Chapter 7.
2 Indifference Curve
An indifference curve shows combinations of goods and services between
which a consumer is indifferent
In other words, each combination on an indifference curve gives the
consumer the same total satisfaction
An indifference curve is normally drawn as convex to the origin
This reflects the assumption of the law of diminishing marginal
satisfaction / marginal utility
I.e. as we consume extra units of something, the extra utility falls, total
utility rises at a diminishing rate
Combinations of products on an indifference curve further from the origin
are assumed to give greater total utility
What Are the Properties of Indifference Curves?
The indifference curve is downward-sloping.
The slope of the indifference curve is convex.
Curves plotted higher and farther to the right correspond with higher
levels of utility.
Various indifference curves can never cross or overlap.
Marginal Rate of Substitution (MRS):
Definition: The slope of the indifference curve.
Represents the rate at which a consumer is willing to substitute one good
for another while maintaining the same utility.
Key Characteristics:
Downward slope: Reflects trade-off between goods.
Diminishing MRS: As more of one good is consumed, willingness to give up
the other decreases.
Based on the principle of diminishing marginal utility (each additional unit
of a good provides less extra satisfaction).
MRS formula = ΔY/ΔX = MUx/Muy
Budget Line & Budget Set
1. Budget Line (BL):
Definition: A straight line showing all possible combinations of two goods
that can be bought using the consumer’s entire income at given prices.
Other names: Price Line, Price-Income Line, Budget Constraint, Price
Opportunity Line.
Example: Income = ₹40, Px=8, Py=4.
Possible bundles = (5,0), (4,2), (3,4), (2,6), (1,8), (0,10).
All these lie on the budget line.
2. Budget Set:
All affordable bundles of two goods with given income and prices.
Includes:
Bundles on BL (income fully spent).
Bundles inside BL (income not fully spent).
Excludes: Bundles outside BL (not affordable).
Example: If income = ₹10, Px=5, Py=5 → budget set = (0,0), (1,0), (0,1),
(1,1), (2,0), (0,2).
3. Properties of Budget Line:
Downward sloping → To buy more of one good, you must give up
some of the other.
Straight line → Price ratio is constant, so the slope does not change.
Boundary of budget set → BL separates affordable from unaffordable
bundles.
Position of Bundles:
On BL: Exactly equal to income (E, F, G, H, I, J in example).
Inside BL: Affordable but income not fully spent.
Outside BL: Not affordable (requires more than income).
5. Shifts in Budget Line:
Change in Income (prices constant):
↑ Income → BL shifts outward/right (parallel).
↓ Income → BL shifts inward/left (parallel).
Shifts in Budget Line:
Change in Prices (income constant):
i) Both goods’ prices fall → BL shifts outward.
ii) Both goods’ prices rise → BL shifts inward.
Shifts in Budget Line:
iii) Price of Good X falls → BL rotates outward on X-axis.
iv) Price of Good X rises → BL rotates inward on X-axis.
v) Price of Good Y falls → BL rotates outward on Y-axis.
vi) Price of Good Y rises → BL rotates inward on Y-axis
VIDEO LINKS
Indifference Curves - Income and Substitution Effects for Inferior Goods
Indifference Curves - Income and Substitution Effects for Normal Goods I A
Level and IB Economics
Question Under Review
A rational consumer will always purchase less of an item as the price
increases.
Discuss, with the use of indifference curve analysis, whether this
statement is correct.
Mark Scheme
Meaning of a rational consumer, definition/description of an indifference
curve (IC), meaning of the budget line (BL). Interaction of IC and BL to
determine quantity demanded. Change in price of a good and its effect on
quantity demanded. Split of change in quantity demanded into
substitution effect (SE) and income effect (YE). The nature of SE is always
negative and YE can be either positive or negative. Combined effect on
quantity demanded. Relevant diagrams.
The effect of a large negative income effect more than offsetting the
substitution effect (Giffen good) may be explained/analysed.
