Theory of Demand: The Indifference Approach

Indifference Curve (YouTube Link)

1. Indifference Curve (IC)

Definition:

• An Indifference Curve shows all combinations of two goods that give the
consumer equal satisfaction
• The consumer is indifferent between any two points on the same curve.
• Example: If a student is equally happy with:
o 3 apples and 2 bananas, and
o 1 apple and 4 bananas,
then both combinations lie on the same indifference curve.

Important Properties of Indifference Curves:

1. Downward Sloping – If the quantity of one good increases, the other must decrease
to maintain the same satisfaction.

Example: More slices of pizza mean fewer burgers to remain equally satisfied.

2. Convex to the Origin – Due to the diminishing marginal rate of substitution

(MRS).

Example: The more of Good X you have, the less of Good Y you’re willing to give
up for more of X.

3. Do Not Intersect – Each curve represents a different level of satisfaction.

4. Higher Curves Represent Higher Satisfaction – More of both goods means more
utility.
 2. Budget Line

Definition:

• A Budget Line shows all combinations of two goods a consumer can afford given
their income and the prices of the goods.

Example: If your income is R100, and:

• Price of apples = R10 each

• Price of bananas = R5 each
You can buy either:
• 10 apples (R10 × 10 = R100), or
• 20 bananas (R5 × 20 = R100),
• or a mix like 5 apples and 10 bananas.

Characteristics of the Budget Line:

1. Downward Sloping – To buy more of one good, the consumer must give up some of
the other.
2. Straight Line – It reflects constant prices.
3. Shifts with Income Changes:
o Increase in income → budget line shifts outward/right.
o Decrease in income → budget line shifts inward/left.
4. Rotates with Price Changes:
o A fall in the price of one good causes the budget line to rotate outward
(flatter).
o A rise in the price causes it to rotate inward (steeper).

Properties of the Budget Line

• Straight line: Due to constant prices.

• Slope = Price Ratio (Px/Py): Reflects trade-offs.
• Shifts: Changes in income or prices shift the line.

Example: Increase in income shifts the line outward (you can buy more of both).
 3. Consumer Equilibrium (Using Indifference Curves and Budget Line)

Definition:

• A consumer reaches equilibrium where the budget line is tangent to the highest
possible indifference curve.
• At this point:
MRS (Marginal Rate of Substitution) = Px
Py

Conditions:

1. Budget constraint is met.

2. MRS equals the ratio of prices of the two goods.
3. The indifference curve is convex to the origin.

Example: A student chooses a combination of 3 smoothies and 2 wraps, which lies on their
budget line and gives the highest satisfaction.

Understanding Consumer Equilibrium through the Indifference Approach

Let’s imagine you are choosing between two of your favourite chocolates: KitKat and
DairyMilk. You have a limited amount of money, and your goal is to spend it in a way that
brings you the most happiness or satisfaction.

Budget Line (AB)

• The budget line shows all the combinations of KitKat and DairyMilk you can afford
with your money.
• Any combination on this line, like points C, D, and E, is affordable.
• Combinations beyond this line (like on curve IC₃) are too expensive.

Indifference Curves (IC₁, IC₂, IC₃)

• These curves represent your preferences.

• Any point on an indifference curve shows a combination of KitKat and DairyMilk
that gives you the same level of satisfaction.
• IC₃ gives you the highest satisfaction, but it’s not affordable.
• IC₁ is within your budget, but gives lower satisfaction.
• IC₂ is just right — the highest satisfaction within your budget.

Consumer Equilibrium: Point D

• The consumer’s equilibrium is at point D, where the budget line touches (is
tangent to) the highest affordable indifference curve (IC₂).
• Why D?
o You can afford C and E, but they lie on a lower satisfaction curve (IC₁).
o At D, you're spending your money wisely and getting the maximum possible
satisfaction.

The Slope: MRS and Prices

• At the point of equilibrium (D), the slope of the budget line is equal to the slope of
the indifference curve.
• This slope is known as the Marginal Rate of Substitution (MRS) — how much of
KitKat you're willing to give up for one more DairyMilk (or vice versa).
• Equilibrium happens when:

MRSXY =Price of X / Price of Y

In Short:

• Budget Line = What you can afford.

• Indifference Curve = What gives you the same happiness.
• Consumer Equilibrium = The point where you are spending wisely and feeling most
satisfied, which happens when the budget line is tangent to the highest possible
indifference curve.
 4. Effects of Changes in Income and Prices

Income Changes:

• Leads to a parallel shift of the budget line.

