Let us start our discussion with a hypothetical situation. You have just received a gift voucher of Music World worth Rs. 1000 as a prize of an event in an Inter College Cultural competition. What will you do with that prize money? You can purchase either video CD of English movies or of regional films or audio CDs of Western classical music/Hindi pop/ instrumental etc.
Now, the problem is, how many of what type (ACDs or VCDs) will you select? In this chapter we will discuss the economic theory of choosing a combination among various alternatives by a rational individual within his limited resources.
Finding the right alternative is a three-step exercise: first, unveiling the concept of indifference curve, second – understanding the concept of budget line and finally, grasping the technique for determining the best alternative.
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Indifference curve of a consumer is a line that joins all the points representing different combinations of two goods, which yield the same level of satisfaction to the consumer. The theory of indifference curve relies on the following assumptions. These assumptions are also called axioms.
Assumptions:
1. Completeness:
By completeness we mean that if two bundles of goods are given to a customer, he will either be able to determine his preference for one bundle over the other or rank both equally. Naturally, this assumption eliminates the possibility of indecisiveness of consumers.
2. Transitivity:
It is assumed that consumers’ preferences are transitive which means that preferences over bundles are consistent. Out of three bundles A, B and C, if a consumer prefers bundle A to bundle B and bundle B to bundle C, then by transitivity we can claim that he prefers bundle A to bundle C.
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Similarly, if a consumer feels equal preference for A arid B and for B and C, then following the assumption of transitivity, we can claim that the customer also feels equal preference for A and C.
3. Non-satiety:
The assumption of non-satiety implies that consumers never reach a point of saturation, ceteris paribus. In other words, non- satiety means, other things being equal, more quantity of goods is always preferred to less.
Suppose, initially a consumer was offered 100 square feet of shelter and 3 Kg of food per day. Now, if another bundle is offered to him, which comprises 100 square feet of shelter and 15 kg of food per day, he will prefer the new bundle, since it gives him 12 kg of extra food per day.
4. Diminishing Marginal Rate of Substitution (MRS):
The assumption of diminishing marginal rate of substitution implies that, the more of one good a consumer possesses, the more of that good he must demand to give up a unit of the other good, because increase in quantity of a good reduces its marginal utility.
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MRS is measured by the ratio of extra amount of good (measured along the horizontal axis) that the consumer accepts to the amount of good (measured along the vertical axis) he forgoes and maintains the same satisfaction level. Thus,
Where, Y is measured along the vertical axis and X is measured along the horizontal axis. MRS at a particular point on the indifference curve is the shope of the indifference curve at that point.
Let us explain this assumption with the help of figure 7.1. Suppose, IC1 is one of the indifference curves of a person who derives satisfaction from two goods — ice cream and video CD. We have chosen three points A, B and C on IC1 Point A is a bundle consisting of 4 ice-creams and 1 VCD.
Points B and C represent bundles of 2 ice-creams with 2 VCDs and 1 ice-cream with 3 VCDs respectively. All these bundles yield equal satisfaction to the person since they lie on the same indifference curve. Here, MRS between point A and point B is measured by
As a consumer moves from point A to point B and maintains the same satisfaction level, his loss in total utility resulting from reduction in quantity of Y is equal to gain in total utility resulting from quantity of extra X consumed. Thus,
