What is an indifference curve and what are its characteristics/properties? Use diagrams in your answer

 An indifference curve:

Definition: An indifference curve is a graph showing combination of two goods that give the consumer equal satisfaction and utility. Each point on an indifference curve indicates that a consumer is indifferent between the two and all points give him the same utility.

Description: Graphically, the indifference curve is drawn as a downward sloping convex to the origin. The graph shows a combination of two goods that the consumer consumes.

The above diagram shows the U indifference curve showing bundles of goods A and B. To the consumer, bundle A and B are the same as both of them give him the equal satisfaction. In other words, point A gives as much utility as point B to the individual. The consumer will be satisfied at any point along the curve assuming that other things are constant.

Characteristics/properties of an indifference curve:

Following are the indifference curve properties:

1. If two commodities are perfect substitute the indifference curve is a straight line.

 

2. When two commodities are not substitutable then the shape is represented by two vertical and horizontal lines.

3. In more typical cases, in which the two commodities can be substituted for each other but are not perfect substitutes, the indifference curve will be curved as

 

4. The more easily the two commodities can be substituted for each other the nearer will the curve approach straight line.

5. Indifference curves normally slope downward, the upward sloping portion of curve shown here s impossible. Basket A has more goods than basket B and therefore it could not be on the same indifference curve.  The indifference curves have normally negative slops – sloping downward.

6. The absolute value of the slope of an indifference curve at any point represents the ratio of the marginal utility of the good and on the horizontal axis to the marginal utility of the good on the vertical axis. The rate at which one good can be substituted for the other without gain or loss in satisfaction is called marginal rate of substitution.

7. Indifference curves are convex, that is, their slope decrease as one moves down and to the right along them. The implies that the ratio of the marginal utility of meat to the marginal utility of the ghee (cooking oil) also known as marginal ratio of substitution of meat for ghee (cooking oil) diminishes as one moves down and to the right along the curve.

8. Indifference curves can be drawn through the point that represents the basket of goods whatsoever.

a)      Explain with the help of an indifference curve analysis how a consumer reaches the highest level of satisfaction? (May’06,Nov’07,’10)

Consumer’s Equilibrium by Indifference Curve:

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.

Conditions of Consumer’s Equilibrium:

The consumer’s equilibrium under the indifference curve theory must meet the following two conditions:

(i) MRS_XY = Ratio of prices or P_X/P_Y

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

MRS_XY = P_X/P_Y

a. If MRS_XY > P_X/P_Y, 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 MRS_XY < P_X/P_Y, 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:

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:

In Fig. 2.12, 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 IC₂. 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.

All other points 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 P_X/P_Y:

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 MRS_XY > P_X/P_Y at all points to the left of point E and MRS_XY < P_X/P_Y at all points to the right of point E. So, equilibrium is established at point E, when MRS_XY = P_X/P_Y.

(ii) MRS continuously falls:

The second condition is also satisfied at point E as MRS is diminishing at point E, i.e. IC₂ is convex to the origin at point E.