In microeconomics, the study deals with the different individuals and their decisions and its effect on the economy. The decisions such as the level of consumption, savings, investment are never the same. But a consumer strives to get the best deal for his commodities which give him highest satisfaction given the budget constraint. The consumer tries to attain that point in the indifference curve where he can get the most utilities from both goods.
An indifference curve or IC is the graphical representation of combinations of two goods that yield the same level of satisfaction to the consumer. The indifference curve operates on the principle of diminishing Marginal Rate of Substitution(MRS). Every point on the indifference curve shows that an individual or a consumer is indifferent between the two products as it gives him the same kind of utility.
There is also a concept of indifference map which is the graphical representation of two or more indifference curves showing the various combination of commodities with different quantities, which a consumer consumes, given his income and the market price of both the commodities.
Before going forward with IC, let’s look what is Marginal Rate of Substitution.
Marginal Rate of Substitution is the rate at which a consumer substitutes some units of one good or willing to forego units of one commodity for additional units of another good which provides the same level of utility or satisfaction. MRS measures the changes in the units of consumption of the combination of two goods but does not influence the utility.
Formula for calculating is MRSxy = MUy / MUx = Px / Py
MRSxy – Marginal Rate of Substitution of good x and good y
MUy and MUx – Marginal utility of good y and good x respectively
Px and Py- Prices of good x and good y respectively
The indifference curve is convex to the origin because of the diminishing Marginal Rate of Substitution.
ASSUMPTIONS OF INDIFFERENCE CURVES
- There are only two goods, say good x and good y. It is also assumed that the prices of the commodities are constant.
- The consumers are rational and thus aim to have the highest utility from the pair of goods. The consumer moves to higher indifference curves for attaining maximum satisfaction.
- The utilities are ordinal because the utility or the amount of satisfaction cannot be quantified.
- The income of the consumer is fixed. Thus, there is a budget constraint.
- There is Diminishing Marginal Rate of Substitution where good y is substituted for good x.
PROPERTIES OF INDIFFERENCE CURVES
- The indifference curve is convex to the origin due to the decreasing marginal rate of substitution. It can never be concave as it violates law of diminishing marginal utility.
- The indifference curve is slopes from left to right as one commodity substitutes another.
- The indifference curves never touch the axes because the assumption states that each point represents different utilities of two goods. If it touches the axes, the utility of one commodity becomes zero.
- Higher indifference curves represent higher quantities of both the goods and thus higher utility.
- Two indifference curves never intersect each other because the two curves represent different utilities.
From the above diagram, we can infer that point c is where the consumer is in equilibrium.
Consumer equilibrium is a situation in which a consumer purchases a combination of goods which gives him maximum satisfaction given the income and prices, he is not willing to make any changes in it.
Conditions for consumer equilibrium
- Slope of IC = Slope of price line (budget line)
- MRSxy=Px / Py
In U1, points a and e cannot be equilibrium points because there are opportunities for consumer to move to U2. Points b and d cannot be equilibrium points because at both points MRSxy is not equal to Px / Py.
At point c in U3, MRSxy= Px / Py and thus the consumer is in the state of rest and attains maximum utility.
The consumer cannot move to U4 because the prices of goods exceed the budget line of the consumer.