Page 55 - DECO405_MANAGERIAL_ECONOMICS

Managerial Economics

Notes Let us suppose that the consumer is initially at point e where he/she is deriving some utility
from OQ of X and OQ of Y. If an indifference curve has a positive slope (i.e., Y/ X>0); as
x y
shown by the line OB and curve JK, it implies that the consumer is equally satisfied with larger
and smaller baskets of X and Y. This means an irrational behaviour of the consumer.
For instance, if the consumer moves from point e to b, the combination of the two goods
increases by ea (= bc) of Y and ec (= ab) of X. Unless MU of ea and ec are equal to zero, the level of
satisfaction is bound to increase whereas on an indifference curve, the total utility is supposed to
remain the same. Therefore, line OB and curve JK cannot be indifference curves.
Similarly, in the case of a vertical indifference line, aQ , and the movement from e to a means an
x
increase in the quantity of Y by ea, while quantity of X remains the same, OQ . If MU of ea>0, the
x
total utility will increase. So is the case if an indifference curve takes the shape of a horizontal
line such as Q C.
y
Indifference Curves are Convex to Origin

Indifference curves are not only negatively sloped but are also convex to the origin. The convexity
of the indifference curves implies two properties:
1. The two commodities are imperfect substitutes for one another
2. The Marginal Rate of Substitution (MRS) between the two goods decreases as a consumer
moves along an indifference curve. This characteristic of indifference curves is based on
the assumption of diminishing marginal rate of substitution.
The assumption of diminishing MRS, as mentioned above, states an observed fact that if a
consumer substitutes one commodity (X) for another (Y), his willingness to sacrifice more units
of Y for one additional unit of X decreases, as quantity of Y decreases. There are two reasons for
this:
1. Two commodities are not perfect substitutes for one another.
2. MU of a commodity increases as its quantity decreases and vice versa.
Therefore, more and more units of the other commodity are needed to keep the total utility
constant.

Indifference Curves can neither Intersect nor be Tangent to one Another

If two indifference curves intersect or are tangent with one another, it will reflect two rather
impossible conclusions:
1. that two equal combinations of two goods yield two different levels of satisfaction
2. that two different combinations – one being larger than the other-yield the same level of
satisfaction.
Such conditions are impossible if the consumer’s subjective valuation of a commodity is greater
than zero. Besides, if two indifference curves intersect, it would mean negation of consistency or
transitivity assumption in consumer’s preferences.
Let us now see what happens when two indifference curves, IC and IC’, intersect each other at
point A (Figure 4.3).
Point A falls on both the indifference curves, IC and IC’. It means that the same basket of goods
(OM of X + AM of Y) yields different levels of utility below and above point A on the same
indifference curve.

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