Date : September 28, 2022

2022-23 (Odd Semester)

Branch : MBA
Year : First Year – MB1

Name of Subject: Managerial Economics

(KMBN102)

UNIT 01
Name of Faculty: Saira Banoo Warsia
Name of Department: Management Studies

[[[

BABU BANARASI DAS

NORTHERN INDIA INSTITUTE OF TECHNOLOGY
LUCKNOW
 NATURE AND SCOPE OF MANAGERIAL ECONOMICS

Nature of Managerial Economics:

Recently Managerial Economics has emerged as a separate subject in Management
Courses. This is primarily due to the following reasons:
1. Growing Complexity of business decision making process due to changing
market conditions and business environment.
2. Increasing use of economic logic, concept, theories and tools of economic
analysis in the process of business decision making.
3. Rapid increase in demand for professionally trained managerial manpower.
Earlier businesses were managed by individuals or business families. Fewer large
industries were there and the scale of business operation was relatively small. So the
more businesses became complex the more were economic concepts and tools
applied to decision making.
Now the question here is what is Managerial Economics?
Before we answer this question let us see what is Economics?
Economics maybe understood as a social science which studies human
behaviour in relation to optimizing allocation of available resources to
achieve the given ends.
The basic function of economics is to study how people- individuals, households, firms
and nations- maximize their gains from the limited resources and opportunities. And
economics terminology would call this as a maximizing or optimizing behaviour.

An appropriate business decision making requires a clear understanding of market

conditions, market fundamentals and business environment. The application of
economic concepts, theories, logic and analytical tools in the assessment and
prediction of market conditions and business environment has proved to be of great
help in business decision making.

So if we were to understand Managerial Economics then we can say that economic

theories and analytical tools which are widely used in business decision making have
been crystallized into a separate branch of management studies called Managerial
Economics or Business Economics.
 Definition of managerial economics
Managerial Economics has been defined in a number of ways but the following
definitions may be noted for the purpose of our understanding.

“Managerial economics is concerned with the application of economic concepts

and economic analysis to the problems of formulating rational managerial
decisions.”

- Edwin Mansfield

Managerial Economics may also be defined as “the integration of economic

theory with business practice for the purpose of facilitating decision
making and forward planning by management”.

- M.H.Spencer & L. Siegelman

Why do managers need to know economics ?

Economics contributes to the managerial profession. The basic function of the

manager of a business firm is to achieve the objective of the firm which is to
maximise its goals with limited resources.

Resources be it finance, men or material are all limited so the basic task of the
management is to optimize the use of the resources.

How does economics contribute to managerial functions?

Baumol, has pointed out three main contributions of economic theory to business
economics.

(i) Economic theories can contribute in building analytical models which help to
recognize the structure of managerial problems, eliminate the minor details
which might obstruct decision making and help to concentrate on the main
issue.

(ii) Economic theories enhance the analytical capabilities of the business analyst.

(iii) They offer clarity to various concepts used in business analysis which helps
managers to avoid conceptual pitfalls.

Business decisions and economic analysis

Business decision making is essentially a process of selecting the best out of the
alternative opportunities open to the firm. The process of decision making comprises
4 main phases:
(i) Determining and defining the objectives to be achieved.

(ii) Collection and analysis of information regarding economic, social, political and
technological environment and foreseeing the necessity and occasion for decision.

(iii) Inventing, developing and analyzing possible course of action.

(iv) Selecting a particular course of action from the available alternatives.

Today a personal business sense and experience alone is not sufficient to run
businesses. Businessmen need to be updated on market conditions and business
environment.

Economic theories state the functional relationship between 2 or more economic

variables.

Application of economic theories facilitates decision making in 3 ways:

(i) It gives clear understanding of various economic concepts.

(i.e., Cost, Price, Demand, so for example the concept ‘cost’ includes ‘Total’,
‘Average’, ‘Marginal’, ‘Fixed’, ‘Variable’, Actual cost. So when you study economics it
is clarified which cost concepts are relevant.

(ii) It helps in ascertaining the relevant variables and specifying the relevant
data.

For example, it helps in deciding what variables need to be considered in estimating

the demand for two different sources of energy- petrol and electricity.

(iii) Theories state the general relationship between 2 or more economic

variables and events.

Theories provide consistency to business analysis and help in reaching right

conclusions.

Scope of Managerial Economics

Managerial Economics tries to help the managers in taking important decisions
particularly in situations involving risk and uncertainty.

