Within the theory of consumer choice that investigates the behavior of an economic agent as a consumer of goods and services, there is an extremely useful tool to facilitate analysis of the consequences of price changes.
This tool is known as the indifference curves, which provides the different combinations of goods that confer the same level of utility or satisfaction to an individual. This is the theme that we develop today in our Concepts of Economics.
What are indifference curves like?
The indifference curve is drawn simply by asking an individual what combination of goods they prefer, for example: 10 hamburgers and 5 movies; 15 hamburgers and 3 movies, 20 hamburgers and 2 movies, or 5 hamburgers and 7 movies. Note that as one option increases, the other decreases. When it comes to two options that are indifferent to the individual, these two points that represent them are on the same indifference curve.
If you move along the curve in one direction, you are willing to accept more movies for fewer hamburgers, if you move the other way, you are willing to accept more hamburgers and fewer movies. But any point within that curve (for example curve A of the graph), gives you the same level of satisfaction.
Utility as an indicator
In Victorian times, philosophers and economists spoke of “utility” as an indicator of the general well-being of people. According to this idea, it was natural to think that consumers made their decisions with a view to maximizing profit. The problem is that these economists never described how to measure utility, since this is a subjective concept that does not report the same for another person. For this reason, later the idea of utility as a measure of happiness was abandoned and the theory of consumer behavior was reformulated according to their preferences.
Indifference curves cannot intersect with each other
The indifference curve shows the different combinations between two goods that report the same satisfaction to a person, and which are preferred over other combinations. For example, all the possible combinations of hamburgers or movies that report to the person the same level of utility or satisfaction. The indifference curve simply reflects preferences between pairs of goods and has nothing to do with money or prices. Along the indifference curve each point has a different monetary value, but its satisfaction is the same.
Likewise, if the individual has the option of increasing the number of hamburgers without decreasing the number of films, it means that they are now in a new indifference curve, which is more useful than the previous one (it goes from curve A to curve B, or from curve B to curve C). That is why it is said that we can draw infinite indifference curves, conforming what is known as indifference curve map. This is the reason that the indifference curves cannot intersect each other since the principle of the same level of utility.
Give up something to get something else
The slope of the indifference curve measures the number of hamburgers the individual is willing to give up to get another movie. The technical term for this slope is Marginal Substitution Rate, which indicates the amount of a good that the individual is willing to give up in exchange for one more unit of the other. This ratio increases or decreases depending on the amount of the good that the consumer already has. Since as we move along the indifference curve we increase the quantity of one of the goods, each time less of the other good is needed to compensate for the change, so the slope of the curve becomes each time flatter. This is what is known as decreasing marginal ratio of substitution.
Individuals choose at the point where the marginal rate of substitution equals the relative price
By definition, a person does not care to be at any point on a given indifference curve, but would prefer to be on the highest possible indifference curve, since the further away from the origin, the higher the level of satisfaction. However, what prevents you from reaching higher indifference curves is your Budget constraint. In other words, and as shown in the graph, the highest indifference curve that a person can reach is the one that touches the Budget constraint in tangent form (curve B of the graph). At this point of tangency, both the curve and the line have the same slope. Therefore, at the point of tangency, the slope of the Marginal Replacement Rate has the same value as the relative prices ratio indicated by the budget constraint. We thus have a basic principle of the consumer’s decision: individuals choose at the point where the marginal rate of substitution equals the relative price.
The budget constraint means that a consumer’s goods are bounded by his income. In this case, you can spend all on hamburgers (intersection with vertical axis), or all income on movies (intersection with horizontal axis). The slope of this budget constraint measures the speed (rate of change) at which a consumer can compensate one good for another, and is given by the relative prices of both goods. That is why the budget constraint is determined by both the consumer’s income and the relative prices of goods. But it makes more sense when we incorporate the analysis of indifference curves, which are those that incorporate consumer preferences.
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