Indifference curves

Indifference curve analysis lies behind a

demand curve. It can be used to
examine the effect of price changes and
income changes.

An indifference curve shows the combination of two products
that provide an individual with a given level of utility
(satisfaction).


Assuming the products are "good" (i.e. we want more
of them rather than less) then if we have more of one
product we must give up some of the other to
compensate and still maintain the same total utility;
therefore an indifference curve must slope downwards
from left to right from quadrant 1 to 3 on the diagram.

No combination in quadrant 2 could be on the same
indifference curve as combination X because it would
have more of product A and product B and would
therefore have a higher utility.

No combination of products in quadrant 4 could be on
the same indifference curve as combination X because
it would have less of product A and B and would
therefore have lower utility
According to the law of diminishing marginal utility each extra unit
of product B will provide successively less extra utility. This means
successively less of product A has to be sacrificed to keep the same
utility overall. This can be seen by the gradient of the indifference
curve.
The gradient of an indifference curve is given by the Marginal Rate
of Substitution (MRS). This shows the amount of product A a
consumer would be prepared to give up for another unit of B and
still maintain the same total utility. The Marginal Rate of
Substitution is given by:
Marginal Utility of B
=
MU B
Marginal Utility of A MU A
i.e. if an additional unit of product B provides twice as much utility as
product A then the consumer would sacrifice 2A for 1B.
The gradient of the indifference curve at this point is:
-2
= -2

1


The further away from the origin on an indifference curve the
higher the total utility; this is because the higher the indifference
curve the more products are being consumed and if goods are
"good" our utility must be therefore be greater.



The budget line

The constraint for consumers is their income. Given the

prices of the products and given an amount of income
there is a limit to what a consumer can buy. The
maximum affordable combination of products that a
consumer can afford is shown by the budget line.

The slope of the budget line depends on the relative

prices of the products. It is given by:
Price of B
=
PB
Price of A PA

Imagine the consumer's income is 100, the
price of A is 10 and the price of B is 20. If all
the income is spent on A then 10 units of
these can be bought. If all the income is spent
on B then 5 units can be bought. The budget
line shows the maximum combinations that
can be afforded given the prices of A and B
and an income of 100.

A consumer will maximise utility by consuming
on the highest possible indifference curve (i.e.
we assume all income is spent). This is where an
indifference curve is tangent to the highest
possible budget line. A consumer could consume
at G, for example, but would be on a higher
indifference curve at H. This means that to
maximise utility the consumer would consume
Q1 of product A and Q2 of product B.
The consumer is maximising utility where the
budget line and indifference curve are tangent
i.e.
MU B
=
P B
MU A P A
Rearranging this equation we get:
MUa
=
MUb
Pa Pb
This is the equi marginal condition. The last unit
of A per pound provides the same utility as the
last unit of B per pound. The consumer cannot
increases her utility by rearranging her
consumption patterns; she is maximising her
utility.
If there were more products available the
condition would be:
MUa
=
MUb
=
MUc
=
MUd
Pa Pb Pc Pd

A fall in the price of a product:
substitution and income effects

If the price of B now falls
the budget line now
pivots. The consumer
now maximises utility
consuming Q3 of product
A and Q4 of product B.
The fall in the price of
product B has led to an
increase in quantity
demanded of Q2Q4. This
can be shown on a
demand curve.

The increase in quantity demanded as a result of the fall in price
can be divided into two parts: the substitution effect and the
income effect.
1. The substitution effect shows the effect of the relatively lower
price of product B compared to product A following a price fall. To
isolate this effect diagrammatically we move the new budget line
inwards and parallel until it is tangent to the old indifference
curve. The new slope reflects the new relative prices but the
utility is the same as it was originally. The substitution effect is
Q2Q6. The substitution effect will always lead to more of the
relatively cheaper product being demanded.

2. The income effect is identified by shifting the budget line back
outwards again. In this case this leads to an increase in quantity
demanded of Q6 Q4. The income effect shows the effect of an
increase in real income following a price fall. If the price of a
product falls you can buy more products because you have more
purchasing power.

In the case of a normal
good the higher real income
leads to an increase in
quantity demanded; this
complements the increase
due to the substitution
effect. This is shown in
diagram 1.
In the case of an inferior
product the income effect
leads to a fall in the quantity
demanded which will work
against the substitution effect.
In diagram 2 the substitution
effect is Q2 Q5; the income
effect in Q5 Q4. However the
substitution effect outweighs
the income effect and overall
the quantity demanded rises.
The overall change in quantity
demanded in an increase of
Q2Q4. This means the demand
curve is downward sloping
because a price fall increases
the quantity demanded.

In the case of a Giffen
product the income
effect leads to a fall in
the quantity demanded
which will work against
the substitution effect
and outweigh it. This
means that following a
price fall the overall the
quantity demanded
falls. This means the
demand curve is
upward sloping.
The effect of a fall in price
Substitution effect Income effect Overall
Normal good Increases quantity
demanded
Increases quantity
demanded
Increases quantity
demanded;
downward sloping
demand curve
Inferior good Increases quantity
demanded
Decreases quantity
demanded
Increases quantity
demanded;
downward sloping
demand curve
Giffen good Increases quantity
demanded
Decreases quantity
demanded
Decreases quantity
demanded; upward
sloping demand
curve
Substitutes and complements

Indifference curve analysis
will also allow us to see
whether two products are
substitutes or
complements.
In the diagram a fall in the
price of product B has led
to a change in the budget
line.
As a result more of product
B and less of product A are
bought. The products are
substitutes. The consumer
has switched from product
A to product B.

In the diagram the
price of product B has
fallen. This has led to an
increase in the quantity
demanded of A and B;
the two products are
complements. A lower
price leads to more of
both goods being
bought.

The impact of a price increase

A price increase can be analysed in exactly
the same way as a price decrease.

Imagine B increases in price, this leads to
the budget line pivoting. To identify the
substitution effect we shift the budget line
outwards and parallel until it is just
tangent with the original indifference
curve.

This shows the substitution effect Q1Q2.
Consumers will always substitute away
from the relatively more expensive
product.

Given an increase in the price of a product
the\ real income falls- the consumer has
less purchasing power. This can be shown
by the effect of shifting the budget line
back in and parallel. In this case the
income effect is to further reduce the
quantity demanded (which means it is a
normal good) by Q2Q3.
The overall change in quantity demanded
is Q1Q3 which can be shown on a demand
curve.

The effect of an increase in price
Substitution effect Income effect Overall
Normal good Decreases quantity
demanded
Decreases quantity
demanded
Decreases quantity
demanded;
downward sloping
demand curve
Inferior good Decreases quantity
demanded
Increases quantity
demanded
Decreases quantity
demanded;
downward sloping
demand curve
Giffen good Decreases quantity
demanded
Increases quantity
demanded
Increases quantity
demanded; upward
sloping demand
curve
An increase in income

The effect on the demand for a product as a result of

an increase in income can also be analysed using
indifference curve analysis.

An increase in income shifts the budget line out

parallel.

The relative prices of the products have not changed

so the gradient of the budget line is the same; income
has increased so the budget line has shifted outwards
as more of the products can be purchased. The new
combinations of products that maximize utility can be
identified; from this the impact of income changes on
the demand for a product can be analyzed.

Bis a normal good. An increase in
income increases the quantity
demanded
B is inferior. An increase in income reduces the
quantity demanded

Whether a commodity is inferior or normal
depends on whether the income effect on its
consumption is positive or negative.
If income effect is negative the commodity is
inferior and if the income effect is positive the
commodity is normal.
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