
• Consistency or Transitivity
– If a consumer regards Q better than R and R better than S then he will
prefer Q to S. Consumer’s choice has to be consistent
• Continuity or substitutability
– Unless one combination can be substituted for another, the
consumer’s preferences will not be possible
• Convexity
– The indifference curve is convex to the origin and shows the
diminishing rate of marginal rate of substitution

4. Indifference Curve
• On the basis of consumer’s scale of preferences,
indifference curve can be drawn
• An indifference curve represents satisfaction of a
consumer from two commodities
• On all points on the indifference curve
satisfaction level is same. Hence the consumer is
indifferent as to the combination lying on an
indifference curve

5. Example
Combination Apples Mangoes
1 15 1
2 11 2
3 8 3
4 6 4
5 5 5

6. Indifference curve Diagram
16
14
12
10
Series 3
8
Series 2
6 Series 1
4
2
0
1 2 3 4 5

7. Indifference Map
• Different indifference curve shows different level of satisfaction
• We cannot say that how much more utility the higher indifference
curve represents. Aggregate utilities are ranked not measurable

8. Marginal Rate of Substitution
• The Marginal Rate of Substitution shows:
– How much of one commodity is substituted for
another or
– At what rate a consumer is willing to substitute
one commodity for another in his consumption
pattern
• The marginal rate of substitution is parallel to
the concept of marginal utility in the
Marshallian analysis of demand

9. Example
Combination Apples Mangoes MRS Of Mangoes
for Apples
1 15 1 -
2 11 2 4:1
3 8 3 3:1
4 6 4 2:1
5 5 5 1:1

10. Diminishing Marginal Rate of
Substitution
• 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.

11. Diminishing Marginal Rate of Substitution
• If we have more and more of good X our desire to have more good X will
diminish and we will forego less and less of good Y for good X
• (MRSxy) =Δy/Δx
• We can see as the consumer slides down Δy becomes shorter and shorter
while Δx is same.

12. Reasons for DMRS
• Diminishing intensity of a want for a good
• Imperfect substitutes
– If perfect substitutes the MRS constant
• MRS of one good for another will not diminish
if the want satisfying power of the other good
has increased at the same time

13. Properties of IC
• Downward Sloping to the right
– It is because if a consumer wishes to have more unit
of good X he has to reduce consumption of good Y
• Non-intersecting
– No two such curves will never cut each other
• Convex to the origin
– Straight line would mean foregoing equal amount of
units of good X to get equal units good Y
– Concave would mean going more units of good X to
get one unit of good Y
– Both of above are opposite to principle of DMRS

14. Indifference Curve
Analysis of Demand

15. Price Line or Budget Line
• A rational consumer will always try to reach
the highest possible indifference curve in
order to obtain the highest possible level of
satisfaction
• In this pursuit, our consumer will be governed
by the amount of the money or income he has
to spend on goods

16. Price Line or Budget Line

17. Shifting the Price Line

18. Consumer’s Equilibrium
• Assumptions
– Our consumer has an indifference map showing
his scale of preferences for various combinations
of the two goods
– He has a constant amount of money to spend. If
he does not spend on one good then he has to
spend on the other
– Prices of the product are constant
– Each of the good is homogenous and divisible
– The consumer acts rationally, this is, he tries to
maximize his satisfaction

19. Consumer’s Equilibrium
• The consumer will maximize its satisfaction or will be in equilibrium
where price line will touch Indifference curve or is to tangent to an
indifference curve

20. Conditions of Equilibrium
• The price line should be tangent to an
indifference curve or MRS of one commodity
for another should be equal to their relative
prices
• At the point of equilibrium, an indifference
curve must be convex to the origin

21. How far is this theory of consumer behaviour valid?
• Few consumers actually equate consciously MRS of the things they
buy to their price ratio
• Customs plays a very important role in the consumer’s purchases
– They keep buying in the same assortment of goods and ignore minor
price changes
• Many commodities are indivisible preventing precise price
adjustment
• No consumer purchases all commodities therefore MRS of money
for that product is zero
• Not many consumers have the time or the energy to be devoted to
the working out the precise balancing of their expenditure in light
of price changes.

22. Income Effect

23. Income Consumption Curve

24. Income Effect (Inferior good)
• When Y is inferior

25. Substitution Effect
• The increase in the amount purchased of X, because of
the fall in its relative price, is the substitution effect

26. Price effect

27. Price Effect
Income Effect
Substitution Effect

28. Derivation of
Demand Curve

29. Similarities
Utility Analysis Vs Indifference Curve
• Rational behaviour of the consumer
• Consumer strive to reach equilibrium or maximize
profit
• Both assumes diminishing utility
– DMU in one case
– DMRS in the other
• Introspection

30. Superiority of IC Technique
• More Realistic Measurement of Utility
– Cardinal Vs Ordinal
• No assumption of constancy of MU of money
– No such assumption as in Utility analysis
• Analyses Multi-goods model
– More than one product can be seen
• Less restrictive
– Less assumptions in this technique
• More general theory of demand
– Less assumption therefore more general theory of demand
• Change in welfare
– Change in welfare due to change in income
• Closer analysis of price effect
– How changes in prices can bring change in demand
• Recognition of relationship of substitution and complimentary
– Marshall analyzed independent utilities. However, this theory recognizes
the effects of substitutes and complimentary goods.

31. Criticism
• Old wine in new bottle
– just replacement of 1,2,3… with 1st ,2nd, 3rd … curve of preference
• Marshallian Base essential
– All the same, just change of terminologies
• Unrealistic
– Jumping from frying pan of the difficulty of measuring utility into the fire of the unreality of
assuming consumer’s complete knowledge of all this scales of preferences
• Absurd
– Ridiculous combinations of goods e.g. three pairs of shoes and six shirts give him same level of
satisfaction as two pairs of shoes and seven shirts.
• Only two-good model
– It is only two good model for three, three dimensional diagram is needed therefore difficult to
understand
• Cannot explain uncertainty
– What in case of risk or uncertainty
• Introspection
– Introspection is unrealistic
• Constancy of tastes
– Assumption that tastes remains same is not correct
• Ignores demonstration effect
– Level of consumption is affected by consumption of others
• Market behaviourignored
– It takes notice of price of two goods and ignores market change in prices

32. Exceptions

33. Thank You

34. Quiz
• Q No. 1: What is difference between Micro-Economics and Macro-
Economics? Explain with examples.
•
• Q No. 2: How didRobbindefined ‘Economics’ and what was criticism
on his definition?
•
• Q No. 3: Define the scientific methods used in Economics with their
merits and de-merits?
•
• Q No. 4: Write the characteristics of Laws of Economics.
•
• Q No. 5: Define Law of Diminishing Marginal Utility and Law of Equi-
Marginal Utility? Explain the difference between two.
•
• Q No. 6: How demand curve is derived from Law of Equi-Marginal
Utility?