Decisions that are included in the scope of Managerial Economics is as follows:

1. Profit Decision

Micro economics decision making is concerned with a business firm. Traditionally,

profit maximization was assumed to be the sole objective of the firm but today this
may not be the case.
Profit decisions can be taken only through critical analysis of business objectives. The
important areas covered under this head are:

(i) Nature and measurement of profit.

(ii) Profit policies and techniques of profit planning like Break Even Point
analysis.

2. Demand Decision

Profit depends on the sales volume and revenue earned. Sales and revenue in turn
are dependent on the nature of individual and market demand.

So the management not only has to decide the current demand for its product but
also has to estimate the future demand. Topics studied here are:

(i) Demand determinants

(ii) Demand distinctions
(iii) Demand forecasting

These are addressed in the Theory of Demand and demand analysis.

3. Production Decision

Demand and supply are related to each other and so demand decisions are
followed by production decisions.

Once a firm estimates the demand for the product then it needs to take the
following decisions before the production takes place:

(i) Where to locate the production unit?

(ii) How much to produce in short run and in long run?
(iii) What would be the scale of production?
(iv) What will be the least cost combinations of inputs required to produce the
concerned output?

All these issues are addressed through an analysis of production function of the
firm.

4. Price Output Decision

Profit decisions mainly depend upon two related questions:
(i) What is the cost of production?
(That is at what price and in what quantity are the productive factors obtained from
factor markets)
(ii) What is the revenue received from the sale of the product?
(That is at what price and in what quantity are the products sold in the commodity
markets)

These issues can be addressed through an analysis of market structure that is the
form of competition which a firm faces.

5. Investment Decision
The decisions taken here involve:
(i) How much to invest?
(ii) What should be the rate of investment?
(iii) What should be the proposition of new investment and replacement
investment?
Such decisions can only be taken through proper analysis of Marginal efficiency of
capital (rate of return) and Cost of Capital (rate of investment).

Background to Managerial Economics

Economics broadly may be classified as Micro Economics and Macro economics.

Micro Economics:

Definition: Microeconomics is the study of individuals, households and firms'

behavior in decision making and allocation of resources. It generally applies to
markets of goods and services and deals with individual and economic issues.

Description: Microeconomic study deals with what choices people make, what
factors influence their choices and how their decisions affect the goods markets by
affecting the price, the supply and demand.

Therefore, the study of individuals like a single firm, single customer, single producer
etc.is classified as microeconomics.

Macro Economics:

Definition: Macroeconomics is the branch of economics that studies the behavior and
performance of an economy as a whole. It focuses on the aggregate changes in the
economy such as unemployment, growth rate, gross domestic product and inflation.

Description: Macroeconomics analyzes all aggregate indicators and the

microeconomic factors that influence the economy. Government and corporations use
macroeconomic models to help in formulating of economic policies and strategies.
Therefore, the study of the whole economy, national Income, national consumption,
total investment, total money supply, overall employment is classified as
macroeconomics.

Difference between Micro economics and Macro economics

Microeconomics Macro economics

Microeconomics deals with economic Macroeconomics deals with economic
issues related to small economic units issues at the level of economy as a whole.
that is an individual household, individual
consumer or an individual firm.
Basis of microeconomics is the price Basis of macroeconomics are determined
mechanism which operates with the help by aggregate demand and aggregate
of demand and supply forces of an supply.
individual.
The objective of microeconomics on the The objective of macroeconomics is to
demand side is to maximise utility attain full employment, economic growth
whereas on the supply side is to and a favourable balance of payment.
maximise profit at minimum cost.
The scope of microeconomics is limited. The scope of macroeconomics is wide.

Reference:

https://economictimes.indiatimes.com/definition/microeconomics

NOTE: NON ECONOMIC background people are requested to please read

additional content too to be clear about Micro and Macroeconomics. Even
googling would be sufficient if no text book is available.

Difference between Traditional Economics and Managerial

Economics

Traditional Economics has both micro and macro aspects whereas Managerial
Economics is essentially micro in character. Traditional Economics deals mainly with
the theoretical aspect only whereas Managerial Economics deals with the practical
aspect.

Traditional Economics Managerial Economics

Traditional has both micro and macro Managerial economics is essentially micro
aspects. in character.
Traditional economics is both positive Managerial economics is normative
(what is being done) and normative (what science.
should be done) science.
Traditional economics deals with the Managerial economics deals with the
theoretical aspects. practical aspects.
Traditional economics analyses problems Managerial economics studies the
from both micro and macro viewpoint. activities of an individual firm or unit.
Traditional economics studies the Managerial economics studies the
economic aspects. economic and non-economic aspects.
Traditional economics deals with the body Managerial economics involves the
of economic principles. application of economic principles to the
problems of a firm.
The scope of Traditional economics is The scope of Managerial economics is
vast. limited.

