MCom I Semester Managerial Economics Indifference Curve Analysis Study Material Notes

MCom I Semester Managerial Economics Indifference Curve Analysis Study Material Notes: History of Indifference Curve Analysis Meaning and Definition of INdefference Curve Analysis Indifference Curve Map Assumptions of Indifference Curve Analysis Indifference Schedule and Indifference Curve Properties of Indifference Curves Budget Line or Price Line Changes in Budget Line Managinal rate of Substitution Important of Indifference Curve Analysis Criticisms or Limitations of Indifference curve Analysis :

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INDIFFERENCE CURVE ANALYSIS

HISTORY OF INDIFFERENCE CURVE ANALYSIS

Indifference curves were used for the first time in 1881 by an English economist Edge worth. It was popularized by an Italian economist V. Pareto. Credit of development of indifference curve analysis goes to Prof. J. R. Hicks and Prof. G. D. Allen. These two economists published an article in 1934 on this aspect. Later, in 1939. Prof. J. R. Hicks explained this concept in details in his book ‘Value and Capital’.

MEANING AND DEFINITION OF INDIFFERENCE CURVE ANALYSIS

Concept of indifference curve analysis is based upon the assumption that every consumer has a scale of preferences between two or more commodities. There are some combinations of these commodities which provide him equal satisfaction. He can choose any of these combinations. If he chooses one combination, he is indifferent to all other combinations. Such combinations can be presented on a curve also. Such a curve is called indifference curve. Thus, an indifference curve is a curve showing a number of indifferent combinations. It can be defined as under:

1 “It is the focus of points representing pairs of quantities between which individual is indifferent, so it is termed as indifference curve.” –Prof. J. K. Smith

2. “Indifference curves are the lines of equal preference. These are called indifferent curves because they represent combinations of quantitis which are neither better nor worse than each other but are indifferent.” – Prof. K. E. Boulding

3. “An indifference schedule may be defined as a schedule of various combinations of goods that will be equally satisfactory to the individual concerned. If we depict this in the form of a curve, we get an indifference curve.” -A. L. Mayers

Thus, an indifference curve is a surve which represents various combinations of commodities which provide equal satisfaction to a consumer. The consumer is indifferent to these combinations.

INDIFFERENCE SCHEDULE AN INDIFFERENCE CURVE

An indifference schedule is a schedule of various combinations of commodities which provide equal satisfaction to a consumer. It has been defined as under:

“An indifference schedule may be defined as a schedule of various combinations of goods that will be equally satisfactory to the individual concerned. If we depict this in the form of a curve, we get an indifference curve.” –A. L. Mayers

Suppose, a consumer is interested in banana and mango and he gives equal preference to both, his indifference schedule can be prepared as follows:

In this diagram, number of bananas have been presented of X axis and the number of mangoes on Y axis. All the points presented on graph, present combinations of different quantities of banana and mango which provide equal satisfaction to the consumer. All the points taken together give an indifference curve.

INDIFFERENCE CURVE MAP

There can be infinite indifference curves for a consumer corresponding to the possible levels of his satisfaction. All the curves can be presented on an indifference map. Infinite number of indifference curves can be constructed for any two substitute goods. Each curve shows the combinations of two commodities that are equally good to the consumer. An indifference curve map can be presented as follows:

In this diagram, IC, IC:, IC; IC , ICs, IC, are some of the indifferent curves that can be constructed with commodity X and Y. A curve that lies right to another is called higher. Any point on a higher curve is preferable to every point on a lower curve because it represents a combination of greater quantity of one commodity accompanies by an unchaged quantity of another commodity.

ASSUMPTIONS OF INDIFFERENCE CURVE ANALYSIS

(1) Utility cannot be Measured. Indifference curve analysis assumes that utility cannot be measured precisely. However, it is possible for the consumer to choose between the commodities.

(2) Scale of Preferences. Every consumer has a scale of preferences. He can arrange these commodities or combinations of commodities in the order of his preference

(3) Concept of Comparative Utility. Indifference curve analysis is based upon the assumption that the utility can be compared. A consumer can compare the satisfaction derived by him from the consumption of various commodities.

(4) Rational Behaviour of Consumers. Indifference curve analysis assumes that all the consumers are rational and they spend their income in the manner that they may get maximum satisfaction out of it.

