Indifference curves analysis is based upon some assumptions, which determine its strength, applicability and shortcomings. W.J. Baumol has taken three main assumptions of non-satiety, transitivity and diminishing marginal rate of substitution.
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The various assumptions of the analysis are explained below.
(a) Non Satiety:
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This assumption implies that the consumer has not reached the point of saturation in the consumption of any good. Thus, he always prefers to have more of both commodities. He always tries to move to a higher indifference curve to get higher and higher satisfaction. This assumption is called monotonicity of preferences.
(b) Completeness:
To enable the consumer to make an optimal choice in the commodity space (entire area lying between the X-axis and Y-axis, it is assumed that between any two bundles, either the consumer is indifferent or one is preferred to other. Thus, every commodity bundle will lie on some indifference curve.
(c) Transitivity:
It is assumed that consumer’s choices are characterised by transitivity and consistency. Given three commodities bundles ‘A’, ‘B’, and ‘C’, if a consumer prefers ‘B’ to ‘A’ and ‘C’ to ‘B’, he will definitely prefers ‘C’ to ‘A’.
That is, if B > A, C > B, then C > A. Similarly, if the consumer is indifferent between ‘A’ and ‘B’, ‘B’ and ‘C\ then he will be indifferent between ‘A’ and ‘C’. The consistency assumption implies well defined preferences, that is, if A< B, then B > A.
(d) Diminishing Marginal Rate of Substitution:
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It is assumed that both the commodities ‘X’ and ‘Y’ obey the law of diminishing marginal utility, even if one of the commodities is money. It implies, as more and more units of ‘X’ are substituted for ‘Y’, consumer will be ready to sacrifice lesser and lesser units of ‘Y’ for each additional unit of ‘X’. Similarly, consumer will be ready to give up lesser and lesser units of commodity ‘X’ for each additional unit of commodity ‘Y’.
(e) Two Commodities:
It is assumed that consumer has a fixed amount of money whole of which is to be spent on the two goods, given constant prices of both the goods. This is a very restrictive assumption, because, in reality, the consumer deals with a large number of commodities. This restrictive assumption is made to facilitate graphic representation of indifference curves.
Though, we can have (at the most) three dimensional diagrams to handle three commodities case, but, is very difficult to work with it. The problem of multi commodities can be overcome by treating a number of commodities as the composite commodity or more conveniently by money.
(f) Ordinal Utility:
Utility can be measured only in ordinal terms and not cardinal ones. In other words, consumer cannot measure precisely utility or satisfaction in absolute units. He can conveniently arrange various combinations of two or more goods in ascending or descending order of preference. Between any two combinations, he is only able to tell that utility from one combination is more than, equal to, or less than the utility from the other combination. He is not in a position to tell as to the amount of difference in the utility from any two combinations.
(g) Positive Marginal Utilities:
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The goods (or commodities) are considered good and have positive marginal utilities. This implies that given any combination of two commodities, increase in quantity of one commodity increases the total satisfaction and vice-versa. Therefore, in order to keep the total utility at the same level, the quantity of one commodity should be increased for every reduction in the quantity of other commodity.
(h) Divisibility:
The commodities are assumed to be divisible. This means that quantities of commodities can be increased (or decreased) in minute amounts and the corresponding changes in total satisfaction can also be very small. This assumption makes indifference curve continuous without gaps or breaks.
(i) Rationality:
Consumer is assumed to be rational. He aims to maximise the total satisfaction, given his income and market prices. He is also assumed to have full knowledge of market conditions. Further, he is consistent in his choice, i.e., if in one situation he chooses combination ‘A’ rather than combination ‘B’ he will not choose ‘B’ in preference to ‘A’ in another situation.