Fundamental Concepts/Principles of Managerial Economics

1. Opportunity Cost Principle:

Opportunity cost is related to the alternative uses of scarce resources. Both natural
and man-made resources are scare and also have alternative uses. This scarcity and
alternative uses of available resources gives rise to the concept of opportunity cost.

The opportunity cost of anything is the next best alternative that could be produced
by the same factors of production consisting of same amount of money.

For example,

A firm has Rs.10 lakh at its disposal and there are three alternatives available before
the firm:

Alternative 1: Expand the size of the firm: Rs. 5 lakh

Alternative 2: Setting up New production: Rs. 4 lakh

Alternative 3: Setting up a Joint venture: Rs. 3 lakh

Based on the return, the firm would pick up the first alternative and as such would
sacrifice the next best available alternative that is 2. This 2 nd alternative is expected
to generate an annual return of Rs. 4 lakh.

In economic sense, Rs.4 lakh is called an Annual Opportunity Cost of an Annual

Income of Rs.5 lakh.

The opportunity cost of availing an opportunity is the expected income forgone from
the second best opportunity of using the resources.

The concept of opportunity cost is useful in all types of business decisions where
there are at least 2 alternative options involving cost and benefits.

2. Marginal Principle

The first thing we need to understand is that what is meant by Marginal. In

economics, marginal refers to an addition by one unit. The marginal principle says
that if the marginal benefits of an activity exceed the marginal costs of an activity
then increase the level of that activity. But if the marginal costs exceed the marginal
benefits of an activity then decrease the activity.

If it is possible one should pick up the level at which the marginal benefit
equals the marginal cost.

For example, the total cost of flying a plane from London to New York will be several
thousand Pounds. However, with a plane 50% full, the cost of carrying one extra
passenger is quite low. Therefore, the marginal cost of carrying the 102nd passenger
is very low compared to the total overall cost.

The marginal principle tell us how to increase or decrease the levels of an

activity by looking at the Marginal Costs and Marginal Benefits.

3. Incremental Principle

Incremental cost principle is an extension of the concept of Marginal Cost.

Marginal cost relates to that cost which occurs on producing one additional unit of
product, but this is not practical to use. For an industrialist it is very difficult to find
the cost of each additional unit every time. This is because in practice the output is
increased by a number of units at a time and not by a single unit. The industrialist
therefore adopts the incremental principle which tries to find out the change in total
cost on account of change in the level of business activity.

For example, a firm is producing 5000 units of a commodity and the cost incurred on
producing these 5000 units is Rs.10,000/-. But the firm wants to increase the
production to 6000 units for which the costs will rise to Rs.14,000/-.
The incremental cost then is Rs.4000, that is 14000 – 10000, for producing 1000
additional units.

The concept of incremental cost is generally considered to decide an

acceptance or rejection regarding expansion of units involving additional
costs

4.Time Perspective Principle

It is usual in economics to divide the time period in two parts:

(i) Short run:

This refers to that period of time wherein some input factors are kept fixed while
others are variable, therefore, the supply is relatively inelastic.

(ii) Long run:

This is defined as that period of time when all input factors are variable. In this period
supply can accordingly be adjusted as per the prevailing market conditions.

A business decision should take into account both the short run and long run effects
on revenues and costs so as to be able maintain a right balance between long-run
and short run perspectives.

5. Discounting Principle

This fundamental principle of economics states that the worth of Re.1 which will be
received tomorrow is less than the worth of Re.1 received today. This is called Time
value of Money.
For example, If we have the option of taking 10000/- today or 10000/- one year
later, we would naturally prefer to take this amount today. This is because of two
reasons:

(i) The future is always uncertain.

(ii) The amount that we receive today may be invested and in such a case we
may earn some interest on Rs.10,000/-, which will be more than the
value of 10,000/- received after one year.

The principle of discounting is important while assessing investment projects

that is investment planning or capital budgeting.

There is another way of illustrating the discounting principle. One may ask how much
money today would be equivalent to Rs. 100 a year from now.

If the rate of interest is 5% the present value of Rs. 100 to be received after
one year is:

100
𝑃𝑉 =
1+𝑖
𝟏𝟎𝟎
= 𝟏+ .𝟎𝟓

=95.24

Where PV = present value and

i = rate of interest

As a cross check one may multiply the PV of Rs. 95.24 by 1.05 to determine how
much money will have accumulated during the year at 5%. The answer is Rs. 95.24 x
1.05 = Rs.100. In other words, Rs. 95.24 plus the interest on it will accumulate to an
amount exactly equal to Rs. 100.

