6.

Consumer's Equilibrium: Indifference Curve Approach

better
through
approach
numerically)
than
Indifference
which
indifference
utility
because
is
curve
known Consumers Equilibrium 47
curve
approach.
utility
approach
as
is
 6.1 Basic Assumptions:
e
inditterence curve analvsis is built upon the following assumptio
(i) Rationality: Like Marshall's utilitv
analysis, indifference curve a
the at maximisation
of utility,
rationality. Accoding
to Hicks, consumer acts rationally
and atmed consumer has full
gven his
incomme and market prices of the commodities. t that
knowledge
of all relevant do
information.
(i) Utility is Ordinal: Indifference curve analvsis has abandoned theie concept
analvsis,
of cardinal
utility is autility
psychic
and
instead has adopted the
concept of ordinal utility. Acccording har hand. the assumption of
entity and therefore cannot be measured in cardinal
terms. On lies
implies that the consumer
that tne consumer is
u i t y quite reasonable and realistic. The ordinal utility
is
is capable of judging wnether
d e ot Simply comparing the different levels of satisfaction. He or nigner
Satstaction obtained from a good or a combination of goods equal to, lowerthan,
is
than another. In
otherwords, the consumer can rank his preferences.
D m i n i s h i n g Marginal Rate of Substitution: Indifference curve analysis IS based on the

In otherwords, it is asSumed
ssumption of the principle of diminishing marginal rate of substitution. the consumerwill be willing to
nat as more and more units of commodity-X are substituted for Y, when more and more of Y
9ive up fewer and fewer units of Y for each additional unit of X. Similarly, unit of
and fewer units of X for each additional
IS Substituted for X, he will be willing to give up feweras the principle of diminishing marginal
rate of
Y.
Ihis rule about consumer behaviouris described the various goods are not
Substitution. This principle follows that particular wants are satiable and
convex to the origin.
perfect substitutes for one another. This makes the indefference curve
in his
(iv) Consistency and Transitivity of Choice: It is assumed that the is consistent
consumer

if in he A B, he will not choose B overA in another period

choice, that is, one period, chooses over
be written as
if both bundles are available to him. The consistency assumption may symbolically
follows:
IfA> B, then B A

choices are characterised by transitivity: if bundle A is

Similarly, it is assumed that consumer's
then bundle A, is preferred toC. Symbolically we may write
preferred to B, and B is preferred C,
to
follows:
the transitivity assumption as
If A> B, and B> C, then A >C

(v) Utility is the Function of Quantity of the Commodities: Larger the quantity of a commodity
from it. In the same mannerá combination having more commodities
larger will be utilities available
combination having less commodities.
will be preferred to the
is being consumed. Thus, if bundle
/vil More is Better:
More of anything is better, it less ot no other
A Contains more of
at least one than
good Dundle B, and no less of anything else, then A will be
better property Is more commonly known as the
monotonicity
to B. The 'more is
oreferred
that tne yet reached the point of satiety in the
consuner nas not known
aroperty. It is thus assumed assumption is, therefore, as non-satiety assumotion.
nsumption of any good. This
6.2 Budget Line
ansider a consumer who has oniy a Ixed amOunt or money equal to Rs 50 to spend.

anay, the prices of which

Let u s e that he spends this money income on two Commodities-xand y, the prices of which
that he:
suppose a r e Rs 10 per unit for x and Rs E
Further m a r k e t . I h e s e prices
the
are aiven in therefore, cannot buy any and every combination of the
two
goods, that he may
The consu The cosumer can afford to buy only those bundles which cost him less than or equal
c o n s u m e r ,

The Th
consume.

want
to
48 Introductory MicroEconomics
 his income. Among these bundles, there are some bundles
to

al to his money income.These are: Ox +10y, 1x+ 8y. 2x+6y.

(combinations) which cost exactly
these different bundles of two goods we obtain a straight
3x+4y, 4x+2y and 5x+0y. By joining
ine which is called budget line. Thus budget line is a line
that shows different possible combinations of the two
goods that can be purchased by a consumer, given his M/P
money income and market prices of goods. 10
The equation ofthe budget line is

