Unit 3

Cardinal Utility Analysis, Law of diminishing marginal Utility, Consumer‟s surplus, Ordinal
Utility analysis, Indifference Curve, Properties, Consumer‟s equilibrium, Price effect, Income
effect and substitution effect.

Utility Analysis

Utility analysis, attempts to explain consumer behavior, on the basis of satisfaction derived from
the consumption of commodities. Of course, the utility derived from the consumption affects the
consumer‟s purchase and consumption decision. The concept of utility can be explained with the
help of various examples:

1. A person who is on fasting for two days when offered food will get utility (satisfaction)

2. A kid when crying is offered toys to play also gets satisfaction.

Thus, both examples referred above offers satisfaction owing to the satisfaction of needs and
wants

Meaning Of Cardinal Utility:

Consumers can express their satisfaction after consuming goods and services known as a
cardinal utility. Since cardinal utility theory holds measurability and quantifiable entity therefore
it can be used for intrapersonal and interpersonal comparison. Although for measuring the
satisfaction level of the consumers, the cardinal utility is measured in “utils” but it has no unit.

For example: If Ram purchases two shirts like X and Y giving him 300 and 400 utils of
satisfaction respectively so it can be inferred that shirt Y provides him with a greater level of
satisfaction.

Types of Utility

There are two types of utility:

1. Total Utility 2. Marginal Utility

Total Utility
The term total utility means the total satisfaction derived from the consumption of
Commodities.
Marginal Utility
Marginal utility be defined as the additional utility derived from the consumption of an
additional unit of a commodity. Therefore ,we can say that Marginal utility is the extra
satisfaction gained from an one more additional unit of that particular commodity.

Marginal utility may be calculated as follows:

Marginal Utility = change in Total Utility /change in quantity consumed

Cardinal Utility Analysis

Cardinal utility analysis is based on the cardinal measurement of utility which assumes that
utility is measurable and additive. This theory was developed by neo-classical economists like
Marshall, Pigou, Robertson etc. It is expressed as a quantity measured in hypothetical units
which called utils. If a consumer imagines that one mango has 8 utils and an apple 4 utils, it
implies that the utility of mango is twice than of an apple.

Assumptions of Cardinal Utility Analysis:

1. Rational consumer
Cardinal utility analysis assumes that consumer is rational. He makes every effort to maximize
his total utility under the income and price constraint. while going for the purchase or
consumption of good ,a consumer will act rationally to maximize his level satisfaction.

2. Cardinal measurement of Utility

The utility of each commodity is measurable and quantifiable i.e. Utility is cardinal concept. The
most convenient measure is money. Thus utility can be measured quantitatively in monetary
units or cardinal units. Therefore whenever a person consumes any commodity,he can express or
measure his satisfaction in cardinal term. For example, a person having a glass of milk can say
that he got 10 utils from it. Moreover cardinal measurement of utility enables the comparison of
utilities derived from two different goods. For example, a person can say that the utility he gets
from the consumption of milk is twice the utility he gets from the consumption of Juice.

3. Constant Marginal Utility of Money

The utility derived from commodities are measured in terms of money. According to Marshall,
money is the measuring rod of money. So, money is a unit of measurement in cardinal approach.
Marshall argues that that the amount of money which a person is prepared to pay for a unit of a
good rather than go without it is a measure of utility he derives from that good. According to him
measurement of marginal utility of good in terms of money is only possible if the marginal utility
of money itself remains constant. Hence, marginal utility of money should be constant.
4. Diminishing Marginal Utility
If the stock of commodities increases with the consumer, each additional stock or unit of the
commodity gives him lesser and lesser satisfaction. Every additional intake of good will yield
less utility as compared to the utility obtained from the previous unit of the good. It means utility
increases at a decreasing rate.

5. Independent Utilities
It means utility obtained from one commodity is not dependent on utility obtained from another
commodity. In other words, it means that the utility which a consumer derives from the
consumption of that commodity is the function of the quantity of only that good. It is not affected
by the consumption of other commodities.

Approaches to Cardinal Utility Analysis

The two approaches of Cardinal utility analysis are as follows:
1. Law of Diminishing Marginal Utility
2. Law of Equi-Marginal Utility

LAW OF DIMINISHING MARGINAL UTILITY

The fundamental assumption of utility theory of demand is that the satisfaction that a person
derives in consuming a particular product diminishes or declines as more and more of a good is
consumed. In other words, as successive quantity of goods is consumed, the utility we derive
diminishes. This is called the law of diminishing marginal utility.

Assumptions of Law of Diminishing Marginal Utility:

The law of DMU operates under certain specific conditions. Economists call them the
„assumptions‟ of this law. Following are the assumptions of the law of diminishing marginal
utility:

1. Cardinal measurement of utility:

It is assumed that utility can be measured and a consumer can express his satisfaction in
quantitative terms such as 1, 2, 3, etc.

2. Monetary measurement of utility:

It is assumed that utility is measurable in monetary terms.

3. Consumption of reasonable quantity:

It is assumed that a reasonable quantity of the commodity is consumed. For example, we should
compare MU of glassfuls of water and not of spoonful‟s. If a thirsty person is given water in a
spoon, then every additional spoon will yield him more utility. So, to hold the law true, suitable
and proper quantity of the commodity should be consumed.

