3.1] Utility analysis and it’s limitations

Indifference curve approach

The indifference curve approach is a graphical representation of a consumer’s preferences. An indifference curve is a line that shows all the combinations of two goods that provide the consumer with the same level of satisfaction or utility. The consumer is indifferent between any two points on the same indifference curve.

Limitations of indifference curve approach

• The indifference curve approach assumes that consumers are rational and can make consistent choices. However, in reality, consumers may not always make rational choices.
• The indifference curve approach assumes that consumers have complete information about the goods they are consuming. However, in reality, consumers may not have complete information about all the goods available to them.
• The indifference curve approach assumes that consumers’ preferences are stable over time. However, in reality, consumers’ preferences may change over time.

Utility analysis

Utility analysis is a method of measuring the satisfaction or benefit that a consumer derives from consuming a good or service. Utility is a cardinal measure, meaning that it can be assigned a numerical value. For example, a consumer might assign a utility of 10 to a slice of pizza and a utility of 20 to a new pair of shoes.

Limitations of utility analysis

• Utility is a subjective measure, meaning that it differs from person to person. There is no objective way to measure utility.
• Utility cannot be directly observed. It can only be inferred from consumer behavior.
• Utility is not a constant. It changes with the amount of a good or service that is consumed.

Comparison of indifference curve approach and utility analysis

The indifference curve approach and utility analysis are both methods of representing consumer preferences. However, they differ in their assumptions about the nature of utility. The indifference curve approach assumes that utility is an ordinal measure, meaning that it can only be ranked. Utility analysis assumes that utility is a cardinal measure, meaning that it can be assigned a numerical value.

The indifference curve approach is generally considered to be more realistic than utility analysis. This is because the indifference curve approach does not require the assumption that utility can be measured. However, the indifference curve approach is also more difficult to use than utility analysis. This is because the indifference curve approach requires the construction of indifference curves, which can be time-consuming.

In general, the indifference curve approach is a more useful tool for analyzing consumer behavior than utility analysis. However, utility analysis can be a useful tool for understanding the concept of utility.

3.2 ] Meaning and Properties of indifference curve

Meaning of indifference curve

An indifference curve is a graphical representation of all the combinations of two goods or services that provide a consumer with the same level of satisfaction or utility. In other words, any two points on an indifference curve are equally preferred by the consumer.

For example, if a consumer is indifferent between having 2 apples and 3 oranges, or 3 apples and 2 oranges, then these two combinations would lie on the same indifference curve.

Properties of indifference curves

• Downward sloping: Indifference curves are typically downward sloping. This is because as a consumer consumes more of one good, they will typically be willing to give up some of the other good in order to maintain the same level of satisfaction. For example, if a consumer is given an extra apple, they may be willing to give up one orange in order to have the same level of satisfaction.
• Convex to the origin: Indifference curves are typically convex to the origin. This is because the marginal rate of substitution (MRS) diminishes as a consumer consumes more of one good. The MRS is the rate at which a consumer is willing to trade one good for another. As a consumer consumes more of one good, they will typically be willing to give up less and less of the other good in order to obtain an additional unit of the first good.
• Non-intersecting: Indifference curves never intersect. This is because if two indifference curves intersected, it would mean that the consumer would prefer one combination of goods to another, even though they are both on the same indifference curve.

Indifference map

An indifference map is a collection of indifference curves that show the consumer’s preferences for different combinations of goods. The higher the indifference curve, the higher the level of satisfaction associated with that combination of goods.

Uses of indifference curves

Indifference curves are used in a variety of economic analyses, such as:

• Consumer theory: Indifference curves are used to analyze consumer behavior and to determine how consumers make choices about what goods and services to consume.
• Welfare economics: Indifference curves are used to measure changes in consumer welfare. For example, if a consumer’s income increases, they will be able to move to a higher indifference curve, indicating a higher level of satisfaction.
• Production theory: Indifference curves can be used to analyze the behavior of firms. For example, a firm can use indifference curves to determine the optimal combination of inputs to use in production.

Conclusion

Indifference curves are a powerful tool for analyzing consumer behavior. By understanding the properties of indifference curves, economists can gain a better understanding of how consumers make choices.

3.3 ] Marginal Rate of substitution and price income line

The marginal rate of substitution (MRS) is the rate at which a consumer is willing to trade one good for another while maintaining the same level of utility. It is equal to the negative of the slope of the indifference curve.

The price income line (PIL) is a graphical representation of a consumer’s budget constraint. It shows all the combinations of two goods that a consumer can afford given their income and the prices of the goods.