P,X,+PX,=M
Here X, and x, show units of goods X and Y
,+P.X,=M
P, and P2 denote prices of goods X and Y and
M/P
M denotes Money income which is given. 0 1 2 4 5
The consumer can afford to buy all those bundles of X-Commodity
two goods that lie on or below the budget line. He cannot Fig. 2.5: Budget Line
buy any bundle of goods that lie above the budget line because of his limited money income.Hence
money income is a budget constraint. It may be noted that all bundles of the two goods thatlie on
the budget line costs exactly equal to the consumer's money income. And bundles that lie below the
budget line cost less than the consumer's money income. All bundles on or below the budget line

constitute the budget set. The budget set,then, consists of all points on the triangle. P. t

consists of all points below the budget line( where not all the income is being spent) and all points on
the budgetline( where all the income is being spent). It is bounded by the two axis because only non
negative quantities are being considered.
M
M
The budget line is a straight line with horizontal intercept and vertical intercept p intercept.
The horizontal intercept represents the bundle that the consumer can buy if he spends his entire
money income on commodity X. Similarly the vertical intercept represents the bundle the consumer
c a n b u y if h e s p e n d s h i s e n t i r e i n c o m e o n c o m m o d i t y Y. T h e s l o p e o f t h e b u d g e t l i n e is p This

implies that budget line has a negative slopeThe negative slope of thebudget line indicates that the
consumer can buy extra units of commodity X only by sacrificing some units of commodity Y.

The slope of budget line is obtained by dividing the perpendicular by base as under

M/P
Slope of budgetlineMP
M/P

Py
P

Consumer's Equilibrium 49
 on the prices af
Changes in the Budget Set the
consumer depends
bundles to either of the
the price of
the set of
available
income or
odthat cosumer's s u p p o s e consumer's
the two g o o d s and either the Now
S income. Thus when budget set of the consumer.

goods changes there will be a change in the De

O m e increases from M to M', the new equation
of budget WIl
P,X,+PaX,=M"
M'VP, in Fig
2.6 (a) This My
shown by M'/P, market prices
budget as
parallel
outward shift of the
of the goods at the prevailing
left implying less
line Implies that consumer c a n buy
more
will shift to the
P, MVP, the budge
ine
ofthe goods
at the prevailing
market
Similarly if income of the consumer decreases, now buy less 1. (See Fig 2.6 b).
The consumer can units of good
n detore. units of aood 2 and M1'/P,
PES.
Can
Fe can now buy maximum M1/p
Y

M/P2
M/P
N

MP2h
M/P

X M/P M/P
M/P, M/P, Good 1
Good 1 b)
(a)
Line
Figure 2.6 Changes in the Budget

Effect of
M/P2 Effect of
M/P2 rise in price
fall in price
of Good 1
of Good1

M/P M/P M/P M/P

Good 1 Good 1
(a) (b)
Fig. 2.7: Effect of change in price of Good 1 on the budget line

Introducory MicroEconomics

50
 Now suppose the price of good 1 changes, price of good 2 and consumer's income remaining
unchanged. Suppose price of good 1 falls the budget line become flatter. Note that the vertical intercept
of the new budget line remain the same but it revolves outwards around the veridical intercept as shown
in panel (a )of Fig. 2.7. This implies that consumer can now buy more of good1 than before, the
maximum quantity of good 2 remaining unchanged.
If the price of good 1 increases the budget line becomes steeper as shown in panel (b) of the figure
2.7.. The budget line now revolves inward around the vertical intercept.This implies that consumer will
now be able to buy less of good 1 than before, maximum quantity of good 2 remaining unchanged.
A change in price of good 2, price of good 1 and the consumer's income remaining unchanged will
bring about similar changes in the budget set of the consumer.

6.3 Indifference Curve Meaning and Properties

The consumer can choose his consumption bundle from the budget set. But on what basis wilhe
make a choice from alternative combinations available to him ? It is assumed that the consumer has
well defined preferences to the set of all possible bundles. He can compare any two bundles. He can
one to the other or he may be indifferent between the two. Further, it is assumed
that the
prefer
consumer can rank the bundles according to his preferences.
The consumer's preferences are assumed to be such that he has more of good1 (x in our example)
for an extra unit
and less of good 2 (y in our example). The amount of good y that he is willing to give up
rate of substitution
of good x will go down. In otherwords, as the amount of good x increases, the
between good y and good x diminishes. Preferences of this kind are called 'Convex preferences'
same satisfaction to the
An indifference curve joins all points representing bundles which yield the
consumer.Thus he is indifferent between combinations indicated by
all points on one indifference
combinations of good x and y that offer the
curve. Consider table 2.5 given below. It shows different
same amount of satisfaction to the consumer. In the
table bundles like a,b,c and d give same level of
bundles of two goods are plotted onna
satisfaction. So these are known as indifference set. If these
graph, we obtain an indifference curve. ( See fig. 2.8).

