CONSUMER EQUILIBRIUM USING INDIFFERENCE CURVE ANALYSIS
Consumer equilibrium using indifference curve analysis is an Ordinal Approach to Consumer Equilibrium. An indifference curve is a locus of all combinations of two goods which yield the same level of satisfaction (utility) to the consumers. Since any combination of the two goods on an indifference curve gives equal level of satisfaction, the consumer is indifferent to any combination he consumes. Thus, an indifference curve is also known as ‘equal satisfaction curve’ or ‘iso-utility curve’. It asserts that the consumer is said to have attained equilibrium when he maximizes his total utility (satisfaction) for the given level of his income and the existing prices of goods and services.
ASSUMPTIONS OF CONSUMER EQUILIBRIUM USING INDIFFERENCE CURVE ANALYSIS
In the indifference curve approach, the equilibrium position of the consumer is achieved under the following assumptions:
- The consumer has a given indifference curve map exhibiting his scale of preferences for various combinations of two goods, X and Y.
- The consumer has a fixed amount of money to be spent on two goods. He has to spend whole of his given money on the two goods.
- Prices of goods are given and constant for him.
- Goods are homogeneous and divisible.
- Tastes and preferences of the consumer remain constant. 6) The consumer seeks maximum satisfaction.
CONDITIONS OF CONSUMER EQUILIBRIUM USING INDIFFERENCE CURVE ANALYSIS
The ordinal approach defines two conditions of consumer equilibrium:
Necessary or First Order Condition
Supplementary or Second Order Condition.
Necessary Condition or First Order Condition: Under the first order condition, the consumer reaches his equilibrium in the same manner as he does under the cardinal approach of the two-commodity model. It is expressed as:
Thus, the necessary condition of the cardinal approach to consumer equilibrium can be written as:
Supplementary or Second Order Condition: The first order condition is necessary but not sufficient. Thus, the second order or supplementary condition requires that the necessary condition must be accomplished at the highest possible indifference curve on the indifference map.
In the figure above, there are three indifference curves, Viz. IC1, IC2, and IC3 presenting a hypothetical indifference map of the consumer. AB is the hypothetical budget line. At point ‘E’, the indifference curve IC2 and Budget line AB intersect and hence, therefore, the slope of IC2 = AB. At this point, both the necessary condition and the supplementary condition get fulfilled, and hence, the consumer attains equilibrium at point ‘E’.
We know that between any two
points on the indifference curve:
ΔY. MUy = ΔX. MUx
Thus, the slope of the indifference curve can be written as:
The slope of budget line is given as:
In the figure above, at point ‘E’, MRS x, y = Px /Py and hence the consumer is said to have attained equilibrium at this point. The IC2 is tangent with the budget line AB, which shows that the consumer has reached to the highest possible indifference curve for a given level of his income and the market price of goods and services. Thus, at point ‘E’ consumer consumes quantity OQx of X and OQy of Y, which yields him the maximum utility or satisfaction.
SUPERIORITY OF INDIFFERENCE CURVE OVER CARDINAL UTILITY ANALYSIS
The indifference curve technique, as developed by Professor Allen and Hicks, is regarded as an improvement over the Marshallian utility analysis because it is based on fewer and more realistic assumptions:
(1) It Dispenses with Cardinal Measurement of Utility:
The entire utility analysis assumes that utility is a cardinally measurable quantity which can be assigned weights called ‘utils’. If the utility of an apple is 10 utils, of a banana it is 20 utils and of a cherry 40 utils, then the utility of a banana is twice that of an apple and of a cherry four times that of apple and twice that of banana.
This is not measurability but transitivity. In fact, the utility which a commodity possesses for a consumer is something subjective and psychological and therefore cannot be measured quantitatively. The indifference approach is superior to the utility analysis because it measures utility ordinally. The consumer arranges the various combinations of goods in a skate of preference marked as first, second, third etc. He can tell whether he prefers the first to the second or the second to the first or he is indifferent between them. But he cannot tell by how much he prefers one to the other. The ordinal method and the assumption of transitivity make this technique more realistic.
