An indifference curve is a set of points with the same utility. It shows the combination of two products that provide an

individual with a given level of utility or satisfaction.

We have two products: Product A and Product B. According to the law of diminishing marginal utility each extra unit of

product B will provide successively less extra utility. This means successively less of product A has to be sacrificed to

keep the same utility overall. The curve of indifference curve is convex.

If a consumer equally prefers two products, then the consumer is indifferent between the two products. The consumer

will get the same level of satisfaction (utility) from either product. The slope of indifference curve is also known as the

marginal rate of substitution (MRS).

Indifference Schedule:-

Combinations

Goods (X) Goods (Y)Level of

satisfactionsA 1 18 S

B 2 13 S

C 3 9 S

D 4 6 S

E 5 4 SS = Same level of Satisfaction.

In the above schedule there are 5 combinations of 2 goods (X) and (Y) but all are achieved combinations of (X)

and (Y).The consumer is indifferent between them. Because to get one more units of X the consumer prefer to give up 5

units or Y. The gain in utility of one additional unit of X will exactly compensated the consumer by the loss of 5 units of

Y. All these combinations give the same level of satisfaction they are also known as utility combination.

Indifference schedule in Indifference curve as shown below:

In the above, X-axis represents product X and Y –axis represents product Y. IC1 is the Indifference curve. All

combinations of the goods X & Y represented by points A, B, C, D & E on the Indifferent curve will be equally

preferable to the consumer. As these goods gives him the same level of satisfactions.

ASSUMPTION OF INDIFFERENCE CURVE:

1. A consumer is assumed to buy any two goods in combinations.

2. A consumer can rank the alternative combinations and compare their level of satisfaction, and he prefers a

combination providing a higher level of satisfaction.

3. It is assumed that utility can be measured in ordinal numbers but not in cardinal measurements.

4. Consumer is rational and his choices are transitive.

5. The consumer behavior is assumed to be constant, throughout the analysis.

6. Indifference curve analysis assumes diminishing marginal rate of substitution.

ProductY

P r o d u c t X

Properties / Characteristics of Indifference Curve

The indifference curves possess certain characteristics which are also called as properties. The important properties are:

1. Indifference Curves are negatively Sloped

2. Higher Indifference Curve Represents Higher Level

3. Indifference curve must be convex to the origin

4. No two Indifference curve intercept with each other.

5. Indifference Curves do not Touch the Horizontal or Vertical Axis

1. Indifference Curves are negatively Sloped: The indifference curves must slope down from left to right. This

means that an indifference curve is negatively sloped. It slopes downward because as the consumer increases the

consumption of X commodity, he has to give up certain units of Y commodity in order to maintain the same level of

satisfaction.

y

y1 A

y2 B

O x1 x2 x

In this the two combinations of commodity product X and Product Y is shown by the points A and B on the same

indifference curve. The consumer is indifferent towards points A and B as they represent equal level of satisfaction.

At point (A) on the indifference curve, the consumer is satisfied with OX1 units of X and OY1 units of Y. He is equally

satisfied with OY2 units of Y and OX2 units of X shown by point b on the indifference curve. It is only on the negatively

sloped curve that different points representing different combinations of goods X and Y give the same level of

satisfaction to make the consumer indifferent.

2. Higher Indifference Curve Represents Higher Level: A higher indifference curve that lies above and to the

right of another indifference curve represents a higher level of satisfaction and combination on a lower indifference

curve yields a lower satisfaction. In other words, we can say that the combination of goods which lies on a higher

indifference curve will be preferred by a consumer to the combination which lies on a lower indifference curve.

 

 

P r o d u c t X

ProductY

ProductY

P r o d u c t X

In this diagram there are three indifference curves, IC1, IC2 and IC3 which represents different levels of satisfaction. The

indifference curve IC3 shows greater amount of satisfaction and it contains more of both goods than IC2 and IC1 (IC3 >

IC2 > IC1).

 

3. Indifference curve must be convex to the origin: The convexity of an Indifference curve is explained by the

law of diminishing marginal rate of substitution. Marginal rate of substitution between X and Y is the quantity of

good Y which the consumer is willing to give up for every additional unity of X, so that the level of satisfaction

remains the same, from all the successive combinations.