(5) Diminishing Marginal Rate of Substitution. This concept assumes that a consumer will accept less quantity of a commodity in exchange of more! quantity of the commodity which is already available with him in adequate quantity.

(6) Consistency. This anslysis assumes consistency in the behaviour of consumers. Example: A consumer in indifferent to (A) and (B) combinations and also to (B) and (C) combinations, he must be indifferent to (A) and (C) combinations also.

(7) Unformity and Divisibility of Commodities. It is assumed that all the units of commodity are uniform and divisible.

PROPERTIES OF INDIFFERENCE CURVES

(1) They are Convex to the Origin. Indifference curves are always convex to the origin. Left hand position of an indifference curve is normally steep and right hand position is normally flat. This is due to diminishing marginal rate of substitution. It can be explained with the help of following diagrams:

(2) They Slope Downwards to the Right. Indifference curves slope downwards from left to right because every consumer wants to keep total satisfaction constant. He will have to give up one commodity and get it compensated for by the other. They cannot be horizontal straight lines, nor they can be upward rising lines. It has been illustrated in diagrams as follows:

Commodities  is equal, the curves will be parallel. If the rate of substitution is qual, the curves will not be parallel. It can be illustrated with the help of two diagrams as above.

(5) Higher Indifference Curves Gives Greater Satisfaction. In an indifference curve map, indifference curve on right hand (Higher curves) gives greater satisfaction than the indifference curves on left hand (Lower curves). It can be explained with the help of following diagram:

In this diagram, three indifference curves are shown as IC, IC, and IC3. Three points have been taken on these curves as R, S and T respectively. These points represent that the quantity of banana is continuously increasing, keeping the quantity of mango constant. IC is providing more satisfaction than IC and IC. Thus, a higher curve provides more satisfaction than lower curves.

CONSUMER’S EQUILIBRIUM WITH THE HELP OF INDIFFERENCE CURVES

Indifference curve analysis is the most important and practical tool to explain consumer’s position. It explains how does a consumer attain maximum satisfaction out of his income. We may assume that the prices of two comodities are given and money income that the consumer wants of spend on these two commodities is also given. Now we can prepare a list of combintions of two commodities that a consumer can buy. If these combinations are presented diagramatically, the result will be a budget line. A consumer attains equilibrium at the point at which this budget line meets one of the indifference curves. It can be illustrated with the help of a diagram as follows:

In this diagram, quantity of commodity X has been presented OX axis and the quantity of commodity Yon OY axis. AB is curve budget line. ICT, IC2, IC3, ICA, are indifference curves. E is the point of equilibrium. Budget line touches IC; at this point. Consumer will attain maximum satisfaction at this point. IC. Is Units of Commodity X a consumer can not achieve this situation with his present Fig. 8.8. Consumer’s Equilibrium with the income. IC and IC, are below help of Indifference curves. the budget line. These curves represent lower level of satisfaction, therefore, no consumer would like to remain at these curves. So every consumer would try to remain at point E

BUDGET LINE OR PRICE LINE

Indifference curves illustrate the points of satisfaction of a consumer. Higher the indifference curve, higher will be the level of satisfaction of consumer. However, there are two important limitations of the behaviour of a consumer :

(A) Prices of Goods-Every consumer has to pay for the goods he purchases.

(B) Limited Resources Resources of a consumer (his income) are always limited and he can buy the goods and services within the limit of his income only.

These two limitations of a consumer can be illustrated with the help of price line or budget line or price opportunity line. Budget line illustrates all the combinations of two commodities that a consumer can buy within the limit of his income. Prof. Samuelson calls it a consumption possibility line.

Explanation of Budget line with Example and Diagram. Suppose a consumer has Rs. 100 which he wants to spend on the consumption of two commodities : X and Y. Price of X is Rs. 10 per unit and that of Y is Rs. 2 per unit. The consumer can purchase commodity X and Y in a number of alternative combinations as follows:

In above diagram, units of commodity X have been presented on OX axis and the units of commodity Y on OY axis. A, B, C, D, E, F points represent the combination of these two commodities which a consumer can buy within his limited income.