Box 2.2 Monotonic preferences

more satisfaction from more quantity

According to monotonicpreferences, aconsumer gets
considera combination of two goods
of a commodity compared to its less quantity. ofexample
For
has both
more as compared to 1 x+ 1y. So the
goods
(x and y) 2x+2y. This combination compared with
Also when
consumer prefers oombination 2 x + 2y to combination 1 x + 1y.
2x +2y as it has more ofy and equal amount of
combination 2 x+1y, he prefers combination combination 2 x +2y, as it has more of x-good
goodx. Similarly compared to1x+2y, prefers
he
this kind are called monotonic preferences.
and equal amountas y-good. Preferencesof
Yielding Equal Satification
Table 2.5 Bundles
Good 2 Marginal Rate of
Good 1
Bundle Substitution (MRS)

(2) (3) (4)

(1)
10
a
3
b
2 7
3 2
5
C
1
4 4
d
Consumer's Equilibrium 51
 a s s o c i a t e d
with a cdecrease in
curve
is In inditterence
indifference

long theindifferern
in the amount of good 1 along
cuve is negative.
An incre
ncrease of
substitution bet
between two
the amount of good 2. This implies that the slope of thneThe rate thusS c a n be defined
other good.
Curve, we see that one good is substituted or the of
rate
substitution
can be calculated
goods in called the marginal rate of s bstitution.
Marginal 1. tIt (MHS) (MRS)
good
unit of
a n adaitional
as the amount of
goo0 2 sacrificed to obtain 1 paid in terms of
A good 2 measures
the price of good
substitution
by Oner words, marginal
rate
agood 1
good 2.

d
IC

HRSx
2 5
GoodX
Fig. 2.8: Indifference Curve
Itis important to note here thatthemarginalrate of substitution between two goods diminishes, In
other words as a consumer gets more units of good1, his Wilingnessto give upthe amount of good 2
declines. This implies that the marginal rate of substitution hastendency of decline. (Refer Table 2.5
Column 4).
Box 2.3 Marignal Rate of Substitution
Marginal rate of substitution is the basis of indifference
which the consumer is willing to give up good2 to curve analysis. MRS is the rate at
total utility. In other words, MRS measures the
get an additional unit of good 1 without
affecting
of consumer's
willingness to pay for
preference for goods is such that he is good to
terms the other good. It is because one in
consumer's
give up some amount of one good for an extra amount of willing
the other without
MRS is expressed as under affecting his total utility.

A good 2
MRSxy A good 1
A good 2
It should be noted that
is the slope of indiffernce curve
1. and this is called
good 2 for good MRS of

52 Introductory MicroEconomics
 Again note that marginal rate of substitution is always diminishing as with every increase in
quantity of good 1, the consumer will be willing to sacrifice lesser quantity of good 2. (Refer Fig
2.11)

Indifference Map
We can draw similar indifference curves
showing bundles of commodityx and commodity-
y which represent greater or lesser satisfaction than
that shown on the indifference curve IC(See Fig
2.8).The consumer's preferences over all the
bundles can be represented by a family of
indifference curves which is called indifference
map. An indifference map shows all the
indifference curves which rank the preferences of I 2
the consumer. Bundles of goods lying on a higher
indifference curve yield higher level of satisfaction
IC
and are preferred. On the other hand, bundles on a
lower indifference curve yield a lower utility.(See
Fig 2.9) GoodX

Fig. 2.9: Indifference Map

Properties of Indifference curves
Some important properties of indifference curves are as follows:

(i)Indifference curves always slope downwards from left to right. We have defined an
indiffference curve as a curve on which all the bundles of two commodities give a consumer equal
satisfaction. It follows that if a consumer wants to have more quantity of a commodity say X, he will
have to give up some quantity of the other commodity say Y in order to derive the same level of
satisfaction. If a consumer could have more of one commodity without a corresponding fall in another

commodity, he would have achieved a higher level of satisfaction. Ploting on a graph the diffferent
bundles that contain more of one commodity and less of another would give a downward sloping curve.