Combinations

Goods (X) Goods (Y) MRSxyLevel of

SatisfactionsA 1 18 — S

B 2 13 5:1 S

C 3 9 4:1 S

D 4 6 3:1 S

E 5 4 2:1 S

Y

Y1

Convexity implies that the consumer is willing to give up less of good Y to obtain a little more of good X. This means, a

diminishing slope ( y/ x) of the indifference curve.

A rational consumer gives less significance to an extra unit of a commodity with a large stock and more

significance to an unit of a commodity with a smaller stock. As the consumer moves down the indifference curve,

quantity or X becomes larger and that of Y becomes smaller. In order to be at the same level of satisfaction, the

consumer will sacrifice less and less of Y in exchange of X. So MRS of X for Y will diminish as the consumer gets more

and more of X. Only then the subsequent combinations will give the consumer an equal level of satisfaction. Hence

indifference curves are convex to the origin.

4. No two Indifference curve intercept with each other: In order to prove that two indifference curve do not

intercept with each other. Let us draw two Indifference curve (IC1 &IC2) intercepting with each other at point A, As

shown in the diagram.

RR1

R2 IC2

IC1

O Q Q1 Q2 Q

Each indifferent curve represents a particular level of satisfaction to the consumer, which is different from other

Indifference Curve representing different level of satisfaction. If two indifference curve intercepts (as shown in the above diagram) it will corresponding to B and C, managed to equal at some other point A.

 5. Indifference Curves do not Touch the Horizontal or Vertical Axis: One of the basic assumptions of

indifference curves is that the consumer purchases combinations of different commodities. He is not supposed to purchase only one commodity. In that case indifference curve will touch one axis. This violates the basic assumption of indifference curves.

  C

E 

It is shown that the in difference IC touches Y axis  at point C and X axis at point E. At point C, the consumer purchase

only OC commodity of rice and no commodity of wheat, similarly at point E, he buys OE quantity of wheat and no

amount of rice. Such indifference curves are against our basic assumption. Our basic assumption is that the consumer

buys two goods in combination.

A Budget Line (budget constraints)The budget line is an important component when analyzing consumer behavior. The budget line illustrates all the

possible combinations of two goods that can be purchased at given prices and for a given consumer budget. The amount

of a good that a person can buy will depend upon his income and the price of the good he is purchasing. So Budget line

is a line showing different combinations of two goods which a consumer can buy, given his income.

Now suppose an individual has a total income of Tk 12 and he has to spend his income on 2 commodities A and B. Price

of A and B are Rs 1.50 and Rs. 1 respectively. 

Units of A Units of B Total expenditurePrice = 1.50 Tk

Price = 1 Tk ( in Tk)

Changing in Total Utility (∆TU)Changing in Consumption (∆Q)

∆TU∆Q

8 0 126 3 124 6 122 9 120 12 12

And the above table can be portrayed in the form of graph like 

In this diagram, with a limited income of 12 Rs, The individual can buy either of the given

combinations of two commodities A and B. Any Point within the triangle is attainable by the

consumer. Any point outside the triangle can not be bought by the consumer with his limited income.

Law of Diminishing Marginal UtilityUtility refers to the amount of satisfaction a person gets from consumption of a certain item. And marginal utility refers

to the addition made to total utility; we get after consuming one more unit.

So after consuming extra one unit a consumer gets extra utility which is called marginal utility. For example, A

consumer got an utility of 14 Tk after using 4 unit of orange and when he consume the next unit he got an utility of 15

Tk. So marginal utility will be (15-14) =1 Tk.

Marginal Utility (MU) =

MU=

An individual's wants are unlimited in number yet each individual's want is satiable. Because of this, the more we have a

commodity, the less we want to have more of it.

This law state that as the amount consumed of a commodity increases, the utility derived by the consumer from the

additional units, i.e marginal utility goes on decreasing.

According to Marshall, “The additional benefit a person derives from a given increase of his stock of a thing diminishes

with every increase in the stock that he already has”

Assumptions:

1. All the units of a commodity must be same in all respects

2. The unit of the good must be standard

3. There should be no change in taste during the process of consumption

4. There must be continuity in consumption

5. There should be no change in the price of the substitute goods

Explanation:

As more and more quantity of a commodity is consumed, the intensity if desire decreases and also the utility derived

from the additional unit.

