Also known as the iso-utility curve, an indifference curve plots out the various combinations of goods that deem you indifferent because each point along the curve yields the same level of satisfaction. In Graph 1, U1(utility curve 1) yields the least satisfaction, while U3 (utility curve 3) yields the most satisfaction. To put it simply, an indifference curve is a graphical representation of one’s indifference schedule.
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The indifference curve follows two assumptions: full rationality, and diminishing marginal rate of substitution (MRS). Consumers are expected to behave in a rational manner, always aiming to maximise total utility. If a consumer knows that having too much of something reduces his utility, he will not make a particular decision. With reference to Graph 1, the consumer will always know that the choices at U3 makes him happier, as compared to U1, or U2.
MRS is defined as the amount of good A that a consumer is willing to trade off for good B while maintaining the same level of utility. Assuming that U3 yields satisfaction level 100, MRS measures how much of good A the consumer will give up, to get more of good B. The willingness to trade usually slows down after a certain point, thus the concept of a diminishing MRS. It simply means that the substitution rate is decreasing. This assumption makes the indifference curve convex to the origin.
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Like all realistic scenarios, the indifference curve is faced with a budget constraint – one cannot exceed his/her endowment. It appears as a straight line in the model. The term “budget” is used loosely in this topic, because it can represent anything – wealth, time, capacity, etc.. It is important to identify the right constraints, so that we can make the right decisions within our means. An incorrect budget constraint may lead to sub-optimal decisions. To be able to make the right decisions, economists make use of the indifference curve and budget line to solve the optimisation problem. How exactly do we choose an optimal bundle?
Room for Dessert?
In an economist’s optimisation problem, the hipster quote “there is always room for dessert”, may not necessarily be true.
Let’s assume we have a friend Jane, who has a sweet tooth. Every day, she has to decide how much of her dinner to consume, so that she can still have dessert after her meal. While she is obsessed with dessert, it does not supply her with adequate nutrients, and there is a limit to how much food she can ingest. Here we have an optimisation problem – Jane needs to maximise her well-being by choosing the optimal bundle of how much to eat for dinner, and dessert. If you find that the above scenario familiar, you’ve already been thinking like an economist!
Choosing the Right Bundle
Jane’s first step is to determine her satisfaction levels for various bundles. Without a doubt, she will prefer IC5 (indifference curve 5) in Graph 2 because it makes her happiest. However, with her current budget constraint (stomach capacity), she can never achieve IC5. She would go for IC3 instead, because that’s the highest satisfaction she can achieve, with her current budget constraint.
The story does not end there, because there are various bundles along the same indifference curves. The bundles each yield the same level of satisfaction, but some exceeds the budget constraint. Having more dinner, and less dessert keeps Jane healthy, but her stomach cannot take all the food. On the other hand, having less dinner, and more dessert also makes her feel bloated. The only bundle Jane should choose, would be the point on IC3 that is tangent to her budget constraint. At that point A, she finishes her dinner, and dessert feeling satisfied, instead of stuffed.
The beauty of the indifference curve is that it is a concept extendable to even the simplest decision-making scenario, rather than being a strictly economics-related model. Adore two dresses, but only have money to purchase one? You’ll realise that you start asking yourself the practicality of the dress, number of times you will actually wear that dress, and if it is worth the value. Your brain subconsciously calculates your utility for both dresses, causing you to purchase the one that you prefer.