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Bsc Chemistry ____________________________________________________________________________________________________ Subject BUSINESS ECONOMICS Paper No and Title 1: Microeconomics Analysis Module No and Title 6: Indifference Curves Module Tag BSE_P1_M6 BUSINESS PAPER NO.1 : MICROECONOMICS ANALYSIS ECONOMICS MODULE NO.6 : INDIFFERENCE CURVES ____________________________________________________________________________________________________ TABLE OF CONTENTS 1. Learning Outcomes 2. Introduction 3. Consumer Preferences 4. Indifference Curves and Indifference Map 5. Marginal Rate of Substitution 5.1 Principle of Diminishing MRS 5.2 Marginal Rate of Substitution and Marginal Utility 6. Properties of Indifference Curves 7. Exceptional Shapes of Indifference Curves 7.1 Perfect Substitutes and Perfect Complements 7.2 Good, Bad and Neutral commodities 8. Summary BUSINESS PAPER NO.1 : MICROECONOMICS ANALYSIS ECONOMICS MODULE NO.6 : INDIFFERENCE CURVES ____________________________________________________________________________________________________ 1. Learning Outcomes After studying this module, you shall be able to learn about Meaning of consumer preferences Concept of indifference curve and indifference map The Law of Diminishing Marginal Rate of Substitution Relationship between Marginal Rate of Substitution and Marginal Utility Properties of Indifference curves Perfect Substitutes and Perfect Complements Good, Bad and Neutral commodities 2. Introduction Indifference curve analysis is a very popular method used to explain consumer behavior. The technique of indifference curve was first invented by Edgeworth (1881) and then by Fischer (1892). Later on the Italian economist Pareto (1906) put it to extensive use and the results were subsequently extended by Soviet economist Slutsky (1915). We have already explained the concepts of cardinal and ordinal utility theories. Modern indifference curve approach uses the concept of ordinal utility. The indifference curve analysis assumes that the consumer have complete information about all the aspects of economic environment. Further, the consumer is assumed to act rationally, so given the money income and prices of goods, he will choose the combination from among various alternatives that gives him maximum satisfaction. 3. Consumer Preferences Preference means choosing one alternative over others. To analyze the preferences under two dimensional set up, the commodities, which a consumer can buy, can be divided into two groups as good X and good Y. The consumer’s choice among various alternatives depends upon his preferences, that is, the ranking he gives to various alternatives. Other factors, for example income and prices also influence his choice of an alternative. In indifference curve approach of consumer behavior, certain important assumptions about the nature of consumer’s preference are the following. 1. Completeness: Under this assumption, the consumer is capable of comparing all the alternative combinations and ranks them according to utility. Given two bundles P and Q, he can decide whether he prefers P to Q, Q to P or he is indifferent between the two. 2. Transitivity: Transitivity of preference means that if a person prefers a combination P to Q and also prefers Q to R, then he will prefer P to R. Thus transitivity implies that consumer’s taste and preferences are consistent. BUSINESS PAPER NO.1 : MICROECONOMICS ANALYSIS ECONOMICS MODULE NO.6 : INDIFFERENCE CURVES ____________________________________________________________________________________________________ 3. Non–Satiation: More of a good is always preferable to less of that good. Put differently, “more is better”, other things remaining constant. The assumption implies that the individual is not already over supplied or over satiated with any good and that the good is desirable. 4. Indifference Curves 4. Indifference Curves An indifference curve represents the various alternative combinations of two commodities, which give the same level of satisfaction to the consumer – so the consumer is ‘indifferent’ between these combinations. The indifference curve is a graphical representation of indifference schedule, where all the alternative combination of commodities gives exactly the same satisfaction level or utility to the consumer. To explain it further, consider the example below: Table 1 Combination Unit of good ‘X’ Unit of good ‘Y’ P 1 100 Q 2 45 R 3 25 S 4 15 T 5 10 The given table shows that the consumer is indifferent between the given five alternative combinations (P, Q, R, S and T) of two goods (X and Y). When all the combinations are represented in the form of a graph, we obtain an indifference curve as shown in the figure 1. [Figure 1: An indifference curve] BUSINESS PAPER NO.1 : MICROECONOMICS ANALYSIS