Suppose a person eats Bread. And 1st unit of bread gives him maximum satisfaction. When he wills to eat 2nd bread his

total satisfaction would increase. But the utility added by 2nd bread (MU) is less then the 1st bread. His Total utility and

marginal utility can be put in the form of a following schedule.

Slice of Bread Total Utility Marginal Utility

0 0 ---

1 70 70

2 110 40

3 130 20

4 140 10

5 140 0

6 130 -10

Graph:

An indifference map

An indifference map is the collection of indifference curves possessed by an individual. 

We can draw more than one indifference curve on the same diagram. This family of curves is called indifference map.

We know that right side curve yield higher utility and it goes on increasing as we move righter, While the curve in the

left yield lesser utility and it goes on decreasing as we move towards left. 

(The reason is right hand side point means more consumption of either of 2 goods, hence higher satisfaction).

IC3

IC1

IC2

In this diagram,

IC1, IC2 and IC3 are three indifference curves.

All the points on IC2 will yield higher satisfaction than the points on IC1 and

All the points on IC3 will yield lesser satisfaction than the points on IC1

Consumer Equilibrium

The point at which a consumer reaches maximum utility, or satisfaction, from the goods and services purchased given

the limitation of income and prices. Consumer’s equilibrium is that point in which consumer consumes the combination

of two goods by his limited income. He gets maximum satisfaction from these goods and never changes this situation. If

he will change this point, his level of satisfaction will decrease. Equilibrium is reached when the consumer purchases the

collection of goods which best meets his satisfaction requirements given his financial limitations.

Assumptions

1. There are two goods i.e commodity X and commodity Y.

2. The consumer’s preference scale for combination of two goods is shown by indifference map.

3. The prices of goods are given and remain constant.

4. The consumer has a given income which sets to limits to his maximizing behavior.

Condition of Consumer Equilibrium

Consumer will attain its equilibrium (maximum satisfaction) at the point, where marginal utility of a product is divided

by the price. For example, a consumer cares about consuming only two goods: good 1 and good 2. This consumer knows

the prices of goods 1 and 2 and has a fixed income or budget that can be used to purchase quantities of goods 1 and 2.

The consumer will purchase quantities of goods 1 and 2 so as to completely exhaust the budget for such purchases. The

actual quantities purchased of each good are determined by the condition for consumer equilibrium, which is 

Marginal utility of good 2Price of good 2

Marginal utility of good 1Price of good 1

=

This condition states that the marginal utility per Tk spent on good 1 must equal the marginal utility per Tk spent on

good 2. If, for example, the marginal utility per Tk spent on good 1 were higher than the marginal utility per Tk spent on

good 2, then it would make sense for the consumer to purchase more of good 1 rather than purchasing any more of good

2. After purchasing more and more of good 1, the marginal utility of good 1 will eventually fall due to the law of

diminishing marginal utility, so that the marginal utility per Tk spent on good 1 will eventually equal that of good 2. It

depends not only on the marginal utilities per Tk spent, but also on the consumer's budget.

For example, the price of good 1 is $2 per unit and the price of good 2 is $1 per unit. The consumer has also a budget of

$5. The marginal utility (MU) that the consumer receives from consuming 1 to 4 units of goods 1 and 2 is reported in

Table 1 . Here, marginal utility is measured in fictional units called utils, which serve to quantify the consumer's

additional utility or satisfaction from consuming different quantities of goods 1 and 2. The larger the number of utils, the

greater is the consumer's marginal utility from consuming that unit of the good. Table 1 also reports the ratio of the

consumer's marginal utility to the price of each good. For example, the consumer receives 24 utils from consuming the

first unit of good 1, and the price of good 1 is $2. Hence, the ratio of the marginal utility of the first unit of good 1 to the

price of good 1 is 12. 

TABLE 1 Illustration of Consumer Equilibrium. Price of good 1 = $2, Price of good 2 = $1, Budget = $5

Units of good 1 MU of good 1, Utils MU/price of good 1 Units of

good 2

MU of good 2,

Utils

MU/price of

good 2

1 24 12 1 9 9

2 18 9 2 8 8

3 12 6 3 5 5

4 6 3 4 1 1

In order to explain consumer equilibrium under Indifference curve analysis, we have to draw the Indifference Map and

the Budget/price line together as shown in the figure below.

