Chapter 7: The theory of demand: the indifference
approach
REVIEW QUESTIONS
1. Use examples to explain the difference between cardinal utility and ordinal utility.
Cardinal utility means or implies that utility can be measured, that a number can be attached to it. For
example, the marginal utility of the consumption of a tin of sardines (ie the satisfaction obtained from
consuming it) is 15 utils (whatever that may mean). Ordinal utility, however, implies that utility cannot be
measured on a cardinal (numerical) scale but that different bundles of goods or services can be ordered (or
ranked) in order of preference. For example, bundle A is preferred to bundle B, without putting any number to
the satisfaction obtained from the consumption of each bundle.
2. What is meant by the term “indifference curve”?
An indifference curve is a curve that shows all the combinations of two products that will provide the consumer
with equal levels of satisfaction or utility.
3. List the three basic assumptions of indifference curves.
Completeness: The consumer is able to rank all possible combinations of goods and services in order of
preferences. That is, he/she prefers bundle A to bundle B, prefers B to A, or values the two bundles equally.
Transitivity or consistency: The consumer acts consistently. That is, if he/she prefers bundle X to bundle Y,
and prefers bundle Y to bundle Z, then he/she must also prefer X over Z.
Non-satiation: The consumer is not yet fully satisfied and prefers more to less. That is, if bundle D consists of
three units of good X and two units of good Y, while bundle E consists of five units of good X and four units of
good Y, the consumer is assumed to prefer E over D.
4. Why is an indifference curve convex to the origin?
The convex shape of the indifference curve illustrates the law of substitution. As we move downwards to the
right along the indifference curve (i.e. as quantity of good X increases and quantity of good Y decreases), the
curve becomes flatter or the slope of the curve decreases. It is because the scarcer a good becomes, the
greater its substitution value will be. In other words, the consumer is prepared to sacrifice fewer and fewer
units of good Y to obtain an additional unit of good X.
5. What variables are held constant along a budget line?
The income of the consumer and the prices of the products.
6. How will an increase in income affect the budget line?
With a higher income the consumer can afford to buy more of the goods than before (at the same prices). This
is illustrated by a parallel shift of the budget line to the right.
7. Prove that the utility approach and the indifference curve approach yield the same consumer equilibrium.
Consider two goods, A and B. According to the utility approach, consumer equilibrium is obtained where the
weighted marginal utilities are equal:
MUA/PA = MUB/PB
According to the indifference approach, consumer equilibrium is obtained where the highest indifference curve
just touches the budget line (or where the budget line is tangential to the highest possible indifference curve).
At this point, the slope of the indifference curve is equal to the slope of the budget line. The slope of the
indifference curve is given by the ratio of the marginal utilities of the two goods = MUA/MUB (= marginal rate of
substitution between A and B).
The slope of the budget line is PA/PB.
Thus equilibrium is where MUA/MUB = PA/PB.
8. Which of the following items are more likely to be inferior goods: Mercedes Benz motorcars, imported beer,
retreaded tyres, restaurant meals, polyester suits? Explain your answer.
Retreated tyres and polyester suits. Consumers with low incomes will tend to purchase these products,
instead of more expensive alternatives. However, as their incomes increase, they will tend to buy fewer of
these goods. Mercedes Benz motorcars, imported beer and restaurant meals will tend to have income
elasticities of demand greater than one, and will therefore be classified as luxury items.
9. Consider a consumer’s choice between meat and fish. Use indifference curves to illustrate the income effect and
the substitution effect of an increase in the price of fish.
With meat on the vertical axis and fish on the horizontal axis, as in the figure below, the original equilibrium is
at A, where indifference curve U1 touches the budget line QmQf. At A the quantity of fish is f1. If the price of fish
increases, it means that fewer fish can be bought with the same income than before. In the figure this is
illustrated by a movement for Qf to Q’ f.
The budget line now becomes QmQ’f and the new equilibrium is at B, where indifference curve U2 touches the
new budget line. At B the quantity of fish is f2, which is lower than f1. This is a familiar result: if the price of a
product increases, the quantity demanded will decrease.
But now we wish to break up the price effect (the movement from A to B) into an income effect and a
substitution effect. We know that the new equilibrium is at a lower indifference curve than before, that is, at a
lower level of consumer satisfaction than before. To identify the income effect we construct a new budget line
ZZ, parallel to the original budget line QmQf, such that ZZ just touches indifference curve U2 at point C in the
diagram. The quantity of fish corresponding to point C is f3. The movement from A to C indicates the income
effect of the price increase. The fact that the price of fish has increased, means that the real income of the
consumer has decreased, ceteris paribus. Since ZZ is parallel to QmQf the movement from A to C shows the
income effect (with the prices of meat and fish held constant).
But the price of fish increased, making fish absolutely and relatively more expensive than before. The impact
of the change in relative prices is a movement away from fish (which has become relatively more expensive)
to meat (which has become relatively cheaper). This is indicated by the movement from C to B along the
same indifference curve (U2). The movement from C to B (and from f3 to f2) indicates the substitution effect of
the price change.
In total we thus have the price effect (A to B, or f1 to f2) broken up into the income effect (A to C, or f1 to f3) and
the substitution effect (C to B, or f3 to f2).
