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Edit Comment Close Premium member Presentation Transcript Module-3 Part II : Module-3 Part II The Indifference Curve Analysis Introduction : Introduction The technique of indifference curves was developed by Edgeworth in 1881 and its refinement was effected by Pareto, an Italian economist in 1906 This technique, however attained perfection and systematic application in the demand analysis by Prof. J R Hicks and RGD Allen in 1934 Prof. Hicks developed and popularized the innovation of the Indifference Curve Approach to the theory of demand in his Value and Capital, published in 1939 The Concept of Scale of Preference : The Concept of Scale of Preference The Indifference Curves have been devised to represent the ordinal measurement of utility (as opposed to cardinal measurement) Ordinal measurement implies comparison and ranking without quantification of the satisfaction enjoyed by the consumer In the ordinal sense, utility is viewed as the level of satisfaction rather than an amount of satisfaction The Concept of Scale of Preference-1 : The Concept of Scale of Preference-1 Hicks asserts that usually people are not interested in any one commodity at a time as assumed by the marginal utility approach Generally people are interested in a combination of commodities and the satisfaction resulting from them Besides they can always compare the level of satisfaction yielded by one particular combination of goods with another combination The Concept of Scale of Preference-2 : The Concept of Scale of Preference-2 A larger stock of goods gives a higher level of satisfaction than a smaller stock of goods Rational consumer, obviously prefers that combination of goods which gives more satisfaction than that combination which gives lower satisfaction Thus the consumer can conceptually arrange goods and their combinations in the order of their level of satisfaction This conceptual (mental) arrangement of combination of goods and services set in the order of the level of satisfaction they give, is called the scale of preference Scale of Preference : Scale of Preference Characteristics of Scale of Preference : Characteristics of Scale of Preference It is always drawn by a consumer consciously or unconsciously It is based on the subjective valuation of goods made by the consumer based on his tastes, preferences, likings, intensity of wants and other psychological factors It is drawn independent of the consumers’ income and prices of income It represents ordinal comparison of the level of satisfaction derived by the consumer from different combination of goods Being a psychological concept the scale of preference differs from person to person Indifference Schedule : Indifference Schedule An indifference schedule is a list of alternative combinations in the stocks of two goods which yield equal satisfaction to the consumer Consequently he will not be in a position to distinguish his preference between them and will be indifferent to these combinations as all these will be equally preferred at a given rank of preference A consumer is said to be indifferent between the various sets of combination of given goods when he experiences the same level of preference for those goods. A list of such combinations of given goods to a consumer which yields equal satisfaction at a given level constitutes an Indifference Schedule The Budget Constraint : The Budget Constraint What a consumer can actually buy depends on the income at his disposal and the prices of goods he wants to buy Income and prices are the two objective factors which form the budgetary constraint of the consumer The consumption or purchase possibility of the consumer is restricted to the budget constraint The Consumer’s Equilibrium : The Consumer’s Equilibrium A rational consumer attains an equilibrium position when his motive of satisfaction is realized The approach by Hicks, says that, the consumer tries to maximize his satisfaction and tries to reach the position of highest level of satisfaction Assumption of the Equilibrium : Assumption of the Equilibrium The consumer has a fixed amount of money income to spend He intends to buy a combination of two goods, X and Y The prices of X and Y are given and constant Each of the goods X and Y are homogeneous and divisible, so that various combinations of these goods can be had The consumer has definite tastes and preferences. So he has a given scale of preference which remains the same throughout the analysis The consumer is rational. The rationality assumption implies that the consumer seeks maximum satisfaction The Income Effect : The Income Effect A consumer’s demand for goods changes when his income changes. Thus his reaction to changes in the income, in relation to the fixed prices of goods and his given scale of preference is called the income effect Definition of the Income Effect:- the income effect refers to the change in demand for a commodity resulting from a change in the income of the consumer, prices of goods being constant The Substitution Effect : The Substitution Effect Whenever there is a change in the relative prices of goods a rational consumer will be induced to substitute a relatively cheaper commodity for the dearer one Under the substitution effect the consumer will tend to buy more of a good the price of which has fallen and less of that good the price of which has remained unchanged or risen This happens because he would re -allocate his expenditure in favour of the relatively cheaper good and substitute it for the dearer one Definition:- the substitution effect is the change in the quantity demanded of a commodity resulting from a change in its price relative to the prices of other commodities, the consumer’s real income or satisfaction level being held constant The Price Effect : The Price Effect The consumer’s reaction to a change in the price of a commodity, other things, i.e. income, tastes and prices of other goods remaining constant is called the price effect Definition:- the price effect is the change in quantity demanded of a commodity, resulting from a change in its price, the consumer’s income being held constant. 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