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INSTITUTE OF COMMERCE
&
ALLIED STUDIES

INDIFFERENCE CURVE ANALYSIS

OR

ORDINAL UTILITY APPROACH

The indifference curve analysis is based on the idea of ORDINAL UTILITY. The ordinal utility
implies that the consumer is capable of simply comparing the utility derived from different
goods(rank or order but not in a position to measure (quantitative or absolute terms).

The indifference curve analysis is based on the idea of a given scale of preference on the part
of the consumer as between different combinations of two goods.

SCALE OF PREFERENCE

A scale of preference of a consumer as between different combinations of two goods implies

that as between these combinations he can definitely say which combinations he prefers to
others as they give him more satisfaction and among which combinations he is indifferent(same
level of satisfaction ).

INDIFFERENCE SCHEDULE:

Indifference schedule is a schedule that shows various combinations of two goods giving equal

satisfaction to the consumer.

Indifference Schedule
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Combination of
Apples and Apples Bananas
Bananas (A) (B)
P 1 15
Q 2 10
R 3 6
S 4 3
T 5 1

INDIFFERENCE CURVE / ISO-Utility Curve

Indifference curve refers to the graphical representation of various alternative combinations of

bundles of two goods among which the consumer is indifferent.

Or

Indifference curve is a locus of points that show such combinations of two commodities which

give the consumer same satisfaction.

Or

Indifference curve shows various combinations of two commodities which give equal

satisfaction to the consumer. It is the graphical representation of indifference schedule.

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As seen in the schedule, consumer is indifferent between five combinations of apple and banana. Combination
‘P’ (1A + 15B) gives the same utility as (2A + 10B), (3A + 6B) and so on. When these combinations are
represented graphically and joined together, we get an indifference curve ‘IC 1’ as shown in the above figure. The
combinations P, Q, R, S and T give equal satisfaction to the consumer and therefore he is indifferent among
them. These combinations are together known as ‘Indifference Set’.

INDIFFERENCE SET

Indifference set is a set of those combinations of two goods which offer the consumer the
same level of satisfaction so that the consumer is indifferent across any number of
combinations in his indifference set.

Monotonic Preferences:
Monotonic preference means that a rational consumer always prefers more of a commodity as

it offers him a higher level of satisfaction. In simple words, monotonic preferences imply that as

consumption increases total utility also increases.

Indifference Map:

Indifference Map refers to the family of indifference curves that represent consumer

preferences over all the bundles of the two goods.

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Marginal Rate of Substitution (MRS):

MRS refers to the rate at which the commodities can be substituted with each other, so that

total satisfaction of the consumer remains the same .

Or

MRS is the rate at which the consumer is willing to substitute one good for another without

changing the level of satisfaction.

MRS between Apple and Banana:

Apples Banana
(A) (B)
Combination MRSAB
P 1 15 –
Q 2 10 1:5
R 3 6 1:4
S 4 3 1:3
T 5 1 1:2
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DMRS (Diminishing marginal rate of substitution) /

Why MRS diminishes?

MRS falls because of the law of diminishing marginal utility.

The indifference curve analysis is based on the assumption of diminishing marginal rate of

substitution. This assumption implies that lesser is the amount of one commodity consumed by

a household, the lesser willing the household will be to give up a unit of that commodity to

obtain an additional unit of the other commodity.

In the given example of apples and bananas, Combination ‘P’ has only 1 apple and, therefore, apple is
relatively more important than bananas. Due to this, the consumer is willing to give up more bananas
for an additional apple. But as he consumes more and more of apples, his marginal utility from apples
keeps on declining. As a result, he is willing to give up less and less of bananas for each apple.

Properties of Indifference Curve:

1. Indifference curves are always convex to the origin:

An indifference curve is convex to the origin because of diminishing MRS. MRS declines

continuously because of the law of diminishing marginal utility. As seen in indifference schedule

, when the consumer consumes more and more of apples, his marginal utility from apples

keeps on declining and he is willing to give up less and less of bananas for each apple.