An individual who can earn 5% on his (or her) money should be indifferent between
receiving Rs. 95.24 today and Rs. 100 after one year. So the present value of Rs. 100
is Rs. 95.24.

The same analysis can be extended to any number of periods.

A sum of Rs. 100 two years from now is worth:

So a general pattern seems to be emerging.

In general, the present value of a sum to be received at any future date can
be found out by using the following formula:

where PV = Present value

r = amount to be received in future

i = rate of interest

n = number of years lapsing between the receipt of R

If the receipts are made available over a number of years, the formula becomes:

Check this link for Time Value of Money PPT: Pearson Education9

https://slideplayer.com/slide/1507347/

6. Equi Marginal Principle

The equi-marginal principle is related with the law of Equi-marginal utility which
states that a utility maximising consumer distributes his expenditure in such a
manner between various goods and services he uses, that the marginal utility derived
from each unit of expenditure on various goods and services is the same.

In this manner he maximises his total satisfaction.

The equi marginal principle can be applied only in cases where firms have limited
resources and these resources have alternative uses.
The Equi-marginal Principle in Economics (Managerial Economics) states that different
courses of action should be pursued up to the point where all the courses give equal
marginal benefit per unit of cost. It claims that a rational decision-maker would
certainly allocate or her resources in a fashion that the ratio of marginal returns and
marginal costs of various uses of a provided resource or of various resources in a
given use is the same.

For instance, a consumer looking for optimum utility (satisfaction) from his
consumption basket, will allocate his consumption budget on services and products
such that,

MU1/MC1 = MU2/ MC2 = ………. = MUn/ MCn

Where MU1 = marginal utility from good one

MC1 = marginal cost of good one and so on.

In the same manner, a manufacturer in search of maximum profit would use the
technique of production (input-mix.) which will ensure:

MRP1/MC1 = MRP2/MC2=…….. =MRPn/MCn

You can easily observe that if the above equation is not satisfied, the decision makers
could increase his utility/profit by shuffling the resources/input e.g. if
MU1/MC1>MU2/MC2 the customer would certainly add to his utility by purchasing
more of item one and less of item two.

Suppose a firm has 100 units of Labour.

And it is involved in 5 activities: A,B,C,D and E.

The firm can increase any one of these activities by employing more labour but only

at the cost i.e., sacrifice of other activities.

An optimum allocation cannot be achieved if the value of the marginal product is

greater in one activity than in another. It would be, therefore, profitable to shift

labour from low marginal value activity to high marginal value activity, thus

increasing the total value of all products taken together.

If, for example, the value of the marginal product of labour in activity A is Rs. 50

while that in activity В is Rs. 70 then it is possible and profitable to shift labour from

activity A to activity B. The optimum is reached when the values of the marginal

product is equal to all activities. This can be expressed symbolically as follows:

VMPLA = VMPLB = VMPLC = VMPLD = VMPLE

Where VMP = Value of Marginal Product.

L = Labour

ABCDE = Activities

i.e., the value of the marginal product of labour employed in A is equal to the value of

the marginal product of the labour employed in В and so on. The equimarginal

principle is an extremely practical notion.

It is behind any rational budgetary procedure. The principle is also applied in

investment decisions and allocation of research expenditures. For a consumer, this

concept implies that money may be allocated over various commodities such that

marginal utility derived from the use of each commodity is the same. Similarly, for a

producer this concept implies that resources be allocated in such a manner that the

marginal product of the inputs is the same in all uses.

Reference and Extra reading:

https://www.yourarticlelibrary.com/managerial-economics/managerial-economics-6-

basic-principles-of-managerial-economics-explained/28361
 Utility Analysis

BASIS OF CONSUMER DEMAND: UTILITY

The consumer demands a commodity because they derive or expect to derive UTILITY
from that commodity. The expected utility from a commodity is the basis of demand
for it.

Utility though is a common term, it has a specific meaning and use in the analysis of
consumer behaviour.

• UTILITY refers to the want satisfying power of a commodity.

• In objective terms it may be defined as the amount of satisfaction derived from

the consumption of a commodity.

MEANING OF UTILITY

The concept of utility can be looked upon from two angles:

• Commodity Angle

• Consumer’s Angle

From a commodity angle utility is the want satisfying property of a commodity.