L4 (18–25 marks): For answer which develops the analysis and discusses
the effect of the change in price on the quantity demanded due to the size
and sign of the SE and YE. Reference to a Giffen good (or a Veblen good) is
made. Evaluation comment(s) is/are made.
L3 (14–17 marks): For an answer which analyses the effect of a change in
price on the quantity demanded. There is reference to the SE and YE.
L2 (10–13 marks): For a limited explanation which describes IC and BL
and the derivation of the quantity demanded at a given price. A basic
diagram of a single equilibrium point is drawn.
L1 (1–9 marks): For an answer which has some basic correct facts but
includes irrelevancies. Errors of theory or omissions of analysis will be
substantial
Sample Answer
9708/42/M/J/22
A rational consumer will always purchase less of an item as the price
increases.
A rational consumer will always purchase less of an item as the price
increases. Discuss with the use of indifference curve analysis, whether the
statement is correct.
A rational consumer makes decisions on what to buy or consume based on
utility, aiming to maximise his overall satisfaction. He will carefully
evaluate all the different goods available to him and analsye the costs and
benefits he will derive from the consumption of the said goods. A rational
consumer is assumed to make decisions independently, prioritising his
own preference and needs.
Indifference curve (IC) is a curve which represents all combinations of two
goods which gives the same satisfaction to the consumer. As depicted in
figure 1, IC1 shows a consumer is indifferent between consuming at point
A or B. Both points give equal satisfaction to the consumer, hence they
are indifferent to consuming either 2 units of Apples and 6 units of
Banana, or 3 units of Apples and four units of Bananas. Nonetheless,
within this model, consumers always prefer to be on higher indifference
curves. For example, a consumer would prefer any combinations from
IC2 rather than IC1 because all combinations on IC2 provide greater
satisfaction than those on IC1.
Indifference curves (IC) are also convex to the origin due to the principle
of the marginal rate of substitution (MRS). The MRS refers to the amount
of one good a consumer is willing to give up to obtain an additional unit of
another good. In Figure 1, at point B, the consumer is willing to
forgo six bananas to acquire one extra apple. However, at point C, the
consumer is only willing to give up two bananas to obtain one
more apple.
This diminishing MRS can be explained by the concept of diminishing
marginal utility. Initially, when the consumer has a greater quantity of
apples, the utility derived from each additional apple decreases. As a
result, the consumer is more willing to trade several apples for one
additional banana. However, as the consumer's apple consumption
decreases and the quantity of apples becomes scarcer, the marginal utility
of apples increases. Consequently, the consumer becomes less willing to
exchange as many apples for an additional banana. This diminishing MRS
is represented by the curvature of the indifference curve, which becomes
flatter as we move down and to the right along the curve.
As mentioned earlier, if consumers continue to choose higher indifference
curves indefinitely, they would not reach a point of equilibrium. Therefore,
the concept of a budget line is introduced in the model. The budget line
represents the range of affordable combinations of goods based on the
consumer's level of income. It serves as a constraint that guides the
consumer's decision-making process, ensuring that their choices align
with their financial means. By considering the affordability represented by
the budget line, consumers can identify the optimal combination of goods
that maximizes their utility while staying within their budgetary limits.
Figure 2 illustrates the consumer's budget line and the tangent point
between the budget line and the indifference curve (IC) at point X. This
tangency represents the consumer's equilibrium, where the optimal
consumption level is achieved. Although the consumer may be indifferent
between consuming at points Y and Z, the budget constraint limits their
ability to afford those combinations. As a result, the consumer's
equilibrium is determined at point X, where the budget line and the
indifference curve intersect. At this point, the consumer can attain the
highest level of satisfaction that is both attainable within their budgetary
constraints and maximizes their utility.
Normal good refers to a type of goods for which the demand increases as
consumer income rises, while it decreases as consumer income falls. As
the price of a normal good increases, consumers tend to purchase less of
it. Figure 3 illustrates the impact of an increase in the price of bananas,
(assuming both bananas and apples are normal goods.) In response to the
higher price of bananas, consumers substitute them with more
apples (point A to B). This substitution occurs because the relative price
of bananas has risen, making apples relatively more affordable and
appealing as a substitute.