4. Continuous consumption:
It is assumed that consumption is a continuous process. For example, if one glass of juice is earn
is consumed in the morning and another in the afternoon, then the second glass may provide
equal or higher satisfaction as compared to the first one.

5. No change in Quality:
Quality of the commodity consumed is assumed to be uniform. A second cup of ice-cream with
nuts and toppings may give more satisfaction than the first one, if the first ice-cream was without
nuts or toppings.
6. Rational consumer:
The consumer is assumed to be rational who measures, calculates and compares the utilities of
different commodities and aims at maximising total satisfaction.

7. Independent utilities:
It is assumed that all the commodities consumed by a consumer are independent. It means, MU
of one commodity has no relation with MU of another commodity. Further, it is also assumed
that one person‟s utility is not affected by the utility of any other person.

8. MU of money remains constant:

As a consumer spends money on the commodity, he is left with lesser money to spend on other
commodities. In this process, the remaining money becomes dearer to the consumer and it
increases MU of money for the consumer. But, such an increase in MU of money is ignored. As
MU of a commodity has to be measured in monetary terms, it is assumed that MU of money
remains constant.

9. Fixed Income and prices:

It is assumed that income of the consumer and prices of the goods which the consumer wishes to
purchase remain constant.

10. Goods are divisible:

It is assumed that whatever the goods are consumed they must be divisible. If the goods are not
divisible the comparison of utility is not possible.

11. Homogeneity:
Another important assumption is that goods consumed should be homogeneous in regard to
quality size, taste, flavors, colour etc.
Limitations of the Law of Diminishing Marginal Utility
When it comes to making business decisions, there are some limitations to the law of
diminishing marginal utility. The law will not operate properly, or may not even apply, if:

 The units being consumed are very small.

 The units being consumed are of different sizes.
 There are long breaks in between consuming the units.
 The consumer is thinking or behaving irrationally, or the consumer is suffering from a
mental illness or addiction.
The units being consumed are part of a collection or are rare objects. The law of diminishing
marginal utility also will not apply if the commodity being considered is money. The utility of
money does not decrease as a person acquires more of it.

Exceptions to the Law of Diminishing Marginal Utility

There is no real exception to the law of diminishing marginal utility.
1. Hobbies: It is pointed out that in case of certain hobbies like stamp collection or old coins,
every addition unit gives more pleasure. MU goes on increasing with the acquisition of every
unit. However careful analysis shows that the person does not like to spend more money on same
type of coins etc.

2. Drunkards: It is believed that every dose of liquor increases the utility of a drunkard. And
diminishing marginal utility does not apply. However, had the law not applied, the drunkard
would have continued to drink.

3. Miser: In the case of miser, greed increases with the acquisition of every additional unit of
money.

4. Reading: reading of more books gives more knowledge and in turn greater satisfactions.

5. Money: it is said that the law does not apply in the case of money also. But we find that a rich
person has less utility for last one rupee than what the poor person has.

Importance of Law of Diminishing Marginal Utility

The marginal utility analysis has a good number of uses and applications.
1. Explanation of the Determination of Prices: The theory helps in explaining why the prices
of some commodities are high and low of others and thus able to explain the water-diamond
paradox or paradox of value which troubled Adam Smith. According to modern economists, it is
marginal utility and not the total utility which determine the price of commodity. Water is
available in abundant quantities and its relative marginal utility Is very low and even zero.
Therefore, its price is very low or zero. On the other hand, the diamonds are scarce and therefore
their marginal utility and hence their relative price is very high.

2. Explanation of Law of Demand: In order to maximize total utility consumer equates the
marginal utility with its price. Since, at larger amount the marginal utility is low. So consumer
would like to pay less price and vice versa.

3. Fiscal Policy: In modern welfare state, in order to increase the social welfare thegovernment
tries to redistribute income of the society from rich to poor. This is based on the assumption that
marginal utility of rich people is less than that of poor people. So government imposes
progressive taxes on rich section of society and spends the tax proceeds on poor section of
society.

Diminishing Marginal Utility

According to the Law of Diminishing Marginal Utility (DMU), with the consumption of more
and more units of a commodity, the utility obtained from each successive unit decreases. Most
consumers spread their income among different varieties of goods when making choices. People
prefer a variety of goods as consuming more and more of any one good diminishes the marginal
satisfaction obtained from continued use of that good. This law explains a significant relationship
between utility and the quantity of a commodity that is consumed. This can be better understood
by using the example mentioned below.

Suppose your mother offers you food after you just got home from work. The first chapatti will
provide you with great satisfaction. With the second chapatti, you will feel less satisfied. As you
consume more, you will reach a point where you will need another chapatti where the marginal
utility will be zero. After that, if you are forced to eat even one more chapatti, it will lead to
disutility. The Law of Diminishing Marginal Utility causes such a decrease in satisfaction with
successive unit consumption.

The concept of diminishing marginal utility can be better understood with the help of the
following schedule and diagram:
In the above diagram, the units of apples are displayed on the X-axis and the MU on the Y-axis.
Points A, B, C, D, and E reflect the MU from each successive unit.

