The Indifference Curve

A
Each point on the IC
curve (e.g. point a or b)
shows a combination of
apples and mangoes which
yields the same total
satisfaction to the
consumer.

15

a
b

5
O 1

IC
M

The Indifference Map

A set of indifference curves

is called an Indifference

Higher indifference curve

gives greater satisfaction i.e.
it can not be said how much
greater utility does IC2
represent than IC1 and IC3,
than IC2, and so on.That is,
the aggregate utilities are
rankable but not measurable;
increases in utility cannot be
ranked.

Apples

Map

Mangoes

IC4
IC3
IC2
IC1
M

The Marginal Rate of Substitution

Hicks: We define marginal rate

of substitution of X for Y as the

quantity of Y which would just
compensate the consumer for the
loss of the marginal unit of X.

Combination Apples

Causes of diminishing MRS:

1.
particular want is satiable
2. Goods are imperfect
substitutes

Slope of IC curve = MRSMA

(next slide)

1
2
3
4
5

15
11
8
6
5

MRS of Mangoes
Mangoes
for Apples

1
4
2
3
3
2
4
1
5

4 :1

3 :1

2 :1

1:1

Properties of Indifference Curves

Downward Sloping to the Right

Convex to the origin

A

4
A
2

IC1
b

a
0

b c

IC

IC1

O 1 2 3

IC
0

A
A

10
6
0

IC
IC

a
1

Non-intersecting
A

Apples

6
5

Mangoes

IC1
IC2
M

The Price Line

(also called: Budget Line, Price Opportunity Line, Price-income Line, Budgetconstraint Line):
The line that shows all possible combinations of goods (in this case Apples
and Mangoes) that the consumer can buy if he spends the whole of his given
sum of money on his purchases at the given prices.

Income (Y) Tk. 100

Price of apple Tk.10
The Price
LineSo, total apples could be purchased Tk. 100 10 apples
A
Tk. 10
10
Price of mango Tk. 20
Tk. 100
So, total mangoes could be purchased
5 mangoes
Tk. 20

rise
Slope of the Pr ice Line
run
YM
QA
YM PM
PM
PA

YM
QM
PA YM
PA
PM

1) Price change of one good

2) Income

Now Suppose, Increased Income Tk. 160

Income Tk. 100

Apple Pr ice ( fixed ) Tk. 10

change

Tk. 160
Tk. 10
16

Now, Apple could be purchased

Mango Pr ice ( changed ) Tk. 16.60

So, now mango could be purchased

Tk. 160
8
Tk. 20
Tk. 100

6 That is, parallel sheft of Pr ice Line

Tk. 16.60

And, Mango could be purchased

16

10

10

M
0

The Equilibrium

Consumers Equilibrium or Maximizing Satisfaction

when money income is fixed
Assumptions:
1) The consumer has an Indifference Map
2) Money-income and Prices of goods are fixed
3) The consumer acts rationally
4) Each of the goods is homogeneous

and divisible

Conditions:
1) Necessary condition: Price
Line should be tangent
2) Sufficient condition: At the
point of equilibrium an IC
must be convex to the origin

Graph of Equilibrium :

c
e

IC4
d

IC3
IC2

IC1
M

The Income Effect:

the effect on consumers equilibrium of a change in consumers income,

relative prices of goods remaining the same.

An Income Consumption Curve (ICC) traces out the Income Effect as

the consumers income changes, with given relative prices of the two goods.

ICC: relationship between income and consumption, while the prices of goods
are fixed

(-)

slope indicates inferiority of a good.

After a certain point, as income rises,
less of a particular good is bought.

ICC

ICC
(45 degree
line)
ICC
M

Inferior good M

Inferior good A M

The Price Effect:

Price-Consumption Curve (which reflects the Price Effect) shows

how the consumption of product M changes, as its prices changes,
the consumers income and price of A remaining the same.

Price Effect = Income Effect + Substitution Effect

A

For real
income
increase

IC1
+SE

+IE

For relative
change in prices
of A and M

PCC
IC2
M

The Substitution Effect:

the change in the quantity of a good purchased which is due only to

the change in relative prices, money income remaining constant.

The substitution effect is a change in the quantity demanded as a result

of a change in relative price after the consumer has been compensated for
a change in his real income. That is, there is a movement along the original
indifference curve, real income remaining the same.
BH or AP is the amount of money income that
should be taken away from the consumer so
that the gain in real income which results from
the fall in the price of M is cancelled out.

Apples

A
P

At point the T, the consumer gets the same

satisfaction as at Q, because both Q and T are

situated on the same indifference curve IC1

Q

R
T

N KL
SE

IC2
IC1
B

Mangoes

H M

Movement from Q to T on the same

indifference curve IC1 is due only to the
relative fall in the price of M. At the point T,
the consumer buys MK more of M than at Q as
M is now relatively cheaper. This MK is the
substitution effect which involves movement
from Q to T.

Splitting the Price Effect:

Normal good, Inferior good, and Giffen good
Splitting the Price Effect
A

Normal good:
SE + IE = + PE

PCC

PCC
0

+SE +IE
=+PE

Giffen good: SE
- IE = - PE

M
0
-PE= -IE +SE

PCC
Inferior good:
SE - IE = + PE

0
+PE = +SE -IE

The Substitution Effect:

Hicks vs. Slutsky
Hicksian Substitution Effect
Eliminates the income-effect by
reducing the consumers income (by
way of taxation) so that he returns
to his (original satisfaction i.e.)
original indifference curve IC1, to
an equilibrium point conforming to
the new price ratio. This has been
done by drawing an imaginary
budget line parallel to the new
budget line and tangent to original
indifference curve (IC1)

Slutsky Substitution Effect

Eliminates the income-effect by
reducing the consumers income so
that he is still able to buy his
original combination of the two goods
(i.e. to his original indifference curve
IC1 and also to his original equilibrium
point) at the new price ratio. This is
done by drawing an imaginary budget
line through the original equilibrium
point

The Substitution Effect:

Hicks vs. Slutsky
Hicksian Substitution Effect

Slutsky Substitution Effect

Hicksian
Effect
Price Effect

Hicksian
Effect Slutsky Effect
Price Effect

Drawing New budget line:

for only food increase - instead of cash

ly
on s h
a s ca
e: ot
lin - n
et d
dg se
bu rea
ew nc
N di
o
fo

Cash lost
(for whatever
the quantity
of food from
A to B)

Cash sacrificed for

food O to D

cash

D
Food

food

Application of
Indifference Curve technique
Cash or Food - which is better ?

cash

Cash
lost

Food
wastage

food