Marginal Utility of BMarginal Utility of A

MU BMU A

A

R

IC2

E IC1

S IC3

O B

A rational consumer will try to reach the highest possible Indifference curve given his income and price per unit of the

two goods X and y.

The consumer will not be equilibrium below the Price line because he will not be spending his entire income and

he will not get maximum level of satisfaction. On the other hand all the combination of X and Y represented by the IC2

is ruled out because his income is not sufficient to reach any point on the IC2.

The consumer equilibrium should be some where n the Budget line neither below nor above. So, ‘E’ is the equilibrium

point. The consumer will not be equilibrium at any point on the Budget line above the point E because MRS is greater.

Similarly, he will not be equilibrium at any point below Equilibrium point E on the Budget line because MRS is lesser

Why does the shape of the indifference curve slope downward? The shape of the indifference curve is sloping downwards because of the marginal rate of substitution (MRS). The marginal rate of

substitution is the amount of one good (i.e. Good A) that has to be given up if the consumer is to obtain one extra unit of

the other good (Good B).

This shows the amount of product A a consumer would be prepared to give up for another unit of B and still maintain the

same total utility.

Marginal Rate of Substitution (MRS) =

=

Using this following table, the marginal rate of substitution between point A and Point B is;

Product Y

Product X

MU BMU A

MRS = -6 / 2 = -3 = 3 (The convention is to ignore the sign).

Combinations Units of A Units of B Units of A given up to get few more units of B

MRS=A/B

A 12 2 -B 6 4 6 units of A to get 2 units of

B=-6/2= -3

C 4 6 2 units of A to get 2 units of B

=-2/2= -1

D 3 8 1 units of A to get 2 units of B

=-1/2 =-0.5

Graph:

IC1

The shape of the indifference curve is not a straight line. The indifference curve is convex to the origin. This is

due to the concept of the diminishing marginal rate of substitution between the two goods.

The marginal rate of substitution is the amount of one good (i.e. Good A) that has to be given up if the consumer

is to obtain one extra unit of the other good (Good B).

The slope of the curve represents the marginal rate of substitution, (MRS)

The reason why the marginal rate of substitution diminishes is due to the principle of diminishing marginal utility.

Where this principle states that the more units of a good are consumed, then additional units will provide less additional

satisfaction than the previous units. Therefore, as a person consumes more of one good (i.e. work) then they will receive

diminishing utility for that extra unit (satisfaction), hence, they will be willing to give up less of their leisure to obtain

one more unit of work.

The relationship between marginal utility and the marginal rate of substitution is often summarized with the following

equation;

MRS =

Uni

ts o

f A

Units of B

Implicit CostImplicit cost is a cost that is represented by lost opportunity in the use of a company's own resources, excluding cash.

Implicit costs do not involve a cash transaction, and so we use the opportunity cost concept to measure them. Implicit

costs are related to forgone benefits of any single transaction. These are intangible costs that are not easily accounted for.

Example, the time and effort that an owner puts into the maintenance of the company rather than working on expansion.

Explicit Cost

Explicit costs are expenses for which one must pay with cash or equivalent. Because a cash transaction is involved, they

are relatively easily accounted for in analysis. These costs are never hidden, one has to pay separately.

Example- Electricity Bill, wages to workers etc.

Fixed CostThe cost that is related to fixed inputs is referred to as fixed cost. Fixed costs are changed according to change in output.

These costs include payment for renting plant and equipment, property taxes, and like. Summation of all fixed costs is

called total fixed costs (TFC).

Fixed Costs Curve:

Total Fixed Costs

(TFC)

It is horizontal or flat to the X axis.

Variable CostsThe cost related to variable inputs is the variable cost. Variable costs change along with the change in output. These costs

include payment of raw materials, fuels, most types of labor, exercise taxes and so on. Summation of all variable costs is

called total variable costs (TVC).

Total Fixed CostTotal Output

TFCQ

Variable Costs Curve: TVC

Total Costs:

Total cost of a firm is the economic cost of the firm. Total cost (TC) is the sum of the total fixed costs (TFC) and the

total variable costs (TVC).

So, Total Costs: Total Fixed Costs (TFC) + Total Variable Costs (TVC)

Total Costs Curve: TC TVC

TFC

Average Fixed Cost (AFC):

Average Fixed Cost (AFC) is the total fixed cost divided by total output.