ECONOMICS MODULE NO.6 : INDIFFERENCE CURVES ____________________________________________________________________________________________________ Figure 1 shows the quantities of commodity ‘X’ on the horizontal axis and of commodity ‘Y’ on the vertical axis. All of the five combinations (shown by points P, Q, R, S and T) fall on same indifference curve indicating that these alternative combinations give equal utility to the consumer. The indifference curve is also called iso-utility curve (“iso” means same) as it represents equal level of satisfaction at every point on the curve. Note, as we move down the indifference curve, an increase in quantity of good X is offset by a decrease in quantity of good Y, so as to maintain the same level of satisfaction along the curve. 4.1 Indifference Map One indifference curve shows consumption bundles providing single level of satisfaction. We can now think of different indifference curves for each given satisfaction level. In fact, we can draw any number of indifference curves representing different level of utility. An indifference map is the whole set of indifference curves representing the consumer’s taste and preferences (figure 2). Higher indifference curve showing greater quantities of both commodities represent higher satisfaction levels as ‘more is better’. On the other hand lower indifference curves showing lesser quantities represents a lower satisfaction level. [Figure 2: Indifference map] In the above diagram indifference curve shown as IC1 represents the lowest satisfaction level while the curve IC4 represents the highest satisfaction level. Along any given indifference curve the level of satisfaction remains same at all points. BUSINESS PAPER NO.1 : MICROECONOMICS ANALYSIS ECONOMICS MODULE NO.6 : INDIFFERENCE CURVES ____________________________________________________________________________________________________ 5. Marginal Rate of Substitution Marginal rate of substitution (MRS) is one of the most basic concepts of the indifference curve approach. It shows the rate at which a consumer is willing to exchange commodities X and Y along a given indifference curve. More specifically, marginal rate of substitution of X for Y (MRSX, Y) is the amount of good Y, which the consumer is willing to give up as he gets one additional unit of good X, so that his satisfaction level remains the same. In our example (table-1), when a consumer moves from P to Q, the consumer sacrifices 55 unit of ‘Y’ for one extra unit of ‘X’ and still remains on the same indifference curve. Therefore, at this stage, MRSX,Y is equal to 55. The movement is shown below in Figure 3. [Figure 3: Marginal Rate of Substitution] When a consumer moves from point P to Q on this indifference curve he sacrifices ΔY for ΔX and remains at the same satisfaction level. This means the marginal rate of substitution of X for Y (MRSX,Y) is ΔY/ ΔX (=PA/AQ). MRSX,Y = (change in Y) / (Change in X) Now, if the points P and Q are very close, the values of ΔY and ΔX will be very small. Then the MRSX,Y will be given by the slope of the tangent to the indifference curve at that point (Figure 5). 5.1 Principle of Diminishing Marginal Rate of Substitution In our example (table 1) we observe that, when the consumer moves from point P to T, he does not have to sacrifice same amount of good Y for each extra unit of good X. Rather, he sacrifices lesser and lesser amount of commodity Y for each extra unit of X as he moves towards point T. This behavior of the consumer is said to be satisfying the principle of diminishing marginal rate of substitution which says that the MRSX,Y diminishes as more and more good X is substituted for BUSINESS PAPER NO.1 : MICROECONOMICS ANALYSIS ECONOMICS MODULE NO.6 : INDIFFERENCE CURVES ____________________________________________________________________________________________________ good Y. The principle of diminishing marginal rate of substitution is illustrated diagrammatically in figure 4a and figure 4b. [Figure 4a and figure 4b: Diminishing Marginal Rate of Substitution] It is evident from the figure 4a that, as the consumer move downwards along the IC, the length of ΔY becomes shorter and shorter while ΔX is kept the same. Put differently, the MRSX,Y falls as the consumer gets more of good X and less of good Y. The diminishing MRSX,Y can also be demonstrated by drawing tangents at different points on the same indifference curve. The MRSX,Y at any point is given by the slope of the tangent at that point on the indifference curve. It is clear from the Figure 4b that the slope of the tangent declines as we go down the indifference curve. From the law of diminishing marginal utility we know that, as consumption of X increases, its marginal utility decreases. Therefore, the consumer sacrifices
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