It can be observed as the consumption of apples rises, the rectangles (which represent each level
of satisfaction) get smaller and smaller. When consumption is increased from first to second and
then third, MU decreases from 25 to 17 and then to 12 utils. The fifth apple is the Point of
Satiety and has no utility (MU= 0). When the sixth apple is consumed, MU turns negative. The
downward-sloping MU curve indicates that the MU of successive units is decreasing.
 CONSUMER SURPLUS

Consumer surplus is an economic measurement of consumer benefits resulting from market

competition. A consumer surplus happens when the price that consumers pay for a product or
service is less than the price they're willing to pay. It's a measure of the additional benefit that
consumers receive because they're paying less for something than what they were willing to pay.

Consumer surplus is measured as the area below the downward-sloping demand curve, or the
amount a consumer is willing to spend for given quantities of a good, and above the actual
market price of the good, depicted with a horizontal line drawn between the y-axis and demand
curve. Consumer surplus can be calculated on either an individual or aggregate basis, depending
on if the demand curve is individual or aggregated.

Consumer surplus always increases as the price of a good falls and decreases as the price of a
good rises. For example, suppose consumers are willing to pay $50 for the first unit of product A
and $20 for the 50th unit. If 50 of the units are sold at $20 each, then 49 of the units were sold at
a consumer surplus, assuming the demand curve is constant.

Example of Consumer Surplus

Consumer surplus is the benefit or good feeling of getting a good deal. For example, let's say that
you bought an airline ticket for a flight to Disney World during school vacation week for $100,
but you were expecting and willing to pay $300 for one ticket. The $200 represents your
consumer surplus.
However, businesses know how to turn consumer surplus into producer surplus or for their gain.
In our example, let's say the airline realizes your surplus and as the calendar draws near to school
vacation week raises its ticket prices to $300 each.

The airline knows there will be a spike in demand for travel to Disney World during school
vacation week and that consumers will be willing to pay higher prices. So by raising the ticket
prices, the airlines are taking consumer surplus and turning it into producer surplus or additional
profits.

Calculating Consumer Surplus

The point where the demand and supply meet is the equilibrium price. The area above the supply
level and below the equilibrium price is called product surplus (PS), and the area below the
demand level and above the equilibrium price is the consumer surplus (CS).

While taking into consideration the demand and supply curves, the formula for consumer surplus
is CS = ½ (base) (height). In our example, CS = ½ (40) (70-50) = 400.
Meaning of Ordinal Utility Theory

J.R. Hicks and R.G.D. Allen, in 1934, According to this approach, a utility cannot be measured
in any quantifiable number. It could only be measured by giving orders, ranks or preferences.

Hence ordinal utility means the consumer‟s preferences or choice for one commodity or for a
basket of goods over the other. Here, the preferences could be expressed in terms of „more‟ or
„less‟ preferable.

Moreover, since the consumers have a limited income which they can spend on their
consumption. Therefore, in this approach, a consumer will prefer a basket of goods over the
other given the prices of the goods and the income of the consumer. This would be explained
with the help of the budget line and indifference curve.

Advantages of Cardinal Utility

1. Allows for precise measurement and comparison of utility, enabling quantitative analysis
of consumer preferences.
2. Provides a framework for conducting welfare economics and policy-making by
quantifying the impact of policy changes on consumer satisfaction.
3. Facilitates the use of mathematical operations to analyze consumer behavior and predict
choices.
 4. Helps in understanding consumer equilibrium through marginal utility analysis, leading
to insights into demand patterns.
5. Allows for efficient allocation of resources by considering the magnitude of utility
derived from different goods or services.
6. Provides a basis for conducting cost-benefit analysis in decision-making processes.
7. Enables the construction of utility functions to model and predict consumer behavior.
8. Supports the development of optimization models for maximizing consumer satisfaction.
9. Assists in evaluating the effectiveness of marketing strategies and pricing policies based
on utility measurements.
10. Offers a theoretical framework for studying the impact of income and wealth distribution
on utility levels.

Disadvantages of Cardinal Utility

1. Assumes interpersonal comparison of utility, which may be subjective and challenging to

measure accurately.
2. Requires assigning numerical values to utility, which can be arbitrary and lack empirical
basis.
3. Ignores individual variations in preferences and subjective experiences of utility.
4. Fails to account for psychological factors and the complexity of human decision-making.
5. Relies heavily on simplifying assumptions that may not accurately represent real-world
consumer behavior.
6. Difficulties in accurately quantifying utility may limit the practical applicability of
cardinal utility theory.
7. The assumption of additive utility may oversimplify consumer preferences, leading to
inaccurate predictions.
8. Cardinal utility theory may overlook external factors that influence consumer choices,
such as social norms or cultural influences.
9. The measurement of utility is often subjective and cannot capture all dimensions of
consumer satisfaction.
10. Cardinal utility theory does not consider the possibility of diminishing marginal utility or
the impact of income and substitution effects.

Ordinal utility

Ordinal utility is a concept in economics that focuses on the relative rankings of preferences
rather than assigning numerical values to utility. It acknowledges that individuals can compare
and rank their preferences but does not require precise measurement or quantification of utility.
Ordinal utility theory often employs preference rankings or utility functions to understand
consumer choices and analyze consumer equilibrium. Unlike cardinal utility, ordinal utility does
not involve mathematical operations on utility values and does not assume interpersonal
comparisons of utility.