It can also be proved by considering other possible shapes of an indifference curve. A curve may

either slope upwards as in Fig 2.10 (), or horizontal as Fig 2.10 (i) or vertical a s in Fig 2.10 (ii. )
in
B has more quantity of commodity X and also
Fig. 2.10 (i) represents two bundles A and B. Bundle
more of commodity Y. It will be wrong to assume that bumdle B with more quantities of both X and Y

B B
B

X X1 X X1
Good-X (6) Good-X (i) Good-X (ii)
Fig. 2.10

Consumer's Equilibrium 53
Commodities will give
satistaction equal to
In Fig 2.10(ii) Dundle
bundle BB has more
bundie Y. In Fig2.10
Oundle B has more m of commmodity X with no less of commodity (ii).
commodity of commodity All the three
Y with but equal of commodity X. shapes are
Contradictory to the
definition of indifference curve. Hence, indifference curves must slope downwards.
about the shape ce curves are always convex towards to the point of origin: This assumption
Consider F i o d i f e r e n c e curves is based on the principle of diminishing marginal rate OrSUDstitution.
Consider Fig
Eare 2.11.Different
marked on the
bundles A, B, C,
D and
given indifference
implies that for a curvelC,.
successive unit increase in the
It

quantity of commodity X, the

Y which the consumer quantity of commodity B
is
falling. A convex curve in ready to give up goes on
the figure clearly shows
that
marginal
rate of substitution is
diminishing.
When
cnsumer moves from
bundle A to bundle B, he is
willing to give up Y,Y, amount of Y commodity to C1
have additional
unit(= X, X,) of commodity X. Now to
get further additional unit of
is now commodity X(=X,X,), he Good X
willing give up smaller amount of commodity
to
Y( =
Y2 Y,). The figure clearly shows Fig. 2.100
YY,<Y,Y
a r y , torthe next unit of X (X,X), heis wiling to give up still smaller amount of Y(=Y,Y) YThis is
appening according to the definition of indiference curve. Hence, indifference curves are convex to the
origin.
3.Higherindifference curves represent higher levels of utility: This again follows from the
more is better property. In Fig 2.12, bundle Aon the higher independence curve IC, contains more of
both commodities compared to B (on the lower indifference curve
IC,).
4. Two indifference curves cannot cross each other: This follows from the 'transitivity' and
more is better properties taken together. The proof is simple. Let two indifference curves-IC, and IC
intersect each other at point A in Fig 2.13. Bundles A and C lie on indifference curve IC, and hence
seem to provide same level of satisfaction. Similarly, bundles Aand Blie on another indifference IC
Then by transitivity bundiesB and C should provide the same levels of satisfaction. But this is not so.

B
IC2 C2
IC1 -\C1
O
O GoodX Good X
Fig. 2.12 Fig. 2.13

I n t r o d u c t o r y MiciOEconomics

54
Bundle Cis betterthan bundle B as it contains more of both commodities. This contradiction came
because the two indifference curves crossed. Hence, indiference curves cannot intersect each other.

6.4 Conditions of Consumer's Equilibrium

The following two conditions must be fulflled for a consumer to be in equibrium.

The first basic condition for consumer equlibrium is that the budiget line should be tengent to the
indifference curve. That is
The slope of indifference curve = the slpe of budget line

or

MRS
MRS, (i.e.ratio of prices of two goods)

M/Py

-IG3
IC2
IC1

X1 M/Px
X Commodity

Fig 2.14 Consumer 'Equlibrium

Fig 2.14 illustrates the position of consumer's equilibrium. At point E,

the budget line is tangent to
the highest attainable indifference curve 1C,.Bundles on the indifference curves above this ike lc
are notaffordable and bundles on the indifference curves below this like IC, are inferior to the
bundles on the indifference curve IC, which is tangent to the budget line. Any point other than E, (

such as E, and E,) on the budget line lies on a lower indifference curve IC, and hence is
inferior to
consumer will be
bundle E (X,+ Y,). Therefore bundle E is the consumer's optimum bundle.Thus, a
in equilibrium when the slope of indifference curve (i.e.MRS and the slope of budget line (the

condition but not sufficient condition for

prices i.e. p ) are equal. This is a necessary
a
ratio of
consumer's equlibrium.lf the consumer buys more units of X beyond the equilibrium level, MRS
will become less than P/P,and he will start losing. So he will not go beyond the equilibrium point.
than
Similarly the consumer will not stop before the equilibrium level. MRS, will become greater to
PPy. It means that the consumer is willing to sacrifice more than he has to sacrifice actually
to obtain
obtain one extra unit of X. So MRS must be equal to the ratio of prices of the two goods
the position of equilibrium.
Consumer's Equilibrium 55
(ii) The second essential condition is that at
Y
the point of consumer's equlibrium,
indifference curve should be convex to the
origin. This condition has been illustrated
in Fig 2.15 In thefigure, the slopes of
indifference curve and budget line are

equal at point R and K. But at point R the

indifference curve is concave. The
consumer would be increasing his level
R
of satisfaction if he were to move at any
other point along the budget line PL, say
at poin K and reach a higher indifference
curve IC,. Thus, point R cannot represent L
GoodX
the stable equlibrium situation for the
Fig 2.15
consumer.