CONSUMER DEMAND THEORY: INDIFFERENCE CURVE APPROACH

Written Report

Submitted to Ms. Ronalyn I. Garcia of the

Department of Management
Cavite State University
Imus City, Cavite

In partial fulfillment
of the requirements for the BMGT 21
Basic Microeconomics

Baculo, Khimberly Jane C.

Bayabao, Abdulwahid P.
Low, Ma. Mariconne D.
Mas, Shiela Ann Y.
Carlos, Sophia Aegeanz
Torlao, Mary Cristine Diane Y.
Pare, Princess Hannah

BSBM 1-B
1ST Semester A.Y 2019-2020
TOPIC:

CONSUMER DEMAND THEORY: INDIFFERENCE CURVE APPROACH

TOPIC CONTENTS:

A. Indifference Schedule and Indifference Curve

B. Characteristics of Indifference Curve
C. The Marginal Rate of Substitution
D. Consumer Equilibrium
E. Derivation of Demand Curve
F. Substitution and Income Effects

LEARNING ACTIVITY: GAME THEORY

Sine Mo ‘To (before the discussion)

MECHANICS:

A certain number of participants from the class will randomly be chosen as

characters from a story created beforehand. The activity will start with the narrator’s
introduction. As the story is narrated, the participants will have to improvise with their role-
acting in the story. As the story concludes, a brief explanation and correlation of the story to
topics A, B, and C will be shown with the provision of a simple graph to further elaborate
certain aspects involved in the story.
DISCUSSION:

Consumer Demand Theory: Indifference Curve Approach

A. Indifference Schedule and Indifference Curve

On the basis of their tastes and preferences, consumers must subjectively choose the
bundle of goods and services that yield the highest level of satisfaction (utility) given their
money income and prices.

An Indifference curve shows the various combinations of two commodities, and each
combination of goods on the indifference curve will yield the same level of total utility to the
consumer. The consumer is said to be indifferent between any combination of the two goods
along an individual indifference curve because he/she receives the same level of satisfaction
from each bundle.

A higher indifference curve shows a greater amount of satisfaction and a lower one, less
satisfaction. Thus, indifference curves show an ordinal rather than a cardinal measure of
utility.

Indifferent Curve l Indifferent Curve ll Indifferent Curve lll

Qx Qy Qx Qy Qx Qy
1 10 3 10 5 12
2 5 4 7 6 9
3 3 5 5 7 7
4 2.3 6 4.2 8 6.2
5 1.7 7 3.5 9 5.5
6 1.2 8 3.2 10 5.2
7 0.8 9 3 11 5
8 0.5 10 2.9 12 4.9
9 0.3
10 0.2

B. Characteristics of Indifference Curve

1. Indifference Curves are Negatively Sloped - the Indifference curves must slope down
from left to right. This means that an Indifferent 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.

2. Higher Indifference curve means Higher Satisfaction - 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.

3. Indifference Curves are Convex to the Origin - this is an important property of

indifference curves. They are convex to the origin (bowed inward). This is equivalent to
saying that as the consumer substitutes commodity X for commodity Y, the marginal rate of
substitution diminishes of X for Y along an indifference curve.
4. Indifference Curves cannot intersect with each other - given the definition of
indifference curve and the assumptions behind it, the indifference curves cannot intersect
each other. It is because at the point of tangency, the higher curve will give as much as the
two commodities as is given by the lower indifference curve. This is absurd and impossible.

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. The Marginal Rate of Substitution (MRS)

The Marginal Rate of Substitution is the amount of a good that a consumer is willing
to consume in relation to another good, as long as the new good is equally satisfying. It is
used in indifference curve to analyze behavior. It is calculated between two goods placed on
an indifference curve, displaying a frontier of utility for each combination of "good X" and
"good Y".

It is important to note that when comparing bundles of goods X and Y that give a
constant utility (points along an indifference curve), the marginal utility of X is measured in
terms of units of Y that is being given up.

For example, if the MRSxy = 2, the consumer will give up 2 units of Y to obtain 1
additional unit of X. As one moves down a (standardly convex) indifference curve, the
marginal rate of substitution decreases (as measured by the absolute value of the slope of
the indifference curve, which decreases). This is known as the law of diminishing marginal
rate of substitution.

Since the indifference curve is convex with respect to the origin and we have defined
the MRS as the negative slope of the indifference curve.

For example, a consumer must choose between hamburgers and hot dogs. In order
to determine the marginal rate of substitution, the consumer is asked what combinations of
hamburgers and hot dogs provide the same level of satisfaction.