Advantages of Ordinal Utility

1. Provides a straightforward and intuitive way to understand consumer preferences by

focusing on relative rankings.
2. Avoids the need for arbitrary numerical assignments to utility, making it less reliant on
subjective measurements.
3. Allows for a more flexible representation of consumer behavior by accommodating
individual variations in preferences.
4. Assists in understanding consumer choices and decision-making processes based on the
relative order of preferences.
5. Supports the construction of preference rankings and utility functions to model consumer
behavior.
6. Offers a useful framework for analyzing consumer equilibrium and identifying optimal
choices.
7. Provides insights into the impact of changes in preferences on consumer decision-
making.
8. Facilitates the comparison of different options based on the order of preference rankings.
9. Enables the study of consumer behavior in situations where precise measurement of
utility is challenging or not feasible.
10. Helps in designing market research studies and surveys by incorporating preference
rankings as a measure of consumer satisfaction.

Disadvantages of Ordinal Utility

1. Does not provide a precise measurement of utility, limiting the ability to compare utility
levels across individuals or goods.
2. Lacks the mathematical rigor and analytical precision offered by cardinal utility theory.
3. Cannot capture the magnitude or intensity of preferences, only the relative order.
4. Does not support mathematical operations on utility values, restricting the application of
optimization techniques.
5. Does not account for the diminishing marginal utility that individuals may experience as
they consume more of a good or service.
6. Ignores the potential impact of income and substitution effects on consumer choices.
7. The construction of preference rankings may be subjective and vary across individuals.
8. Ordinal utility theory may not provide clear guidance on policy-making or welfare
analysis due to the absence of precise measurements.
9. The analysis based on ordinal utility may be less robust to changes in preferences or
external factors compared to cardinal utility analysis.
 10. Ordinal utility theory may not adequately address complex consumer behavior or
decision-making involving multiple factors.

AN INDIFFERENCE CURVE

An indifference curve is a contour line that slopes downward from left to right, showing equal
levels of satisfaction on each of its points, with the given amount of income spent on different
combinations.

As the indifference curve is always convex to the origin it shows that the Marginal Rate of
Substitutions (MRS) gradually falls, to enable the consumer to move from one combination to
another of two commodities or more. Key characteristics of indifference curve are as under:

 Equal Satisfaction: All points along the curve represent bundles of goods that yield an
equal level of satisfaction or utility to the consumer. In other words, the consumer is
indifferent between any two points on the same curve.
 Downward Sloping: Indifference curves typically slope downward from left to right.
This means that as the quantity of one good increase, the quantity of the other good must
decrease to maintain the same level of satisfaction.
 Convex Shape: Indifference curves are generally convex to the origin (bowed inward).
This convexity reflects the principle of diminishing marginal rate of substitution, which
means that consumers are willing to trade off less of one good for more of another but at
a diminishing rate.
 Non-Intersecting: Indifference curves do not intersect with each other. If they did, it
would imply that a consumer is indifferent between two different levels of satisfaction,
which is not possible.
 Higher Curve, Higher Satisfaction: A higher indifference curve represents a higher
level of satisfaction. Consumers aim to reach higher indifference curves whenever
possible.
Tangent to Budget Constraint: An optimal consumption point is where an indifference curve is
tangent to the consumer‟s budget constraint, representing the highest level of satisfaction
attainable given the budget.

Properties of Indifference Curves

The properties of indifference curves are crucial for understanding consumer preferences and
choices in microeconomics. These properties help economists analyze how consumers make
decisions based on their preferences for various combinations of goods and services. Here are the
key properties of indifference curves:
1. Negatively Sloped: Indifference curves slope downward from left to right. This means
that as a consumer increases the quantity of one good while keeping the consumption of
the other good constant, the level of satisfaction (utility) remains the same. The negative
slope reflects the concept of the diminishing marginal rate of substitution (MRS), where
consumers are willing to give up less of one good to gain more of another.
2. Convex to the Origin: Indifference curves are typically convex to the origin, which
means they bend inward as they move away from the origin. This convexity indicates that
consumers exhibit a diminishing marginal rate of substitution. In other words, consumers
become less willing to trade one good for another as they move along the indifference
curve.
3. Cannot Intersect: Indifference curves for a single consumer cannot intersect with each
other, If they did intersect, it would imply that the consumer is equally satisfied with two
different combinations of goods, which contradicts the concept of rational consumer
choice. A unique level of utility we see in each indifference curve.
4. Higher Indifference Curve Represents Higher Utility: As we move away from the
origin, toward the upper-right side of the graph, we encounter indifference curves that
represent higher levels of utility. This indicates that consumers prefer higher utility
(greater satisfaction) to lower utility.
5. Indifference Maps: A collection of indifference curves for a single consumer is called
an “indifference map.” These maps provide a comprehensive view of a consumer‟s
preferences for various combinations of goods. Higher indifference curves (farther from
the origin) represent greater satisfaction.
6. Diminishing Marginal Rate of Substitution: The marginal rate of substitution (MRS)
decreases as indifference curve move from left to right. This reflects the decreasing
willingness of consumers to trade one good for another while keeping their satisfaction
constant.
7. Transitivity: Transitivity is a property of preferences implied by indifference curves. If a
consumer prefers bundle A to bundle B and bundle B to bundle C, then they must also
prefer bundle A to bundle C. Indifference curves align with the principle of transitivity in
consumer preferences.
8. Completeness: Completeness implies that consumers can compare and rank all possible
combinations of goods. For any two bundles of goods, consumers can indicate a
preference for one over the other or express indifference.
9. Monotonicity: Monotonicity means that consumers generally prefer more of each good
to less. An increase in the quantity of at least one good, while holding the other constant,
should lead to a higher level of satisfaction. Indifference curves align with this preference
pattern.
Indifference Curve Graph and Table

As we know that indifference curve is a fundamental concept in microeconomics used to

illustrate consumer preferences and choices. They show various combinations of two goods or
services that provide the same level of satisfaction or utility to a consumer.