All these combinations have been presented on budget line. M and N are the points presented out of budget line. M point is out of the reach of consumer and he cannot achieve this situation because of his limited income. N point represents the sitution at which the consumer has not spent his income in full. He will not like to remain at this situation because he will not be getting full satisfaction at this point. Therefore, he will have to choose any of the combinations presented on budget line to achieve maximum satisfaction.

CHANGES IN BUDGET LINE

There can be a change is budget line due to two causes as follows: (i) Change in the income of consumer, (ii) Change in the prices of goods.

(i) Effect of Changes in the Income of Consumer on Budget Line. If the income of a consumer increases and the prices of goods remain constant, budget line will move upwards to the right because the consumer will be in a position to purchase more commodities than earlier. If, on the contrary, there is a decrease in the income of a consumer and the prices of goods remain constant, the budget line will move downwards to the left because the consumer will be in a position to purchase less commodities than earlier. It can be illustrated with the help of a

Units of Commodity X In this diagram, units of commodity X have been presented on OX axis and the units of commodity Yon OY axis. PQ is the Fig. 8.10. Effect of Change in the original budget line. On an increase Income of Consumer on Budget Line. in the income of consumer, budget line moves upwards to the right and P Q is the new budget line. On a decrease in the income of consumer, the budget line moves downwards to the left and P Q2 is the new budget line.

(ii) Effect of Changes in the Prices of Goods on Budget Line. If there is a change in the price of any commodity and the income of consumer remains constant, budget line will change. If the price of a commodity increases but the price of another commodity and income of consumer remain constant, budget line will move downwards to the left because the consumer can buy only less units of this commodity. If the price of a commodity decreases but the price of another commodity and income of consumer remain constant, budget line will move upwards to the right because the consumer can buy more units of this commodity. It can be illustrated with the help of two diagrams as follows:

MARGINAL RATE OF SUBSTITUTION

Concept of marginal rate of substitution is the most important concept of indifference curve analysis. It is the rate at which a consumer can agree to exchange a certain quantity of one commodity for a certain quantity of another commodity without affecting his total utility. Thus, it is the ratio between marginal quantities of two commodities. It has been defined as under:

LAW OF DIMINISHING MARGINAL RATE OF SUBSTITUTION

Marginal rate of substitution tends to be diminishing. It means that a consumer agrees to accept less quantity of a commodity in exchange of another commodity which is already available with him in adequate quantity

Explanation with the Help of Example. A consumer has two units of commodity A and 20 units of commodity B. He wants to get more units of commodity A. Naturally, he will have to give up some units of commodity B. This rate of exchange between commodity A and B will be the marginal rate of substitution. It can be explained with the help of following table and diagram:

CAUSES OF OPERATION OF THE LAW OF DIMINISHING MARGINAL RATE OF SUBSTITUTION

1 Wants of every consumer are unlimited but a particular want can be satisfied at a particular time.

2. Commodities are not perfect substitutes to each other.

3. To increase the quantity of one commodity, the consumer will have to give up a certain quantity of another commodity.

4. Substitution of one commodity to another does not change the level of satisfaction of the consumer.

EXCEPTIONS TO THE LAW OF DIMINISHING

MARGINAL RATE OF SUBSTITUTION OR OTHER TYPES OF MARGINAL RATE OF

SUBSTITUTION

(1) Constant Marginal Rate of Substitution. If two goods are perfect substitutes to each other, marginal rate of substitution will be constant. The consumer will exchange a constant quantity of one commodity for another at all the stages. It can be illustrated with the help of following diagram:

In this case, the curve of marginal rate of substitution (MRS Curve) is in the form of a diagonal line. It is always at 45° with OX axis MRS remains content at all the stages of combinations.

(2) Increasing Marginal Rate of Substitution. If a consumer agrees to give up more quantity of one commodity at all the stages of A exchange, marginal rate of substitution will be increasing. It is an . imaginary concept. It can be possible only if the consumer spends all his income on one consumer agrees to give of one commodity commodity. As this is not a practically possible, MRS can never be increasing. It is illustrated in following diagram :

(3) Zero Marginal Rate of Substitution. If two commodities are perfect complementary to each other, marginal rate of substitution will be zero. Pen and ink, scooter and petrol, bus and diesel, etc. are the examples are perfect of such goods. One of these other, goods is useless in the absence

IMPORTANCE OF INDIFFERENCE CURVE ANALYSIS

Indifference curve analysis is an important tool of economic analysis. Economic analysis is incomplete in the absence of indifference curve analysis. It can be explained as under:

(1) Consumer’s Equilibrium. Indifference curve analysis explains the equilibrium of consumer. It establishes that a consumer is in the state of equilibrium at the point at which the budget line (Price line) touches an indifference curve. The consumer gets maximum satisfaction at this point.

