What Is an Indifference Curve - Essay Example

Running Head: Indifference Curve Indifference Curve Analysis -------------------------- --------------------- -------------- Indifference Curve Analysis Introduction: What is an Indifference Curve An indifference curve is a two dimensional graphical representation of all those bundles of two goods which can be combined to give a consumer the same amount of utility which is also maximum utility for combinations of given goods. Here the two axes (horizontal and vertical) of the graph would represent the units of each good and points plotted in the plot area, the various combinations of the two goods combined in consumption situations. While in practice the consumer may go in for a particular combination of the two goods(quite irrespective of the utility derived) the indifference curve carries hypothetical consumption states strictly for analyzing and exhibiting a manner in which consumption decisions are reached. The indifference curve is a particular selection of such combinations of goods, from out of the plot area, and all combinations on an indifference curve represent the fact that the consumer derives the same amount of total utility from consumption. Since utility derived from variously combined two goods on an indifference curve is same; the consumer is said to be indifferent between various combinations of two goods and the curve carrying all such combinations is termed as the indifference curve. Normally, with desirable goods on both axes (say, apples and oranges) the curve has a certain shape, further from the origin when both quantities are positive than when one is zero. (Definition,2006)Convexity to the origin of the indifference curves is explained by the fact that as one consumes more of one good its overall utility diminishes and tendencies to replace it with other increase. An example could illustrate this construct: Units of Apples Units of Oranges Total Utility(In Utils) 10 20 100 12 10 100 20 08 100 The above table data can be plotted in the form of an Indifference Curve as below(not drawn strictly as per scale): Budget Line and Choice Decision It has been stated above that indifference curve carries mostly hypothetical pairs of goods combination ,amongst which the consumer is indifferent.However,the consumer cannot purchase quite a few of these combinations due to two factors. One is the prices of the two goods and the other is his income or budget available for expenditure on these two goods. Budget is an unalterable constraint while prices can be taken care of by moving from one good to the other. Continuing with the example above, suppose each apple was priced at $2 and each orange at $2.5 and given the fact that the consumer had an unalterable budget allocated for purchasing these two goods at $ 50 we observe that the consumer could either purchase 25 apples and no oranges or 20 oranges and no apples in two situations of exhausting the entire budget. However in neither of these situations the consumer maximizes his utility as he is away from his indifference curve despite exhausting his budget. In fact these two points represent the two extremes of the budget line and lie on the horizontal and vertical axes respectively. In the figure below the line formed by joining the points (0, 20) and (25, 0) is the budget line. Budget line forms a triangular area with the two axes. This triangular area is the area of feasible purchases. The budget line, and everything inside it, is called the "feasible set" or the "consumption opportunity set."(Modern,2006).All combinations of apples and oranges plotted in this triangular area can be purchased from out of the given budget. This area is depicted by red lines. All goods combinations falling out of this triangular area cannot be purchased as they would not fit in with the budget constraint. This are is depicted with blue lines.Thus budget line narrows down the choice available to the consumer. In case the consumer increases his budget for the two goods across the board (say consequent to a rise in his income) then he can purchase more of either goods or both as the budget line would move in a parallel fashion to the existing budget line outwards and away from the origin. In that case the consumer would most probably define another indifference curve for himself. Consumer decision point has been defined as the point of tangency between the indifference curve and the budget line. This point of tangency gives out that combination of goods which not only maximizes the utility of the consumer along an indifference curve but also is affordable given his budget and prices of two goods. This is also the point of consumer equilibrium. In our illustration it is about (12, 10) wherein the consumer is exhausting his budget($49-not $50 due to the fact figures are not exactly drawn to scale). Case of a decrease in price of a good Suppose the price of orange was to decrease to $2 as well. Now the vertical axes budget line extreme point would move up to the point (0,25) and the budget line would shift outward maintaining a fixed rotation point (25,0) on horizontal axis.Given the same indifference curve the consumer would arrive in equilibrium at a different point clearly indicating that he would now purchase more of oranges when compared to apples as oranges have turned cheaper. Thus there will be a tendency to substitute the expensive good with the cheaper one. The consumer would now move to a new equilibrium point D on a new indifference curve as is shown in figure below.This new equilibrium points confirms that now the consumer can purchase more of oranges.Plotting all such new equilibrium points as prices of orange fluctuate and joining them would yield the demand curve for orange which would be downward sloping curve. The above analysis has revealed that indifference curve construct is a useful construct in understanding the consumer decision process given the fact that consumer can dispassionately and honestly declare his consumption intentions.Once such intentions have been revealed then prices and budgets are facts which can be superimposed on such data to arrive at rather pointed solutions to consumer problems. The theory of indifference curve is based on observation of behavior and requires little more that supposing that people can rank order preferences among goods .It supposes that the consumer wishes to choose between "market baskets" of apples and oranges. The underlying assumptions about individual preferences are :the consumer knows his own preferences: for any market baskets A and B he can reveal his preference patterns; that his preferences have transitivity; for any good, more is better than less and variety in consumption is preferred to consuming single goods.(Modern,2006)Computerized software can be written to advise various category of consumers of multiple types of consumption they intend to take on with in their budgets. However analysis turns arduous the moment one increases the number of goods to be reckoned. References Definition of Indifference Curve". Retrieved on November 15, 2006 from http://economics.about.com/cs/economicsglossary/g/indifference.htm. Modern consumer theory: indifference curve analysis. Retrieved on November 15, 2006 from www1.appstate.edu/mcraelt/Consumer.pdf. Read More