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INDIFFERENCE CURVE AND

UTILITY ANALYSIS

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DEMAND THEORY

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Basics of Demand Theory■ Consumer’s desire and the

willingness to pay■ Market demand■ Law of Demand■ Reasons for inverse relation■ Shape of demand curve

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Shift in Demand Curve■ Temporary shift vs Permanent

Shift■ Income of the buyer■ Consumer trends and tastes.■ Expectations of future prices,

supply, needs, etc.■ The price of substitute goods

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Exceptions to Law of Demand

■ Inferior goods/ Giffen goods■ Goods having prestige value■ Price expectation■ Fear of shortage■ Change in income, fashion■ Basic necessities of life

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INDIFFERENCE CURVE

PROPERTIES AND APPLICATION

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PROPERTIES

•Negatively Sloped

•Higher Indifference Curve Represents Higher Level of Satisfaction

•Convex to origin

•Do not intersect each other

•Do not touch axes.

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APPLICATIONS■ The Problem of Exchange■ Effects of Subsidy on Consumers■ The Problem of Rationing■ Index Numbers: Measuring Cost of Living■ The Supply of Labour■ The Effect of Income Tax vs. Excise Duty■ The Saving Plan of an Individual

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DIFFERENT SHAPES OF INDIFFERENCE CURVE

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PERFECT SUBSTITUTES

•Interchangeable goods

•Utility for both the goods is same

•Consumer does not mind having either

•Consumer would not trade less quantity of one good for more quantity of another good

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PERFECT COMPLIMENTS•Demand for complementary goods is not independent but directly related.

•E.g. – Gloves

•Virtually no difference in happiness whether you have one right glove or one left glove.

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BADS

•When for a consumer a commodity is a bad’ that is undesirable object, the more of it will lower his satisfaction.

•E.g. Portfolio AnalysisAverage return – GoodRisk - Bad

•Investor prefers high average return and low risk.

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NEUTRAL GOODS

•Consumer doesn't care about one of the goods, meaning that getting more of that good or less of that good doesn't make them happier or sad

•E.g. Getting CDs vs getting expired movie tickets

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INDIFFERENCE CURVE AND

BUDGET LINE

Budget line / Income Line

Budget Line: Optimal choice of goods for consumer:

Income: 40 Rs.Costs: Apple- 1 Rs/Piece Banana-2Rs/Piece

Income-consumption curve Impact of lower price

Impact of Higher Price

Income effect• Increase in the price of goods affects

on person’s disposable income. • If the price of a good increases, then

consumers will have relatively lower available income to use.

• As an example, suppose the price of petrol rises, consumers may not be able to afford to drive/use as much as earlier, leading to lower demand.

Substitution effect:

• See the effect of price increase in the goods compared to alternatives on increase of demand of substitute.

• If the price of petrol rises, then it is relatively cheaper to go by bus.

• So, it will increase the demand of substitute.

Substitution EffectQ3

l1

20Bananas

APPLES

Q2Q1

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b

B2 B3 B1

Income Effect

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EFFECT ON NORMAL GOODS

40

Substitution EffectQ3

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20Bananas

APPLES

Q2

Q1

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b

B2 B3 B1

Income Effect

l2

EFFECT ON INFERIOR GOODS

40

Substitution Effect

Q3

l1

20Bananas

APPLES

Q2

Q1

c

a

b

B2 B3 B1

Income Effect

l2

EFFECT ON GIFFEN GOODS

Consumer’s Equilibrium

■ Given the price line and the indifference map:

 "A consumer is said to be in an equilibrium at a point where the budget line is touching the highest achievable indifference curve from below".

CE

F

H B IBananas

APPLES

IC2

IC3

IC1

P R

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U

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UTILITY ANALYSIS

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Utility Analysis■ Total satisfaction received from

consuming a good or service■ Directly influence the demand■ Consumers will strive to maximize

their utility■ Cardinal utility vs ordinal utility■ Types of Utility– Total utility– Marginal utility– Zero utility– Negative utility

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Utility Function■ Cobb-Douglas utility function– u(x, y) = x a y 1 - a.

■ Perfect Substitutes Utility Function– U(X,Y) = aX + bY

■ Perfect Complements Utility Function

– U(X,Y) = MIN(aX,bY)

■ Marginal Utility– MU(x) = dU/dx

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Utility FunctionPerfect Substitutes U(X,Y) = aX + bY

Perfect ComplementsU(X,Y) = MIN(aX , bY)

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LAW OF DIMINISHING MARGINAL

UTILITY

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LAW OF DIMINISHING MARGINAL UTILITY ■ As Consumption increases

utility decreases■ Assumptions– All units of given

commodity are homogenous

– Consumption is continuous– Only one type of

commodity– Utility can be measured

cardinally– Consumer is rational

human being and aims at maximum of satisfaction

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Exceptions and Limitations

Exceptions■ Rare collections■ Not fully applicable to

money■ Unreasonable quantity■ Habitual goods■ Durable and valuable

goods

Limitations■ Unrealistic assumptions -

homogeneity, continuity, and constancy

■ Inapplicability to certain goods

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Applications and Importance ■ Basic law of consumption■ Reason for bringing variety in consumption and production■ Diamond-water paradox■ Progression in taxation■ Socialist plea for an equitable distribution of wealth.

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LAW OF EQUI MARGINAL

UTILITY

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LAW OF EQUI MARGINAL UTILITY

■ Consumer is in equilibrium position

■ Marginal utility of money expenditure on each goods is same.

■ Given by Australian economists H. H. Gossen

■ Law of maximum satisfaction or Law of substitution

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Assumption

■ No change in price of goods.

■ Income of consumer is fixed..

■ Marginal utility of money is constant..

■ Consumer has perfect knowledge of utility.

■ Consumer tries to seek maximum satisfaction.

Applications

■ Helpful in the field of production

■ Field of exchange■ Public finance

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Summary■ Demand Theory■ Indifference Curve– Properties– Applications– Different Shapes■ Budget Line■ Utility Analysis■ Law of Diminishing Marginal Utility■ Law of equi-marginal Utility