The MRS and the PIL intersect at the consumer’s optimal consumption bundle. This is the bundle that provides the consumer with the highest level of utility given their budget constraint.

At the optimal consumption bundle, the MRS is equal to the ratio of the prices of the two goods. This is because the consumer is willing to trade one good for another at a rate that is equal to the rate at which they can exchange the goods in the market.

For example, if the price of good X is $1 and the price of good Y is $2, then the consumer will be willing to trade one unit of good X for two units of good Y. This is because the consumer can sell one unit of good X for $1 and use that money to buy two units of good Y.

The MRS and the PIL can be used to analyze a variety of consumer behavior. For example, they can be used to predict how a consumer will respond to a change in the price of a good or a change in their income.

In addition, the MRS and the PIL can be used to derive the demand curve for a good. The demand curve shows the quantity of a good that a consumer will demand at different prices.

The MRS and the PIL are important tools for understanding consumer behavior. They can be used to analyze a variety of consumer decisions and to predict how consumers will respond to changes in the economic environment.

3.4] Consumer Equalibrium

Consumer equilibrium is a state in which a consumer has achieved maximum satisfaction from their given income and the prevailing prices of goods and services. In other words, the consumer has allocated their income in such a way that they cannot derive any further satisfaction by reallocating it.

There are two main conditions for consumer equilibrium:

1. The marginal utility of the last unit of each good consumed must be equal to its price. This means that the consumer is getting the same amount of satisfaction from the last unit of each good they are consuming.
2. The consumer’s budget line must be tangent to their indifference curve. This means that the consumer is spending their entire income and cannot increase their satisfaction by buying more of one good and less of another.

Consumer equilibrium can be graphically represented by the point of tangency between a consumer’s indifference curve and their budget line.

For example, consider a consumer who has an income of $100 and is faced with the following prices:

• Good X: $20 per unit
• Good Y: $10 per unit

The consumer’s indifference curve shows the combinations of goods X and Y that give them the same level of satisfaction. The consumer’s budget line shows the combinations of goods X and Y that they can afford to buy given their income.

The point of tangency between the indifference curve and the budget line is the consumer’s equilibrium point. At this point, the consumer is getting the maximum amount of satisfaction possible from their income.

In this example, the consumer’s equilibrium point is at 3 units of good X and 2 units of good Y. This means that the consumer is getting the same amount of satisfaction from the last unit of good X as they are from the last unit of good Y. They are also spending their entire income and cannot increase their satisfaction by buying more of one good and less of another.

Consumer equilibrium is an important concept in economics because it helps to explain how consumers make decisions about what to buy. By understanding how consumers achieve equilibrium, businesses can better understand how consumers will respond to changes in prices and income.

3.5] Price, Income and Substitution effect

Price effect

The price effect is the total change in the quantity demanded of a good or service as a result of a change in its price. It is the sum of the substitution effect and the income effect.

Substitution effect

The substitution effect is the change in the quantity demanded of a good or service as a result of a change in its relative price. When the price of a good rises, consumers will tend to substitute away from that good and towards other goods that are now relatively cheaper. For example, if the price of beef rises, consumers may switch to buying more chicken or pork.

Income effect

The income effect is the change in the quantity demanded of a good or service as a result of a change in the consumer’s real income. When the price of a good rises, the consumer’s real income falls (because they can buy less of other goods with the same amount of money). This can lead to a decrease in the quantity demanded of the good, even if there are no close substitutes available. For example, if the price of gasoline rises, consumers may drive less, even if there is no other form of transportation readily available.

Normal goods and inferior goods

The income effect can be either positive or negative, depending on whether the good is a normal good or an inferior good. A normal good is a good for which the quantity demanded increases as income increases. For example, as people earn more money, they tend to buy more cars, more clothes, and more restaurant meals. An inferior good is a good for which the quantity demanded decreases as income increases. For example, as people earn more money, they tend to buy less rice, less beans, and less public transportation.

Example

Suppose the price of beef rises from $5 per pound to $6 per pound. The substitution effect would lead consumers to switch to buying more chicken or pork. The income effect would lead consumers to buy less beef, even if they did not switch to other meats. The total change in the quantity demanded of beef would be the sum of the substitution effect and the income effect.

In this case, the substitution effect would likely be negative, as consumers would switch away from beef. The income effect could be either positive or negative, depending on whether beef is a normal good or an inferior good. If beef is a normal good, the income effect would be negative, as the rise in the price of beef would reduce consumers’ real income. If beef is an inferior good, the income effect would be positive, as the rise in the price of beef would lead consumers to buy less of it. The overall effect of the price change on the quantity demanded of beef would depend on the relative magnitudes of the substitution effect and the income effect.