Consequently, the consumer is forced to move to a lower indifference
curve, specifically IC2. On IC2, the consumer reaches a new equilibrium at
point Y, where the budget line and the indifference curve are tangent.
At this new equilibrium, the consumer reduces the consumption of
bananas from Q1 to Q3. This reduction in quantity purchased is a result of
both the substitution effect and the income effect. The substitution effect
leads the consumer to substitute bananas with apples due to the price
increase (Q1 to Q2). Simultaneously, the income effect occurs because
the higher price of bananas reduces the consumer's purchasing power,
necessitating a decrease in overall quantity purchased.(Q2 to Q3). For
normal goods, the substitution effect and income effect both work in the
same direction, reinforcing the decrease in quantity purchased as the
price increases.
In the case of inferior goods, an increase in price typically leads to a
decrease in the quantity purchased. This is because as individuals' income
rises, they have the ability to purchase higher-quality substitutes or
alternatives to the inferior goods. However, the dynamics of inferior goods
differ from those of normal goods due to their lower quality or status.
While the price increase initially discourages some consumers from
purchasing the inferior goods, there is a countervailing income effect.
The income effect arises because the higher price of the inferior good
reduces the consumer's purchasing power. As a result, some consumers
who may have preferred to purchase a higher-priced normal good are now
inclined to purchase more of the relatively cheaper inferior good due to
budgetary constraints. In other words, the increase in the price of the
normal good makes the relatively lower-priced inferior good a more
affordable option for these consumers.
However, it's important to note that despite the income effect pushing
some consumers to buy more of the inferior goods, the substitution effect
remains significant. The substitution effect reflects the consumer's
tendency to replace the inferior good with a superior alternative as their
income increases or as the price of the inferior good rises.
Overall, as shown in Figure 4, while the income effect may lead to a
temporary increase in the quantity purchased of an inferior good (Q2 to
Q3) when its price rises, the substitution effect (Q1 to Q2) eventually
dominates. This results in an overall decrease in the quantity purchased
as the price of the inferior good increases, as consumers ultimately seek
higher-quality alternatives.
The behavior of Giffen goods deviates from the patterns observed with
normal and inferior goods. Giffen goods are a unique type of inferior
goods which are characterized by having no close substitutes and being
considered essential goods for certain individuals or communities.
Figure 5 represents the behavior of a Giffen good, specifically crushed
rice, as its price increases. In this scenario, the quantity purchased of
crushed rice actually increases despite the higher price. This phenomenon
occurs due to the interplay of the substitution effect and the income
effect.
The substitution effect in the case of Giffen goods still operates in the
same direction as with other goods. As the price of crushed rice rises,
consumers are incentivized to seek alternatives, such as normal rice,
which becomes relatively more affordable. The substitution effect would
typically lead to a decrease in the quantity purchased of crushed rice (Q1
to Q2).
However, the income effect for Giffen goods works in the opposite
direction compared to normal and inferior goods. With the increase in
price, the consumer's purchasing power decreases, making it more
difficult to afford alternative goods. In this case, the income effect pushes
consumers to consume more of the Giffen good, as it becomes a relatively
cheaper option compared to the alternatives. In the specific context of
Giffen goods, the income effect outweighs the substitution effect,
resulting in an overall increase in the quantity purchased as the price
increases. This counterintuitive behavior distinguishes Giffen goods from
other types of goods, highlighting their unique nature and the complex
dynamics that govern their demand.
Using indifference curve analysis, substitution and income effects
highlights important insights into consumer behavior concerning different
types of goods. Nevertheless it is important to acknowledge a few
limitations of the analysis. In this analysis, we are assuming, consumers
are rational when making decisions. Nevertheless, in reality, consumers
often rely on heuristics or make decisions based on limited information.
