Various A-Level Economics Notes

Indifference Curve Analysis: Ordinal Approach of Consumer Equilibrium
An indifference curve shows the different combinations of two goods say x apples and
y oranges which yield equal utility to the consumer. Since all the combinations on an
indifference curve yield the same utility, the consumer is indifferent to what
combination he consumes. In other words, all the combinations of the goods lying on
a consumer’s indifference are equally desirable to or equally preferred by him.
From the indifference curve IC given above the consumer derives the same
satisfaction from combination S and T and is therefore indifferent from S or T.
The diagram shown below depicts an indifference map
An indifference map shows a set of indifference curves. On IC 1 consumers are

indifferent to the consumption of combinations A, B or C since they yield the same
level of satisfaction. However, higher indifference curves depict higher level of
satisfaction. In the diagram above IC2 shows a higher level of utility than IC1. Similarly,
the level of satisfaction of IC3 is greater than IC2 and IC1.
PROPERTIES OF INDIFFERENCE CURVES
1. Indifference curves can never intersect. If they intersect it means that there is
a common point on the two indifference curves that yields the same level of
satisfaction which is contrary to theory.
2. Indifference curves slope downwards from the left to the right. They must be
negatively sloped.
3. Indifference curves are convex to origin. Indifference curves must be relatively
flatter on its right hand side and relatively steeper on its left hand side.
4. A higher indifference curve represents a higher level of satisfaction than a
lower indifference curve.
THE MARGINAL RATE OF SUBSTITUTION

The marginal rate of substitution is defined as the rate at which a consumer is
prepared to exchange two goods for example x apples and y oranges. In other words,
the marginal rate of substitution of apples and oranges refers to the amount of
oranges a consumer is willing to give up in order to increase the consumption of apple
by 1 unit and still remain on the same indifference curve.
Indifference Schedule
Combination Apples (Good X) Oranges (Good Y) MRSAO
A 1 12 -
B 2 8 4
C 3 5 3
D 4 3 2
E 5 2 1
MRS Apples Oranges = ∆ Oranges

∆ Apples
From the schedule it can be concluded that as the consumption of apples increases
the MRSAO falls.
Marginal Rate of Substitution
14
12
10
Oranges
0
0 1 2 3 4 5 6
Apples
From the diagram above, it is deduced that the marginal rate of substitution of apples
for oranges declines. In other words, MRS Apples Oranges falls, as a consumer increases his
consumption of apples. Consider the indifference schedule given below.
Exceptional Indifference Curves

1. Perfect Substitutes
Indifference curves for perfect substitutes are straight lines which slope from left to
right. Examples of perfect substitutes are spectacles and contact lenses. In this case a
consumer would be willing to substitute one pair of spectacles for one pair of contact
lenses. In other words, exchange will take place at the rate of one is to one. Thus, it is
negatively sloped.
2. Perfect Complements
Indifference curves for perfect complements are ‘L-shaped’. Examples of perfect
complements are left and right hands gloves. There is no rate at which a consumer
would be willing to substitute one kind of glove for another.
3. An absolute necessity
Water is a necessity and there is a minimum amount of water essential to sustain life.
As the consumption of water falls towards W0, increasingly amounts of other goods
has to be sacrificed to increase the amount of water even by a small amount.
4. A commodity that gives zero utility

If a good yield zero utility, a consumer would not be prepared to sacrifice even a very
small amount of other goods to obtain the good in question. For example, a vegetarian
would not forgo even a small quantity of vegetable to get kgs20 of meat.
5. A good that gives negative utility after some level of consumption
Beyond a certain level, the consumption of certain goods such as foods, beverages,
movies… would reduce satisfaction. Beyond that point, the indifference curve is
upwards sloping indicating that consumer is willing to sacrifice other goods only to
reduce the amount of the good giving negative utility.
THE BUDGET LINE [THE PRICE LINE]
The budget line shows all the different combinations of two goods for example apples
and orange that a consumer can buy given his money income and prices of the two
commodities. Suppose one apple costs Rs2 and one orange Rs5 and income is Rs20,
then the budget line is
All points on the budget line represent bundles of goods that a household can
consume using his complete income. It implies that when the household moves from
one point on the budget line to another, the change in expenditure on apples must be
of equal value but opposite sign to the change in expenditure on oranges. Assume ∆A
and ∆O is the change in quantities of apples and oranges and Pa and Po stand for the
prices of apples and oranges. The above relationship can be mathematically
represented as
(∆O x Po) = - (∆A x Pa)
The formula states that if any amount more spent on a good, the same amount less must
be spent on the good. By dividing the above equation by ∆A, it is reduced to
(∆O x Po)/ ∆A = - (∆A x Pa)/ ∆A
(∆O x Po)/ ∆A = -Pa, which can further be re-arranged as
∆O/∆A = -Pa/Po
Therefore, the slope of the budget line is the negative of the ratio of the two prices
(with the price of the good on the horizontal axis appearing on the numerator and that
of the vertical axis on the denominator). Hence it can be concluded that the slope of
the budget line depends only on the relation between the two prices. In fact, the slope
represents the opportunity cost of apples in terms of oranges.
Consumer Equilibrium
A rational consumer is in equilibrium when given his budget line he maximises his total
utility. A consumer is in equilibrium when he is buying such a combination of goods
that reallocation and increasing total utility is impossible. Diagrammatically, this is
shown when his budget line is tangent to the highest indifference curve.
In the diagram above, the x-axis represents the quantity of apples and the y-axis the
quantity of oranges. The rational consumer is in equilibrium when the budget line AB
is tangent to the highest possible indifference curve IC 2.At equilibrium the consumer
demands ON of apples and OM of oranges.

Various A-Level Economics Notes

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Indifference Curve Analysis: Ordinal Approach of Consumer Equilibrium

The diagram shown below depicts an indifference map

An indifference map shows a set of indifference curves. On IC 1 consumers are

THE MARGINAL RATE OF SUBSTITUTION

MRS Apples Oranges = ∆ Oranges

Marginal Rate of Substitution

Exceptional Indifference Curves

4. A commodity that gives zero utility

(∆O x Po)/ ∆A = -Pa, which can further be re-arranged as

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