Understanding Consumer Demand: Indifference Curve Theory
Consumer Demand Theory: Indifference Curves
1. Definition
An indifference curve illustrates various combinations of product X and product Y that provide equal utility or customer satisfaction. A higher indifference curve indicates a higher degree of satisfaction, while a lower curve represents lower satisfaction.
2. Marginal Rate of Substitution
The marginal rate of substitution of Y for X (MRSxy) refers to the amount of Y a consumer is willing to sacrifice to obtain an additional unit of X, while remaining on the same indifference curve. As consumers move down the indifference curve, the MRSxy decreases.
3. Characteristics of Indifference Curves
Indifference curves exhibit three basic characteristics:
- Have a negative slope
- Are convex to the origin
- Cannot intersect
4. Budget Line Restriction
The budget line constraint shows all the different combinations of two products that a consumer can purchase, given their monetary income and the prices of the two products.
5. Consumer Equilibrium
A consumer is in equilibrium when, given their income and pricing constraints, they maximize the total utility or satisfaction derived from their spending. In other words, equilibrium is achieved when, given their budget line, the consumer reaches the highest possible indifference curve.
Consumers ideally want to reach indifference curve III, but this is unattainable due to income and pricing restrictions. The consumer could choose consumption at point N (1,9) or point R (9, 0.2) on indifference curve I, but doing so would not maximize total satisfaction from their expenditure. Indifference curve II represents the highest level of satisfaction consumers can achieve with their budget constraint. To achieve equilibrium, the consumer must spend $5 of their income to buy 5 units of Y and the remaining $5 to buy 5 units of X.
6. Exchange
In a world with two consumers (A and B) and two products (X and Y), a mutually beneficial exchange is possible as long as the MRSxy for consumer A differs from that of consumer B. As the quantity increases, MRSxy values for both consumers converge until they become identical. At this point, there is no basis for a mutually beneficial exchange, and trade will cease.
7. Income-Consumption Curve and Engel Curve
By varying a consumer’s monetary income while keeping their tastes and the prices of X and Y constant, we can derive the income-consumption curve and the Engel curve.
- The income-consumption curve is the locus of equilibrium points that a consumer reaches as their income varies.
- The Engel curve shows the quantity of a product that consumers buy in a unit of time at different levels of income.
8. Price-Consumption Curve and Consumer Demand Curve
By varying the price of X while keeping the price of Y, tastes, and consumer monetary income constant, we can derive the price-consumption curve and the consumer demand curve for product X. The price-consumption curve for product X is the locus of equilibrium points of consumers that are modified only when the price of X changes. The consumer demand curve for product X shows how much of X consumers would buy at various prices, ceteris paribus.
9. Separation of Substitution and Income Effects
When the price of X (Px) decreases from $1 to $0.50 (ceteris paribus), we move from point E to point T, and the quantity of X (Qx) increases from 5 to 9 units. Since X is a normal product, the income effect in this case reinforces the substitution effect to produce this increase in Qx.
We can isolate the substitution effect by reducing the consumer’s monetary income enough to maintain real income constant. This can be achieved by shifting the budget line KJ downwards and parallel to itself until it is tangent to indifference curve II. The movement along indifference curve II will give the substitution effect. The total effect of the price change (ET) minus the substitution effect will give us the income effect. Having done this, we could derive a demand curve that shows only the substitution effect (i.e., a demand curve along which real income remains constant, rather than money income).