(2) It studies Combinations of two Goods instead of one Good:
The utility approach is a single-commodity analysis in which the utility of one commodity is regarded independent of the other. Marshall avoided the discussion of substitutes and complementary goods by grouping them together as one commodity.
This assumption is far from reality because a consumer buys not one but combinations of goods at a time. The indifference curve technique is a two commodity model which discusses consumer behaviour in the case of substitutes, complementaries and unrelated goods. It is thus superior to the utility analysis.
(3) It provides a Better Classification of Goods into Substitutes and Complements:
The earlier economists explained substitutes and complements in terms of cross elasticity of demand. Hicks considers this inadequate and explains them after making compensating variation in income. He thus overcomes the ambiguity to be found in the traditional classification of substitutes and complements.
(4) It explains the Law of Diminishing Marginal Utility without the Unrealistic Assumptions of the Utility Analysis:
The utility analysis postulates the law of diminishing marginal utility which is applicable to all types of goods, including money. Since this law is based on the cardinal measurement, it possesses all the defects inherent in the later. In the preference theory, this law has been replaced by the principle of diminishing marginal rate of substitution.
The latter, according to Prof. Hicks, “is not mere translation but it is a positive change”. It is scientific and is, at the same time, free from the psychological quantitative measurement of the utility analysis. The application of this principle in the fields of consumption, production and distribution has made economics more realistic.
(5) It is Free from the Assumption of Constant Marginal Utility of Money:
Marshall justified it on the plea that an individual consumer spends only a small part of his whole expenditure on any one thing at a time. This assumption makes the utility theory unrealistic in more than one way. It is applicable to a single-commodity model. It fails to use money as the measuring rod of an individual’s satisfaction derived from the consumption of various goods. On the other hand, the indifference curve technique analyses the income effect when the income of the consumer changes.
(6) This Analysis explains the Dual Effect of the Price Effect:
One of the main defects in the Marshallian utility analysis is that it fails to analyze the income and substitution effects of a price change. In the indifference curve technique when the price of a good falls, the real income of the consumer increases. This is the income effect. Secondly, with the fall in price, the good becomes cheaper.
The consumer substitutes it for some other good. This is the substitution effect. The indifference curve technique is definitely superior to the utility analysis because it discusses the income effect when the consumer’s income changes; the price effect when the price of a particular good changes and its dual effect in the form of the income and substitution effect. It also studies the cross effect when with change in the consumer’s income, the price of the other good also changes.
(7) It explains the Proportionality Rule in a Better Way:
The indifference curve technique explains consumer’s equilibrium in a similar but better way than the Marshallian proportionality rule. The consumer is in equilibrium at a point where his budget line is tangent to the indifference curve. At this point the slope of the indifference curve equals the budget line, so that the
(8) It rehabilitates the Concept of Consumer’s Surplus:
Hicks have explained the concept of consumer’s surplus by dispensing with the unrealistic assumption of the constancy of the marginal utility of money. He regards consumer’s surplus “as a means of expressing, in terms of money income, the gain which accrues to the consumer as a result of a fall in price.’’ Thus the doctrine of consumer’s surplus is no longer a ‘mathematical puzzle’ and has been freed from the introspective cardinalism of the utility theory.
(9) It explains the Law of Demand more Realistically:
The indifference curve technique explains the Marshallian law of demand in a more realistic manner in more than one way. It is untainted by the psychological assumptions of the utility analysis. It explains the effect of the fall in the price of an inferior good on consumer’s demand. Giffen goods which remained a paradox for Marshall throughout have been ably explained with the help of this technique.
Whereas in the Marshallian law of demand the demand for a commodity varies inversely with its price and the demand curve slopes negatively downward to the right, the indifference analysis explains two more situations:
(i) With the fall in the price of a commodity, its demand remains unchanged. It happens in the case of those inferior goods whose income effect exactly equals substitution effect.
(ii) When the price of the commodity falls, its demand also falls. This is the case of Giffen goods whose income effect outweighs the substitution effect and the demand curve slopes upward having a positive slope. Marshall failed to explain these cases. This makes the indifference curve technique definitely superior to the Marshallian introspective cardinalism.