(2) Producer’s Equilibrium. Indifference curve analysis (known as ISO-product curve in the field of production) helps in establishing the equilibrium of a producer also. A producer is in the state of equilibrium at the point at which iso-product curve touches iso-cost curve. He gets maximum production at minimum cost at this point.

(3) Importance in Exchange. If the scale of preference of two consumers and the supply of two commodities are given, two limits can be determined within which the rate of exchange will be determined.

(4) Importance in Public Finance. Indifference curve analysis helps in comparing as to which of the direct and indirect taxes is better from the point of view of consumers.

(5) Importance in the field of Index Numbers. Indifference curve analysis helps in comparing the level of satisfaction on the purchase of certain goods on two different indices. Example : A consumer purchased a certian combination of two goods at different price levels. Indifference curve analysis helps in comparing the level of his satisfaction.

(6) Importance in the field of Government Grants. Government provides certain grants for the welfare of weaker sections of society and for the developoment of backward areas of country. Indifference curves help in analysing and comparing the effect of such grants.

CRITICISMS OR LIMITATIONS OF INDIFFERENCECURVE ANALYSIS

(1) Based on Unreal Assumptions. Following assumptions of this analysis do not hold true in practical life-(i) Perfect competition in market, (ii) Rational behaviour of consumers, (ii) Perfect knowledge of their indifference curve map, (iv) Standardised goods, (v) Freedom to choose combinations.

(2) No New Concept. According to Prof. Schumpeter, indifference curve analysis is not at all a new concept. Only the words ‘Utility and Marginal Utility’ have been replaced by ‘preference and marginal rate of substitution’.

(3) Two-Goods Model is Unreal. Indifference curve analysis is based on two-goods model. It assumes that a consumer spends his income on two-goods only. It is a funny assumption of this analysis. Though it considers more than two goods also but in that case the analysis gets highly complicated and confusing

(4) Impractical for Macro Studies. Indifference curve analysis does not give any explanation to national problems like unemployment, price level, economic development etc.

(5) Lack of Measurement of Satisfaction. Indifference curve analysis is an ordinal approach. It does not measure utility and satisfaction in quantitative terms.

INDIFFERENCE CURVE ANALYSIS AN

IMPROVEMENT OVER UTILITY ANALYSIS ? OR IS HICKSIAN APPROACH AN IMPROVEMENT

OVER MARSHALL’S APPROACH ?

Similarities Between Indifference Curve Analysis and Utility Analysis :

1 Both analysis assume rational behaviour of consumer. It is assumed that the consumer wants to spend his limited resources on his unlimited wants in the manner that he may get maximum satisfaction.

2. Both analysis assume that the consumer has perfect knowledge of economic environment in which he is working.

3. Both analysis are based on the law of diminishing marginal utility. Prof. Marshall has used it as such and Prof. Hicks has used it as diminishing marginal rate of substitution. 4. Basic condition of the equilibrium of a consumer is same in both the

Indifference Curve Analysis is an Improvement over Utility Analysis:

(1) Not Based on Unreal Assumptions. Indifference curve analysis is not based on the unreal assumption of constant marginal utility of money. This way, it is an improvement over Marshall’s approach.

(2) Real Measurement of Satisfaction. Indifference curve analysis does not measure utility in terms of money or units. Practical experience proves that ordinal approach is better than cardinal approach of measurement of utility.

(3) Explanation of Income, Substitution and Price Effect. Indifference curve analysis explains the effect of income, substitution and price on the satisfaction of consumer while utility analysis fails to do so.

(4) Real Explanation of Consumer’s Equilibrium. Indifference curve analysis presents a real explanation of equilibrium of a consumer while utility analysis of Marshall does not give so real explanation.

Conclusion. On the basis of above discussion, it may be concluded that both the utility analysis and indifference curve analysis provide a real explanation of consumer’s equilibrium. However, indifference curve analysis is more real and practical.