For example, consumers may also buy goods on an impulse. In this case,
consumers are making spontaneous purchases without carefully
considering their needs or budget. They may be influenced by emotions,
marketing tactics or social pressure. Furthermore, the assumption that
consumers have perfect knowledge may not hold true as well. They may
not have complete awareness of all available options, the prices of goods,
or the specific attributes and qualities of each item. This lack of perfect
knowledge can significantly impact the application of indifference
analysis.
In conclusion, indifference curve analysis helps us to understand how
price changes influence consumer bahaviour. A rational consumer will
purchase less of a good as price increases in the case of normal and
inferior goods. However, Giffen goods are an exception, as consumers
increase the quantity purchased when the price increases. It is also
important to recognise the limitation of the analysis since in the real world
a consumer may not always be rational.
Past Year Paper Based Question
9708/42/O/N/23
Evaluate the use of indifference curve analysis to derive the demand
curve for a normal good and the demand curve for an inferior good. [20]
9708/42/M/J/22
A rational consumer will always purchase less of an item as the price
increases.
Discuss, with the use of indifference curve analysis, whether this
statement is correct. [25]
9708/42/F/M/22
Explain what economists mean by indifference curves and budget lines
and evaluate whether they might be used together to support rational
consumer decision making. [12]
Use indifference theory to analyse the view that the demand for an
inferior good is likely to be more price inelastic than the demand for a
normal good. [13]
9708/43/O/N/21
Explain the theory of how a consumer decides to achieve the situation
described as ‘equilibrium’ when purchasing two different products. [12]
Two shops sell clothes. One has luxury fashionable designs. The other has
cheaper inferior alternatives. Both shops decided to have promotional
sales with price reductions. Consider how indifference curve analysis could
be used to explain a consumer’s reaction to both the price reductions.
[13]
9708/42/O/N/21
Use indifference curve analysis to discuss whether the demand curve for a
good will always slope downwards. [13]
9708/42/M/J/21
Use indifference curve analysis to explain how an individual’s demand
curve for an inferior good is derived. [12]
9708/41/M/J/21
Explain what is meant by the concept of the ‘equilibrium position of a
consumer’ and how the concept might be used to construct a demand
curve for a good. [12]
Distinguish between the income and substitution effects of a change in a
good’s price and analyse why the effect of a change in price is not always
the same for different goods. [13]
Worksheet
How can total utility be defined?
Can you provide an example to illustrate the concept of total utility?
What factors contribute to an individual's total utility when consuming
goods and services?
How would you describe marginal utility and its significance in
consumption?
What is the difference between total utility and marginal utility?
If I gain 15 units of satisfaction from consuming 5 candies and 19 units of
satisfaction from consuming 6 candies, then my marginal utility from the
6th candy is ...
Total utility will fall whenever
A. marginal utility is falling.
B. marginal utility is rising.
C. marginal utility has reached a maximum.
D. marginal utility is zero.
E. marginal utility is negative.In what ways does the level of total utility
impact an individual's purchasing decisions?
How can understanding total and marginal utility assist businesses in
catering to consumer preferences?
To understand the connection between utility and consumer decision-
making, it is helpful to make the assumption that utility can be quantified.
Therefore, a hypothetical measurement unit for satisfaction known as
'utils' is introduced.
9. Table 7.11 shows the total utility that Sammy derives from visits to the
botanical park per week.
a. Fill in the figures for marginal utility.
b. Draw a graph of the figures for total and marginal utility.
c. Assume that Sammy now has to study for an exam. As a result her
marginal utility for each visit halves. What is his total utility now for:
(i) 2 visits?
(ii) 5 visits?
(iii) 8 visits?
10. Diminishing marginal utility implies that total utility:
A. decreases at a decreasing rate.
B. decreases at a constant rate.
C. increases at a constant rate.
D. increases at an increasing rate.
E. increases at a decreasing rate.
11. If at the current level of consumption MUA/PA < MUB/PB, to maximise
total utility the consumer should
A. buy more A relative to B.
B. buy more A relative to B