Average Fixed Cost=

AFC=

Total Variable CostTotal Output

TVCQ

Total CostTotal Output

Average Variable Cost (AVC):

Average Variable Cost (AVC) is the total variable cost divided by total output.

Average Variable Cost =

AVC =

Total Average Cost (AC):Total Average Cost (AC) is the total cost divided by total output. Average cost can also be computed by adding average

fixed cost and average variable cost.

Total Average Cost (AC) =

Law of diminishing returns

The classical economists were of the opinion that the taw of diminishing returns applies only to agriculture and to some

extractive industries, such as mining, fisheries urban land, etc. The law was first stated by a Scottish farmer as such. It is

the practical experience of every farmer that if he wishes to raise a large quantity of food or other raw material

requirements of the world from a particular piece of land, he cannot do so. He knows it fully that the producing capacity

of the soil is limited and is subject to exhaustion. As he applies more and more units of labor to a given piece of land, the

total produce increases but it increases at a diminishing rate.

This law is stated that as more and more variable factors are added to a given quantity of fixed factors, holding

technology constant, marginal product eventually drops.

For example, if the number of labor is doubled, the total yield of his land will not be double. It will be less than double.

If it becomes possible to increase the yield in the very same ratio in which the units of labor are increased, then the raw

material can be met by intensive cultivation in a single flower-pot. This is not possible, for that a rational farmer

increases the application of the units of labor on a piece of land up to a point which is most profitable to him. This is in

brief, is the law of diminishing returns.

Marshall has stated this law as such: "As Increase in capital and labor applied to the cultivation of land causes in general

a less than proportionate increase in the amount of the produce raised, unless it happens to coincide with the

improvement in the act of agriculture".

Assumptions of Law of Diminishing Returns:1. The time is too short for a firm to change the quantity of fixed factors.

2. It is assumed that labor is the only variable factor. As output increases, there occurs no change in the factor

prices.

3. All the units of the variable factor are equally efficient.

4. There are no changes in the techniques of production.

Explanation:This law can be made clearer if we explain it with the help, of a schedule and a curve.

Schedule:

In the schedule given above, a firm first cultivates 12 acres of land (Fixed input) by applying one unit of labor and

produces 50 tons of wheat and marginal production is also same. When it applies 2 units of labor, the total production

increases to 120 tons of wheat and marginal production increases in70 tons. It is because the piece of land is under-

cultivated. In our schedules the rate of return is at its maximum when two units of labor are applied. When a third unit of

labor is employed, the marginal return comes down to 60 tons of wheat with the application of 4th unit. The marginal

return goes down to 20 tons of wheat and when 5th unit is applied it makes no addition to the total output. The sixth unit

decreased it. This tendency of marginal returns to diminish as successive units of a variable resource (labor) are added to

a fixed resource (land) is called the law of diminishing returns.

The above schedule can be represented graphically as follows

In this figure, OX is measured amount of labor applied to a piece of land and OY, total product, average product and

marginal product. In the beginning the land was not adequately cultivated, so the additional product of the second unit

increased more than of first. When 2 units of labor were applied, the total yield was the highest and so was the marginal

return. When the number of workers is increased from 2 to 3 and more, The MP begins to decrease. As fifth unit of labor

was applied, the marginal return fell down to zero and then it decreased to 5 tons.

Fixed Input

Inputs of Variable Resources(Labor)

Total Produce TP

(in tons)

Average product MP (in

tons)

Marginal product MP (in tons)

12 Acres 1 50 50 5012 Acres 2 120 60 7012 Acers 3 180 60 6012 Acres 4 200 50 2012 Acers 5 200 40 012 Acres 6 195 32.5 -5

Indifference curves normally used in analyses are convex in shape. However, there are some exceptions. For example, for two goods that are perfect substitutes, indifference curve is linear, as in Figure 4.5(a). A linear indifference curve indicates that the consumer does not mind whether he consumes only good X or good Y or any other combinations because both will give the same level of satisfaction.

Figure shows the indifference curve for goods that are perfect complements. For example, if you already have a pair of shoes (at point A), an addition of the right pair of shoes (Y) only will not increase satisfaction (point B), because the complement is missing. Satisfaction will only be increased when you have both right and left pair of shoes (point D).