Uses of Indifference Curve MBA Economics Notes

Wed, 12/21/2011 - 06:08 -- Umar Farooq

Uses of Indifference Curve

Suppose you have a budget of Rs. 10 per week. You can spend your money on potatoes at Rs. 2 per kg or tomatoes at Rs. 1 per kg or on some combination of the two. The consumption opportunity line or budget line shows all possible combinations.

1. Consumer equilibrium, E is the point of consumer equilibrium on the indifference curve and the budget line shown. All other points for goods that the consumer can afford as A and D lie on lower indifference curve than E and are thus less preferred.

Equilibrium =      Marginal Utility of potatoes         =             Price of Potatoes

                                Marginal utility of tomatoes                        Price of tomatoes

2. Effect of a fall in price of commodity, MC is a price line. With this amount OC quantity of A can be purchased when price of A falls MC1 amount can be purchased. Previously the consumer equilibrium was at L with OQ1 of A and OM1 of money as a basket. Now due to a fall in price of “A” Lq is a point of equilibrium with the basket of OQ2 of A and OM2 of money.

3. The affect of inflation (a fall in the value of money). OM1 is the budget line which can purchase OX of good A. Inflation has raised money income OM1 to OM2. But due to a fall in the value of money still OX of god A can be purchases. Before inflation the basket was L1 and now a larger basket L2.

4. The effect of a rise in income M1Q1 is the previous budget line, M2O2 is the present income line, L1 is the previous basket with OX1 of good A plus OE1 of money, L2 is the new basket with OX2 of good A and OE2 of money and higher satisfaction.

M1Q1 = Low Income Line

M2Q2 = High Income Line

5. The income and substitution effect with indifference curve

  1. The Price of commodity A has fallen, so with the given amount, OC1 instead of OC can be purchased.
  2. Instead of buying OC1 of A and keeping OM1 money, the consumer buys OQ2 of A and keeps OM2 of money.
  3. A new budget line M4C4 is drawn parallel to MC and is tangent to 1C2 at a point M3O3. Therefore, the income effect is a change from Q1 to Q3 and from M1 to M3 while the substitution effect is change from Q3 to Q2 and from M2 to M3.