Lecture 3

Lecture 3Theory of Demand Indifference Curve

Indifference Curve Technique• In view of the shortcomings of the utility analysis, modern

economists have adopted a new technique called the indifference curve technique for the analysis of demand

• All desires of consumers are not of equal urgency or importance. Resources are limited therefore, he has to choose more important desires for satisfaction. Ability to arrange preferences in order of urgency or importance is inherent in human nature

• The consumer’s scale of preferences is independent of the prices ruling in the market. On the basis of scale of preferences he knows that one combination of goods yields him the same satisfaction as another

Assumptions• Completeness– It is assumed that consumer’s scale of preference is so complete that he is able

to choose any one of the two combinations of commodities presented to him or is indifferent between them

• Non-satiation– A consumer prefers more to less

• Consistency or Transitivity– If a consumer regards Q better than R and R better than S then he will prefer Q to

S. Consumer’s choice has to be consistent

• Continuity or substitutability – Unless one combination can be substituted for another, the consumer’s

preferences will not be possible • Convexity – The indifference curve is convex to the origin and shows the diminishing rate of

marginal rate of substitution

Indifference Curve• On the basis of consumer’s scale of preferences,

indifference curve can be drawn

• An indifference curve represents satisfaction of a consumer from two commodities

• On all points on the indifference curve satisfaction level is same. Hence the consumer is indifferent as to the combination lying on an indifference curve

ExampleCombination Apples Mangoes

1 15 1

2 11 2

3 8 3

4 6 4

5 5 5

Indifference curve Diagram

1 2 3 4 50

2

4

6

8

10

12

Series 3Series 2Series 1

Indifference Map

• Different indifference curve shows different level of satisfaction

• We cannot say that how much more utility the higher indifference curve represents. Aggregate utilities are ranked not measurable

Marginal Rate of Substitution• The Marginal Rate of Substitution shows:– How much of one commodity is substituted for

another or – At what rate a consumer is willing to substitute

one commodity for another in his consumption pattern

• The marginal rate of substitution is parallel to the concept of marginal utility in the Marshallian analysis of demand

ExampleCombination Apples Mangoes MRS Of Mangoes

for Apples

1 15 1 -

2 11 2 4:1

3 8 3 3:1

4 6 4 2:1

5 5 5 1:1

Diminishing Marginal Rate of Substitution

• This behavior showing falling MRS of good X for good Y and yet to remain at the same level of satisfaction is known as diminishing marginal rate of substitution.

Diminishing Marginal Rate of Substitution

• If we have more and more of good X our desire to have more good X will diminish and we will forego less and less of good Y for good X

• (MRSxy) =Δy/Δx• We can see as the consumer slides down Δy becomes shorter and shorter

while Δx is same.

Reasons for DMRS

• Diminishing intensity of a want for a good

• Imperfect substitutes– If perfect substitutes the MRS constant

• MRS of one good for another will not diminish if the want satisfying power of the other good has increased at the same time

Properties of IC

• Downward Sloping to the right– It is because if a consumer wishes to have more unit of good

X he has to reduce consumption of good Y• Non-intersecting– No two such curves will never cut each other

• Convex to the origin– Straight line would mean foregoing equal amount of units

of good X to get equal units good Y – Concave would mean going more units of good X to get one

unit of good Y– Both of above are opposite to principle of DMRS

Indifference Curve Analysis of Demand

Price Line or Budget Line

• A rational consumer will always try to reach the highest possible indifference curve in order to obtain the highest possible level of satisfaction

• In this pursuit, our consumer will be governed by the amount of the money or income he has to spend on goods

Price Line or Budget Line

Shifting the Price Line

Consumer’s Equilibrium• Assumptions– Our consumer has an indifference map showing

his scale of preferences for various combinations of the two goods

– He has a constant amount of money to spend. If he does not spend on one good then he has to spend on the other

– Prices of the product are constant– Each of the good is homogenous and divisible– The consumer acts rationally, this is, he tries to

maximize his satisfaction

Consumer’s Equilibrium

• The consumer will maximize its satisfaction or will be in equilibrium where price line will touch Indifference curve or is to tangent to an indifference curve

Conditions of Equilibrium

• The price line should be tangent to an indifference curve or MRS of one commodity for another should be equal to their relative prices

• At the point of equilibrium, an indifference curve must be convex to the origin

How far is this theory of consumer behaviour valid?• Few consumers actually equate consciously MRS of the things

they buy to their price ratio

• Customs plays a very important role in the consumer’s purchases– They keep buying in the same assortment of goods and ignore minor

price changes

• Many commodities are indivisible preventing precise price adjustment

• No consumer purchases all commodities therefore MRS of money for that product is zero

• Not many consumers have the time or the energy to be devoted to the working out the precise balancing of their expenditure in light of price changes.

Income Effect

Income Consumption Curve

Income Effect (Inferior good)

• When Y is inferior

Substitution Effect

• The increase in the amount purchased of X, because of the fall in its relative price, is the substitution effect

Price effect

Price EffectIncome EffectSubstitution Effect

Derivation of Demand Curve

Similarities Utility Analysis Vs Indifference Curve

• Rational behaviour of the consumer

• Consumer strive to reach equilibrium or maximize profit

• Both assumes diminishing utility– DMU in one case – DMRS in the other

• Introspection

Superiority of IC Technique• More Realistic Measurement of Utility

– Cardinal Vs Ordinal• No assumption of constancy of MU of money

– No such assumption as in Utility analysis• Analyses Multi-goods model

– More than one product can be seen• Less restrictive

– Less assumptions in this technique• More general theory of demand

– Less assumption therefore more general theory of demand• Change in welfare

– Change in welfare due to change in income• Closer analysis of price effect

– How changes in prices can bring change in demand• Recognition of relationship of substitution and complimentary

– Marshall analyzed independent utilities. However, this theory recognizes the effects of substitutes and complimentary goods.

Criticism• Old wine in new bottle

– just replacement of 1,2,3… with 1st ,2nd, 3rd … curve of preference• Marshallian Base essential

– All the same, just change of terminologies• Unrealistic

– Jumping from frying pan of the difficulty of measuring utility into the fire of the unreality of assuming consumer’s complete knowledge of all this scales of preferences

• Absurd– Ridiculous combinations of goods e.g. three pairs of shoes and six shirts give him same level

of satisfaction as two pairs of shoes and seven shirts.• Only two-good model

– It is only two good model for three, three dimensional diagram is needed therefore difficult to understand

• Cannot explain uncertainty– What in case of risk or uncertainty

• Introspection– Introspection is unrealistic

• Constancy of tastes– Assumption that tastes remains same is not correct

• Ignores demonstration effect– Level of consumption is affected by consumption of others

• Market behaviour ignored– It takes notice of price of two goods and ignores market change in prices

Exceptions

Thank You

Quiz• Q No. 1: What is difference between Micro-Economics and Macro-

Economics? Explain with examples.• • Q No. 2: How did Robbin defined ‘Economics’ and what was

criticism on his definition?• • Q No. 3: Define the scientific methods used in Economics with

their merits and de-merits?• • Q No. 4: Write the characteristics of Laws of Economics. • • Q No. 5: Define Law of Diminishing Marginal Utility and Law of

Equi-Marginal Utility? Explain the difference between two. • • Q No. 6: How demand curve is derived from Law of Equi-Marginal

Utility?