When these combinations are graphed, the slope of the resulting line is negative.
This means that the consumer faces a diminishing marginal rate of substitution: the more
hamburgers they have relative to hot dogs, the fewer hot dogs they are willing to consume. If
the marginal rate of substitution of hamburgers for hot dogs is -2, then the individual would
be willing to give up 2 hot dogs for every additional hamburger consumption.
D. Consumer Equilibrium

When consumers make choices about the quantity of goods and services to
consume, it is presumed that their objective is to maximize total utility.
In maximizing total utility, the consumer faces a number of constraints, the most
important of which are the consumer's income and the prices of the goods and services that
the consumer wishes to consume.
The consumer's effort to maximize total utility, subject to these constraints, is referred
to as the consumer's problem.
The solution to the consumer's problem, which entails decisions about how much the
consumer will consume of a number of goods and services, is referred to as consumer
equilibrium.

Consider the simple case of a consumer who 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

This condition states that the marginal utility per dollar spent on good 1 must equal
the marginal utility per dollar spent on good 2. If, for example, the marginal utility per dollar
spent on good 1 were higher than the marginal utility per dollar 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 dollar spent on
good 1 will eventually equal that of good 2. Of course, the amount purchased of goods 1 and
2 cannot be limitless and will depend not only on the marginal utilities per dollar spent, but
also on the consumer's budget.

To illustrate how the consumer equilibrium condition determines the quantity of

goods 1 and 2 that the consumer demands, suppose that the price of good 1 is $2 per unit
and the price of good 2 is $1 per unit. Suppose also that the consumer has 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 the table below. 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 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.
 The consumer equilibrium is found by comparing the marginal utility per dollar spent
(the ratio of the marginal utility to the price of a good) for goods 1 and 2, subject to the
constraint that the consumer does not exceed her budget of $5. The marginal utility per
dollar spent on the first unit of good 1 is greater than the marginal utility per dollar spent on
the first unit of good 2(12 utils > 9 utils). Because the price of good 1 is $2 per unit, the
consumer can afford to purchase this first unit of good 1, and so she does. She now has $5
− $2 = $3 remaining in her budget. The consumer's next step is to compare the marginal
utility per dollar spent on the second unit of good 1 with marginal utility per dollar spent on
the first unit of good 2. Because these ratios are both equal to 9 utils, the consumer
is indifferent between purchasing the second unit of good 1 and first unit of good 2, so she
purchases both. She can afford to do so because the second unit of good 1 costs $2 and the
first unit of good 2 costs $1, for a total of $3. At this point, the consumer has exhausted her
budget of $5 and has arrived at the consumer equilibrium, where the marginal utilities per
dollar spent are equal. The consumer's equilibrium choice is to purchase 2 units of good 1
and 1 unit of good 2.

E. Derivation of Demand Curve

In economics, a demand curve is a graph depicting the relationship between the

price of a certain commodity (the y-axis) and the quantity of that commodity that is
demanded at that price (the x-axis). Demand curves may be used to model the price-
quantity relationship for an individual consumer (an individual demand curve), or more
commonly for all consumers in a particular market (a market demand curve). It is
generally assumed that demand curves are downward-sloping, as shown in the adjacent
image. This is because of the law of demand: for most goods, the quantity demanded
will decrease in response to an increase in price, and will increase in response to a
decrease in price.

A market demand curve is the horizontal summation of all individual demand

curves. Any factor that can shift an individual demand curve can shift a market demand
curve.
FOR EXAMPLE:

To derive a market demand curve, simply add the quantities that each consumer
buys at each price. The prices on the vertical axis do not change, but the quantities on
the horizontal axis are the sums of the consumers’ demand. This group of quantities is
called horizontal summation.

QUANTITY QUANTITY MARKET

PRICE (PRINCESS) (KHIM) DEMAND
50 1 2 3
6

=
40 2 4
30 3 6 9
20 4 8 12
10 5 10 15
5 6 12 18

Continue to find points on the market demand curves that are the sums of the
individual quantities. Connect the points to get the market demand curve. The market
demand curve on the left is labelled D.

Any factor that shifts any of the individual demand curves will shift the market
demand curve. In the example on the left, only Bob’s income changed. The change shifts
Bob’s individual demand curve and the market demand curve outward because a larger
quantity is demanded at each price.

Since the market demand is based on individuals demands, any variable that
shifts the individual demand curve will also shift the marker demand curve.

F. Substitution and Income Effects

• The income effect expresses the impact of increased purchasing power on consumption.
It is the change in consumption of goods based on income. This means consumers will
generally spend more if they experience an increase in income, and they may spend less if
their income drops. It can be both direct (when it is directly related to a change in income) or
indirect (when consumers must make buying decisions not directly related to their incomes).

• Substitution effect describes how consumption is impacted by changing relative income

and prices. The substitution may occur when a consumer replaces cheaper or moderately
priced items with ones that are more expensive. A small reduction in price may make an
expensive product more attractive to consumers, which can also lead to the substitution
effect.