Therefore, indifference curves are convex to the origin (see indifference schedule). It must be

noted that MRS indicates the slope of indifference curve.

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2. Indifference curve slopes downwards from left to right:

It implies that as a consumer consumes more of one good, he must consume less of the other

good. It happens because if the consumer decides to have more units of one good (say apples),

he will have to reduce the number of units of another good (say bananas), so that total utility

remains the same.

3. Higher Indifference curves represent higher levels of satisfaction:

Higher indifference curve represents large bundle of goods, which means more utility because

of monotonic preference. A rational consumer will obtain higher utility from more goods on a

higher indifference curve.

4. Indifference curves can never intersect each other:

As two indifference curves cannot represent the same level of satisfaction, they cannot
intersect each other. It means, only one indifference curve will pass through a given point on an
indifference map.

 What does the slope of indifference curve indicate?

Marginal rate of substitution indicates the slope of indifference curve.

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 Why indifference curve is convex to the origin?

An indifference curve is convex to the origin because of diminishing Marginal rate of

substitution.

 Why does an indifference curve slope downwards from left to right?

Or

 Why indifference curve negatively sloped?

Because indifference curve is based on the assumption that a consumer consumes more

of one good, he must consume less of the other good.

Assumptions of Indifference Curve

The various assumptions of indifference curve are:

1. Two commodities:

It is assumed that the consumer has a fixed amount of money, whole of which is to be spent on

the two goods, given constant prices of both the goods.

2. Non Satiety:

It is assumed that the consumer has not reached the point of saturation. Consumer always
prefer more of both commodities, i.e. he always tries to move to a higher indifference curve to

get higher and higher satisfaction.

3. Ordinal Utility:

Consumer can rank his preferences on the basis of the satisfaction from each bundle of goods.

4. Diminishing marginal rate of substitution:

Indifference curve analysis assumes diminishing marginal rate of substitution. Due to this
assumption, an indifference curve is convex to the origin.
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5. Rational Consumer:

The consumer is assumed to behave in a rational manner, i.e. he aims to maximize his total

satisfaction.

Understanding Consumer’s Equilibrium by Indifference Curve Analysis!

Consumer equilibrium refers to a situation, in which a consumer derives maximum satisfaction,

with no intention to change it and subject to given prices and his given income. The point of
maximum satisfaction is achieved by studying indifference map and budget line together.

On an indifference map, higher indifference curve represents a higher level of satisfaction than

any lower indifference curve. So, a consumer always tries to remain at the highest possible

indifference curve, subject to his budget constraint. Consumer Budget states the real income or

purchasing power of the consumer from which he can purchase certain quantitative bundles of

two goods at given price. It means, a consumer can purchase only those combinations (bundles)

of goods, which cost less than or equal to his income.

BUDGET LINE / PRICE LINE

A budget line shows various combinations of two commodities which can be purchased with a

given budget at given prices of the two commodities.

Or

Budget line is a graphical representation of all possible combinations of two goods which can be

purchased with given income and prices, such that the cost of each of these combinations is

equal to the money income of the consumer.

Or
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Alternately, Budget Line is locus of different combinations of the two goods which the

consumer consumes and which cost exactly his income.

Example:

Let us understand the concept of Budget line with the help of an example: Suppose, a consumer has an
income of Rs. 20. He wants to spend it on two commodities: X and Y and both are priced at Rs. 10 each.
Now, the consumer has three options to spend his entire income: (i) Buy 2 units of X; (ii) Buy 2 units of Y;
or (iii) Buy 1 unit of X and 1 unit of Y. It means, possible bundles can be: (2, 0); (0, 2) or (1, 1). When all
these three bundles are represented graphically, we get a downward sloping straight line, known as
‘Budget Line’. It is also known as price line.

Budget Set:

Budget set is the set of all possible combinations of the two goods which a consumer can

afford, given his income and prices in the market.