Indifference Curve Graph

In the graph below, we‟ll consider a hypothetical consumer, Alex, who is making choices
between Commodity X and Commodity Y. The two axes represent the quantities of Commodity
X (x-axis) and Commodity Y (y-axis). The indifference curve (IC) represents combinations of
Commodity X and Commodity Y that provide the same level of satisfaction to Alex.
In this table:

 Combination A represents zero units of Commodity X and four units of Commodity Y,

yielding a total utility of 50.
 Combination B consists of one unit of Commodity X and five units of Commodity Y,
providing the same total utility of 50.
 Combination C consists of two units of Commodity X and seven units of Commodity Y,
also resulting in a total utility of 50.
 Combinations D and E similarly provide the same total utility of 50 by varying the
quantities of Commodity X and Commodity Y.

Understanding the Indifference Curve:

 Downward Sloping Curve: As we move from Combination X to Combination Y along

the indifference curve, the quantity of one good decreases while the quantity of the other
increases. This is why indifference curves are downward-sloping.
 Equal Utility: Alex is indifferent between these combinations because they all provide
the same level of satisfaction (total utility of 50). The curve connects all these
combinations.
 Diminishing Marginal Rate of Substitution: The principle of diminishing marginal rate
of substitution is evident. Alex is willing to give up fewer Y to gain an additional cup of
X as we move to the right along the curve. The rate of substitution decreases as we go
from Combination X to E.
 Convex Shape: The curve is convex to the origin, indicating that the trade-off between X
and Y becomes less favorable as we move to the right. This reflects the diminishing
marginal utility of each good.

Assumptions of Indifference Curve

The analysis of indifference curves in microeconomics is based on several fundamental

assumptions that help us understand consumer preferences and choices. These assumptions are
as follows:

1. Transitivity: Consumers are assumed to be rational, meaning they have clear preferences
and can make consistent choices. Transitivity assumes that if a consumer prefers bundle
A to bundle B and bundle B to bundle C, then they must prefer bundle A to bundle C. In
other words, preferences are logically consistent.
2. Completeness: This assumption implies that consumers can compare and rank all
possible bundles of goods. When faced with two different combinations of goods,
consumers are capable of determining which one they prefer, even if it‟s a matter of
indifference.
 3. More Is Better: This assumption suggests that, in general, having more of a good is
preferred to having less. In other words, goods are desirable, and consumers strive to
increase their consumption of goods.
4. Non-Satiation: This is often called the assumption of “wanting more.” It implies that
consumers always prefer more of a good to less. In economic terms, there‟s no point at
which a consumer says they‟ve had “enough” of a good. More is always better.
5. Diminishing Marginal Rate of Substitution: This is a key assumption specifically
related to indifference curves. It suggests that as a consumer moves along an indifference
curve (keeping utility constant), they are willing to give up smaller and smaller amounts
of one good to obtain more of the other good. In simpler terms, the trade-off between the
two goods becomes less steep as you move along the curve.
6. Convexity: The assumption of convexity is related to the diminishing marginal rate of
substitution. It means that indifference curves are typically convex to the origin. This
convexity implies that the consumer is willing to trade off goods at a diminishing rate. In
other words, the consumer is less willing to give up one good for more of the other as
they consume more.

Limitations of Indifference Curve

While indifference curves are a valuable tool for analyzing consumer preferences and choices,
they also come with limitations. Understanding these limitations is crucial for applying the
model effectively. Here are some of the key limitations of indifference curve analysis:

1. Cardinal Measurement: Indifference curve analysis is based on the cardinal utility

approach, which assumes that utility can be measured in absolute units (utils). This
concept has limitations because utility is a subjective measure, and there‟s no universal
standard for measuring it. Different individuals may assign different values to the same
level of utility.
2. Income and Wealth Effects: The model does not consider income and wealth effects.
Changes in a consumer‟s income or wealth can lead to shifts in their budget constraint
and, consequently, changes in their preferences and consumption patterns. The
indifference curve analysis assumes a fixed budget constraint.
3. Inadequate Treatment of Necessities and Luxuries: The model treats all goods as
substitutes or complements, regardless of whether they are necessities (e.g., basic food
items) or luxuries (e.g., expensive vacations). In reality, consumers may have different
preferences for necessities and luxuries, and the model doesn‟t account for these
distinctions.
4. Limited Realism: Indifference curves are simplifications of real-world consumer
behavior. They assume that consumers make choices based solely on utility and do not
consider psychological or sociological factors that influence consumption decisions.
 5. Constant Marginal Rate of Substitution: While diminishing marginal rates of
substitution are assumed along an indifference curve, this assumption doesn‟t always
hold true in practice. In some cases, consumers may face corner solutions where they
only consume one of the two goods.
6. Single Consumer Model: The model focuses on the behavior of a single consumer. In
reality, many consumption decisions are made by households or families, and individual
preferences may not always align with the choices made at the household level.
7. Time Frame: The model assumes that preferences remain stable over time. However,
consumer preferences may change due to factors like changing demographics, trends, or
new information.
8. Complexity of Preferences: Consumer preferences are often multifaceted and can
involve various considerations beyond the consumption of goods, such as brand
preferences, ethical concerns, and social influences. The model simplifies preferences
into a two-dimensional space.
9. Non-Convex Preferences: While the model assumes convex preferences (diminishing
marginal rate of substitution), some consumers may exhibit non-convex preferences,
particularly when dealing with discrete goods or imperfect substitutability.