• Can result in a new consumer equilibrium.
• Increase in income: Budget line shifts outward → consumer can reach a higher
indifference curve.
Example: More income lets you buy more clothes and food, increasing satisfaction.

Price Changes:

• Causes rotation of the budget line.

• Impacts the quantity demanded of the good whose price has changed.

Price decrease of one good: Budget line pivots → slope changes.

Example: If the price of rice drops, you can buy more rice for the same money,
allowing a better combination with curry.

Suppose, from our original budget of $56, movies double in price from $7 to $14. Again, to
plot the new graph, simply find the new intercepts:
Budget: $56

Price of movies: $14

Price of T-shirts: $14

Maximum number of movies (y-intercept): $56/$14 = 4

Maximum number of T-shirts (x-intercept): $56/$14 = 4

5. Income and Substitution Effects (of a Price Change)

What Affects Consumption?

People buy more or less depending on their income and the prices of goods.

Income Effect

• When your income increases, you can afford to buy more.

• When your income decreases, you buy less or cheaper things.
• You might not always buy more items- sometimes you just choose better quality
ones.
• The price change affects the real purchasing power of the consumer:
o Normal goods: Demand increases with more real income.
o Inferior goods: Demand decreases with more real income.

When prices go up or down, it changes what you can afford — this is called
your real purchasing power.
🛍️ Normal Goods

These are things people buy more of when they have more money.

• Example: Branded clothes, fresh fruit, or eating at nice restaurants.

• So, if prices drop or your income goes up, you feel richer — and you buy more of
these goods.

🥫 Inferior Goods

These are things people buy less of when they have more money.

• Example: Instant noodles, cheap transport, or second-hand clothes.

• When you earn more or prices go down, you feel richer and switch to better options,
so you buy less of these goods.
👛 In Summary:

• Normal goods → Buy more when you feel richer.

• Inferior goods → Buy less when you feel richer (you upgrade to something better).

Substitution Effect

🔄 What is the Substitution Effect?

The substitution effect happens when you switch from one product to another because of
a change in price.

🧃🍫 Example:

Let’s say you like chocolate bars and juice boxes.

• A chocolate bar costs R10.

• A juice box costs R5.

If the price of chocolate goes up to R15, you might decide it’s too expensive now, and
instead buy more juice — because it’s the cheaper option.
This switch is called the substitution effect.

💡 In Simple Terms:

• When a product becomes more expensive, you might stop buying it.
• You look for something cheaper but similar to replace it.
• That change in your choice is the substitution effect.
• When the price of something goes up, people look for cheaper alternatives.
• When prices drop, people might choose to buy the item that was too expensive before.

Example: If private college becomes a little cheaper, more people may choose it over
public college. Businesses also do this — they may outsource work to cheaper labor
to save costs.

Total Effect of a Price Change = Substitution Effect + Income Effect

Substitution Effect (SE): When price of a good falls, it becomes cheaper relative to other
goods → you substitute towards it.

• Example: If oranges become cheaper than apples, you may buy more oranges.
Income Effect (IE): A lower price increases your real income (increases purchasing power)
→ you can buy more of both goods.

• Example: You now afford more oranges and maybe a few more apples too.

Key Differences

Income Effect Substitution Effect

Caused by change in income Caused by change in prices
Affects how much people can afford overall Affects what people choose to buy instead

Other Useful Concepts

• Marginal Propensity to Consume (MPC): This shows how likely people are to
spend any extra income they get.
o Example: If someone gets R100 extra and spends R80 of it, their MPC is 0.8.

Bottom Line

What people buy depends on:

• How much money they have (income)

• How much things cost
• Whether there are cheaper options

7. Derivation of the Demand Curve

As the price of a good changes and other things remain the same:

• New equilibriums are plotted.

• The demand curve is downward sloping: as price ↓, quantity demanded ↑.

Example: As the price of chocolate drops from R20 to R10 to R5, the student chooses
more chocolate each time → demand curve slopes downward.

By plotting the different equilibrium points as price changes, the individual demand
curve can be derived.
 Summary Table: Key Concepts

Concept Definition / Explanation

Indifference Curve Shows equal satisfaction from various good combinations
Budget Line All affordable combinations given income & prices
Consumer Budget line is tangent (touches but doesn’t cross it) to highest
Equilibrium possible IC
Substitution Effect Change in demand due to relative price change
Income Effect Change in demand due to change in real income
Demand Curve Shows relationship between price and quantity demanded