In addition to the three options, there are some more options available to the consumer within his
income, even if entire income is not spent. Budget set includes all the bundles with the total income of
Rs. 20, i.e. possible bundles or Consumer’s bundles are: (0, 0); (0, 1); (0, 2); (1, 0); (2, 0); (1,1).
Consumer’s Bundle is a quantitative combination of two goods which can be purchased by a consumer
from his given income.

Diagrammatic Explanation of Budget Line:

Suppose, a consumer has a budget of Rs. 20 to be spent on two commodities: apples (A) and

bananas (B). If apple is priced at Rs. 4 each and banana at Rs. 2 each, then the consumer can

determine the various combinations (bundles), which form the budget line. The possible

options of spending income of Rs. 20 are given in Table below:

Schedule of Budget Line

Combination of
Apples and Apples (A) Bananas (B) Money spent =
Bananas 4 each) (Rs. 2 each) Income (Rs.)
(5 x 4) + (0 x 2) =
E 5 0 20
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(4 x 4) + (2 x 2) =
F 4 2 20
(3 x 4) + (4 x 2) =
G 3 4 20
(2 x 4) + (6 x 2) =
H 2 6 20
(1 x 4) + (8 x 2) =
1 1 8 20
J 0 10 (Ox 4)+ (10×2) =20

Main properties of budget line :

• Negatively sloped.

• Slope of budget line is equal to the price ratio of two commodities

• It is a straight line as we assume given prices of the two commodities while drawing it.
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The consumer’s equilibrium under the indifference curve theory must meet the following two

conditions:

(i) MRSXY = Ratio of prices or PX/PY

Let the two goods be X and Y. The first condition for consumer’s equilibrium is that

MRSXY = PX/PY

a. If MRSXY > PX/PY, it means that the consumer is willing to pay more for X than the price

prevailing in the market. As a result, the consumer buys more of X. As a result, MRS falls till it

becomes equal to the ratio of prices and the equilibrium is established.

b. If MRSXY < PX/PY, it means that the consumer is willing to pay less for X than the price

prevailing in the market. It induces the consumer to buys less of X and more of Y. As a result,

MRS rises till it becomes equal to the ratio of prices and the equilibrium is established.

(ii) MRS continuously falls: ( convex to the origin).

The second condition for consumer’s equilibrium is that MRS must be diminishing at the point

of equilibrium, i.e. the indifference curve must be convex to the origin at the point of

equilibrium. Unless MRS continuously falls, the equilibrium cannot be established.

Thus, both the conditions need to be fulfilled for a consumer to be in equilibrium.

Let us now understand this with the help of a diagram:

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In, IC1, IC2 and IC3 are the three indifference curves and AB is the budget line. With the

constraint of budget line, the highest indifference curve, which a consumer can reach, is IC 2.

The budget line is tangent to indifference curve IC2 at point ‘E’. This is the point of consumer

equilibrium, where the consumer purchases OM quantity of commodity ‘X’ and ON quantity of

commodity ‘Y. The consumer cannot purchase any combination , which lies to the right of the

budget line AB such as combination H because it is out of his reach with the given income an

All other point on the budget line to the left or right of point ‘E’ will lie on lower indifference

curves and thus indicate a lower level of satisfaction. As budget line can be tangent to one and

only one indifference curve, consumer maximizes his satisfaction at point E, when both the

conditions of consumer’s equilibrium are satisfied:

(i) MRS = Ratio of prices or PX/PY:

At tangency point E, the absolute value of the slope of the indifference curve (MRS between X

and Y) and that of the budget line (price ratio) are same. Equilibrium cannot be established at

any other point as MRSXY > PX/PY at all points to the left of point E and MRSXY < PX/PY at all

points to the right of point E. So, equilibrium is established at point E, when MRSXY = PX/PY.

(ii) MRS continuously falls:

The second condition is also satisfied at point E as MRS is diminishing at point E, i.e. IC 2is

convex to the origin at point E.