Importance of Indifference Curve

The significance of indifference curves in economics lies in their role as a foundational tool for
understanding and analyzing consumer preferences, choices, and behavior. Here are the key
aspects of their significance:

Consumer Preferences Analysis:

Indifference curves provide a graphical representation of how consumers make choices between
different combinations of goods and services. They help economists understand how consumers
rank and evaluate various consumption bundles based on their preferences.

1. Optimal Consumer Choices:

By combining indifference curves with budget constraints, economists can determine the
consumption bundle that maximizes a consumer‟s utility, subject to their income
limitations. This is critical for understanding how consumers allocate their resources
among different goods and services.
2. Utility Maximization:
Indifference curves are central to the concept of utility maximization. Consumers aim to
reach the highest possible level of satisfaction (utility) given their budget. This process is
essential for both microeconomic analysis and consumer theory.

3. Consumer Surplus:
Indifference curves help in calculating consumer surplus, which is the difference between
what consumers are willing to pay for a good and what they actually pay. This concept is
crucial for assessing the welfare of consumers resulting from different market conditions.

4. Market Demand Analysis:

Indifference curve analysis allows for the aggregation of individual demand curves to
derive market demand curves. This helps in understanding the overall demand for a
product in a market.

5. Welfare Economics:
In welfare economics, indifference curves are used to assess changes in consumer welfare
resulting from shifts in market prices or policy changes. This is particularly relevant for
evaluating the impacts of economic policies and market interventions.

6. Labor-Leisure Tradeoff:
Indifference curves can be applied to analyze the labor-leisure tradeoff. It helps in
understanding how individuals make choices between work and leisure time, which is
essential for labor economics.

7. Investment and Saving Decisions:

Economists use indifference curve analysis to examine how individuals make decisions
about saving and investing. It provides insights into the choices people make between
current consumption and future income.

8. Comparative Statics:
Indifference curve analysis allows for comparing the effects of changes in prices, income,
or preferences on consumer choices. This is vital for understanding how economic
variables impact consumer behavior.

9. Teaching and Learning Tool:

Indifference curves are widely used in economics education to illustrate economic
concepts and demonstrate how consumers make choices. They serve as a valuable
pedagogical tool.
 INDIFFERENCE SCHEDULE

An indifference schedule is a list of various combinations of commodities that give equal

satisfaction or utility to consumers. For simplicity, we have considered only two commodities,
„X‟ and „Y‟, in our Table. It shows various combinations of X and Y; however, all these
combinations give equal satisfaction (k) to the consumer.

You can construct an indifference curve from an indifference schedule in the same way you
construct a demand curve from a demand schedule.

Properties of Indifference Curves

• Indifference curves are downward sloping.
• Higher indifference curve represents higher utility.
• Indifference curves can never intersect.
• Indifference curves are convex to the origin.

CONSUMER EQUILIBRIUM

Consumer Equilibrium

The state of balance obtained by an end-user of products refers to the number of goods and
services they can buy, given their existing level of income and the prevailing level of cost prices.
Consumer equilibrium permits a customer to get the most satisfaction possible from their
income.

Consumer‟s Equilibrium means a state of maximum satisfaction.

A situation where a consumer spends his given income purchasing one or more commodities so
that he gets maximum satisfaction and has no urge to change this level of consumption, given the
prices of commodities, is known as the consumer‟s equilibrium.

Assumptions

 The income of the consumer is constant.

 The two goods purchased with income can be substituted for one another.
 The rational customer always aims to maximise their level of satisfaction.
 The price of goods is constant.
 The consumer knows the prices of the commodities.
 Consumer can spend the income in small quantities.
 The market is in perfect competition.
 The goods can be divided.
 The indifference map is well known to the consumer.

Consumers Equilibrium

In order to display the combination of two goods X and Y, that the consumer buys to be in
equilibrium, let‟s bring his indifference curves and budget line together.

We know that,

Indifference Map – shows the consumer‟s preference scale between various combinations of
two goods

Budget Line – depicts various combinations that he can afford to buy with his money income
and prices of both the goods.
In the following figure, we depict an indifference map with 5 indifference curves – IC1, IC2,
IC3, IC4, and IC5 along with the budget line PL for good X and good Y.

From the figure, we can see that the combinations R, S, Q, T, and H cost the same to the consumer.
In order to maximize his level of satisfaction, the consumer will try to reach the highest indifference
curve. Since we have assumed a budget constraint, he will be forced to remain on the budget line.

Equilibrium Point in the Indifference Curve

Let‟s say that he chooses the combination R. From Fig. 1, we can see that R lies on a lower
indifference curve – IC1. He can easily afford the combinations S, Q, or T which lie on the
higher ICs. Even if he chooses the combination H, the argument is similar since H lies on the
curve IC1 too.

Next, let‟s look at the combination S lying on the curve IC2. Here again, he can reach a higher
level of satisfaction within his budget by choosing the combination Q lying on IC3 – higher
indifference curve level. The argument is similar for the combination T since T lies on the curve
IC2 too.

Equilibrium Point is Maximum satisfaction but on the budgeted line

This is the best choice since Q lies on his budget line and pts puts him on the highest possible
indifference curve, IC3. While there are higher curves, IC4 and IC5, they are beyond his budget.
Therefore, he reaches the equilibrium at point Q on curve IC3.

Notice that at this point, the budget line PL is tangential to the indifference curve IC3. Also, in
this position, the consumer buys OM quantity of X and ON quantity of Y.
Since point Q is the tangent point, the slopes of line PL and curve IC3 are equal at this point.
Further, the slope of the indifference curve shows a marginal rate of substitution of X for Y with
the marginal price of the product indicates the ratio between the prices of X and Y and is equal to
the utility of Product X and Y.

Explanation: 2

We know that a consumer is indifferent among the combinations of the same indifference curve.
However, it is important to note that they prefer the combinations on the higher indifference
curves to those on the lower ones. This is because a higher indifference curve implies a higher
level of satisfaction. Therefore, all combinations on IC1 offer the same satisfaction, but all
combinations on IC2 give greater satisfaction than those on IC1.

The consumer weighs the given commodity's price (or cost) against its utility to determine the
equilibrium point (satisfaction or benefit). As a rational consumer, they will be in equilibrium
when the price paid for the good equals the marginal utility. We know that price and marginal
utility are stated in terms of utils. However, it is only possible to compare marginal utility and
price when expressed in the same units. As a result, the marginal value of utils is stated in
monetary terms. Money-based marginal utility equals marginal utility in utils/M

Similarly, if there are three goods, X, Y, and Z, then the equilibrium condition will be simply
MU Money. Thus, to be in equilibrium

1. Marginal utility of the last rupee of expenditure on each good is the same.

2. Marginal utility of a good falls as more of it is consumed.

PRICE CONSUMPTION CURVE: WITH DIAGRAM

We will now explain how the consumer reacts to charges in the price of a good, his money
income, tastes and prices of other goods remaining the same. Price effect shows this reaction of
the consumer and measures the full effect of the change in the price of a good on the quantity
purchased since no compensating variation in income is made in this case.

When, the price of good charges, the consumer would be either better off or worse off than
before, depending upon whether the price falls or rises. In other words, as a result of change in
price of a good, his equilibrium position would lie at a higher indifference curve in case of the
fall in price and at a lower indifference curve in case of the rise in price.

Types of Price Consumption Curve (PCC)

1. Downward-Sloping Price Consumption Curve

2. Upward-Sloping Price Consumption Curve
3. Backward-Sloping Price Consumption Curve
4. Horizontal-Sloping Price Consumption Curve

Downward-Sloping Price Consumption Curve

Price effect is shown in Fig 1, With given prices of goods X and Y, and a given money income
as represented by the budget line PL1, the consumer is in equilibrium at Q on indifference curve
C1. In this equilibrium position at Q, he is buying OM1 of X and ON1 of Y. Let price of good id
X fall, price of Y and his money income remaining unchanged.

Figure 1-Downward-Sloping Price Consumption Curve

As a result of this price change, budget line shifts to the position PL

The consumer is now in equilibrium at R on a higher indifference curve IC2 and is buying OM2
of X and ON2 of Y. He has thus become better off, that is, his level of satisfaction has increased
as a consequence of the fall in the price of good X. Suppose that price of X further falls so that
PL3 is now the relevant price line.

With budget line PL3 the consumer is in equilibrium at S on indifference curve IC3 where he has
OM3 of X and ON3 of Y. If the price of good X falls still further so that budget line now takes
the position of PL4, the consumer now attains equilibrium at T on indifference curve IC4 and has
OM4 of X and ON4 of Y.

When all the equilibrium points such as Q, R, S, and T are joined together, we get what is called
Price Consumption Curve (PCC). Price consumption curve traces out the price effect. It shows
how the changes in price of good X will affect the consumer‟s purchases of X, price of Y, his
tastes and money income remaining unaltered.

In Fig. 1 price consumption curve (PCC) is sloping downward. Downward sloping price
consumption curve for good X means that as the price of good X falls, the consumer purchases a
larger quantity of good X and a smaller quantity of good Y. This is quite evident from Fig. 8.31.

In elasticity of demand, we obtain downward-sloping price consumption curve for good X when
demand for it is elastic (i.e., price elasticity is greater than one). But downward sloping is one
possible shape of price consumption curve. Price consumption curve can have other shapes also.

In Fig. 2 upward-sloping price consumption curve is shown. Upward-sloping price consumption

curve for X means that when the price of good X falls, the quantity demanded of both goods X
and Y rises. We obtain the upward-sloping price consumption curve for good X when the
demand for good is inelastic, (i.e., price elasticity is less than one).

Fig. 2 - Upward-Sloping Price Consumption Curve

Price consumption curve can also have a backward-sloping shape, which is depicted in Fig. 3.
Backward-sloping price consumption curve for good X indicates that when price of X falls, after
a point smaller quantity of it is demanded or purchased. This is true in case of exceptional type
of goods called Giffen Goods.

Fig. 3. - Backward-Sloping Price Consumption Curve

Price consumption curve for a good can take horizontal shape too. It means that when the price
of the good X declines, its quantity purchased rises proportionately but quantity purchased of Y
remains the same. Horizontal price consumption curve is shown in Fig. 4. We obtain horizontal
price consumption curve of good X when the price elasticity of demand for good X is equal to
unity.

Fig. 4 - Horizontal-Sloping Price Consumption Curve

But it is rarely found that price consumption curve slopes downward throughout or slopes
upward throughout or slopes backward throughout. More generally, price consumption curve has
different slopes at different price ranges. At higher price levels it generally slopes downward,
and it may then have a horizontal shape for some price ranges but ultimately it will be sloping
upward. For some price ranges it can be backward sloping as in case of Giffen goods. A price
consumption curve which has different shapes or slopes at different price ranges.

INCOME EFFECT: INCOME CONSUMPTION CURVE (ICC)

With a given money income to spend on goods, given prices of the two goods and given an
indifference map (which portrays given tastes and preferences of the consumers), the consumer
will be in equilibrium at a point in an indifference map.

We are interested in knowing how the consumer will react in regard to his purchases of the
goods when his money income changes, prices of the goods and his tastes and preferences
remaining unchanged.

Income effect shows this reaction of the consumer. Thus, the income effect means the change in
consumer‟s purchases of the goods as a result of a change in his money income. Income effect is
illustrated Fig.1 below.

Types of Income Effect: Income Consumption Curve

 Positive Income Effect: Income Consumption Curve

 Negative Income Effect: Income Consumption Curve (Goods X and Y)

Fig.1 - Positive Income Effect: Income Consumption Curve

With given prices and a given money income as indicated by the budget line P1L1 the consumer
is initially in equilibrium at point Q1 on the indifference curve IC1 and is having OM1 of X and
ON1 of Y. Now suppose that income of the consumer increases. With his increased income, he
would be able to purchase larger quantities of both the goods.

As a result, budget line will shift upward and will be parallel to the original budget line P

1L1. Let us assume that the consumer‟s money income increases by such an amount that the new
budget line is P2L2 (consumer‟s income has increased by L1L2 in terms of X or P1P2 in terms
of Y). With budget line P2L2, the consumer is in equilibrium at point Q2 on indifference curves
IC2 and is buying OM2 of X and ON2 of Y.

In case of inferior goods, indifference map would be such as to yield income consumption curve
which either slopes backward (i.e., toward the left) as in Fig. 2, or downward to the right as in
Fig. 8.30. It would be noticed from these two figures that income effect becomes negative only
after a point. It signifies that only at higher ranges of income, some goods become inferior goods
and up to a point their consumption behaves like those of normal goods. In Fig. 2 income
consumption curve (ICC) slopes backward i.e., bends toward the Y-axis.

This shows good X to be an inferior good, since beyond point Q2, income effect is negative for
good X and as a result its quantity demanded falls as income increases. In Fig.3 income
consumption curve (ICC) slopes downward to the right beyond point Q2 bends towards the X-
axis.

Fig.2 - Negative Income Effect: Income Consumption Curve (Good X )

Fig.3 - Negative Income Effect: Income Consumption Curve (Good Y )

This signifies that good Y is an inferior good because beyond point Q2, income effect is negative
for good Y and as a result its quantity demanded falls as income increases. It follows from above
that the income consumption curve can have various possible shapes.

SUBSTITUTION EFFECT CONSUMPTION CURVE

The substitution effect occurs when a consumer replaces one product with another due to a
change in relative prices and personal finances. This includes replacing cheaper items with those
more expensive, or vice versa. A good return on an investment or other windfall may prompt a
consumer to replace the older model item, such as a car, with a newer one.

While the substitution effect changes consumption patterns in favor of the more affordable
alternative, even a modest reduction in price may make a more expensive product more attractive
to consumers.

The substitution effect is all about how people change their purchases of one product in reaction
to a price change of another good. Consider the following scenario. Ordering pizza costs $20,
while Chinese food costs $25. At these prices, potential customers will weigh their preferences
against these different prices. If someone orders Chinese food in this scenario, they are revealing
that it‟s worth the extra $5 for them. Now, imagine the Chinese food suddenly goes up to $30. If
the customer doesn‟t think the difference in taste is worth $10, they will buy the pizza instead.
That‟s the substitution effect.
 Fig. 4 - Substitution Effect on Consumption Curve

In fig 4, the quantities purchased of Coca Cla and Pepsi are shown on X-axis and Y-axis
respectively. AB is the Original budget line with on income level of Rs. 200 and IC 1 is the
original indifference curve. Here, the consumer is equilibrium at point E, by getting 6 units of
Pepsi and 2 units of Coca-Cola. As the price of Coca Cola falls, the AB budget line shifts
outward to the right as AC and Tangent to the higher indifference curve IC2 at point D which will
be the new equilibrium point, here, the consumer is able to buy more of both commodities and
the real income will be more than before.

To make the real income of consumer constant as before, we will take away his extra income i.e.
Rs. 40. When this money has been taken away, G H will be the new budget line with the income
level of Rs.160. The new budget line is tangent to indifference curve IC1 at F, which is the new
equilibrium point of the consumer with constant real income.