From a consumer’s angle, utility is the psychological feeling of satisfaction, pleasure,

happiness or well-being which a consumer derives from the consumption, possession
or the use of a commodity.

CHARACTERISTICS OF UTILITY

1. Utility is subjective.

2. Utility is not measurable.

3. Utility is variable.
4. Utility is different from usefulness.

The concept of a want satisfying property of a commodity is ABSOLUTE in the sense

that this property is ingrained in the commodity irrespective of whether one needs it
or not. For example, a pen has its own utility irrespective of whether a person is
literate or illiterate.

On the other hand, from a consumer’s point of view, utility is a post consumption
phenomenon as one derives satisfaction from a commodity only when one consumes
or uses it. Utility in the sense of satisfaction is a ‘subjective’ or ‘relative’ concept
because:

1. A commodity may not be useful for all. Eg. Cigarettes do not have any utility for
non-smokers and meat has no utility for strict vegetarians.

2. Utility of a commodity varies from person to person and from time to time.

3. A commodity need not have the same utility for the same consumer at different
points of time, at different levels of consumption and at different moods of a
consumer.

In consumer analysis, only the subjective concept of utility is used. Now let us study
some concepts used in utility analysis.
(i) Total Utility
Assuming that utility is measurable and additive, total utility may be defined as the
sum of the utilities derived by a consumer from the various units of goods and
services he/she consumes.

Suppose a consumer consumes 4 units of a commodity X at a time and derives utility

as 𝑼𝟏 , 𝑼𝟐 , 𝑼𝟑 and 𝑼𝟒 , his total utility (𝑻𝑼𝒙 ) from commodity X can be measured
as follows:
𝑻𝑼𝒙 = 𝑼𝟏 +𝑼𝟐 +𝑼𝟑 +𝑼𝟒
If a consumer consumes n number of commodities, his total utility, 𝑻𝑼𝒏 , will be the
sum of total utilities derived from each commodity.
For instance, if the consumption of goods are X,Y and Z and their total respective
utilities are 𝑼𝒙 , 𝑼𝒚, and 𝑼𝒛 , then,
 𝑻𝑼𝒏 = 𝑼𝒙 +𝑼𝒚 +𝑼𝒛
(ii) Marginal Utility
Marginal utility is the utility derived from the marginal unit consumed.
OR
Marginal Utility refers to the additional utility derived from the consumption of an
additional unit of a commodity.
It may also be defined as the addition to the total utility resulting from the
consumption ( or accumulation ) of one additional unit.
Marginal Utility thus refers to the change in the Total Utility (i.e.,  TU) obtained from
the consumption of an additional unit of a commodity. It may be expressed as:
𝚫𝑻𝑼
𝚫𝑸
Where, TU= Total Utility
Q=  in quantity demanded by one unit.
This can also be expressed as:

𝑴𝑼𝒏 = 𝑻𝑼𝒏 - 𝑻𝑼𝒏−𝟏

Law of Diminishing Marginal Utility

The law of Diminishing Marginal Utility states that as the quantity consumed of a
commodity increases, the utility derived from each successive unit decreases,
consumption of all other commodities remaining the same.

In simple words, when a person consumes more and more units of a commodity per
unit of time for example, Ice-cream, keeping the consumption of all other
commodities constant, the utility which he derives from the successive units of
consumption goes on diminishing.

This law applies to all types of consumer goods, durable and non-durable sooner or
later.
The law can be illustrated numerically and graphically.

Total utility is increasing but at a diminishing rate. The total utility increases from 20
to 50 and then starts decreasing. When we look at the graph we can see that
Marginal Utility curve is a downward sloping curve which shows that marginal utility
goes on decreasing as consumption increases.

At 5 units, the TU reaches its maximum level, and the MU becomes 0. This is the
point of saturation. Beyond this point MU is negative and TU begins to decline.

The downward sloping MU curve illustrates the Law of Diminishing Marginal Utility.

Why does the MU decrease?

When a person consumes successive units of a commodity, his need is satisfied by

degrees in the process of consumption and the intensity of his need goes on
decreasing. Therefore, the utility obtained from each successive unit goes on
decreasing.

Assumptions of the Law

1. The unit of consumer good must be a standard one.

2. The consumer’s taste and preferences must remain the same during period of
consumption.

3. There must be continuity in consumption.

4. The mental condition of the consumer must remain normal during the period of
consumption.

Theory of Consumer Behaviour/ Utility Analysis/ Cardinal Utility

and Ordinal Utility
The theory of consumer behaviour is based on the assumption that a consumer is
rational and tries to maximise his satisfaction or utility.
But in order to achieve this objective he must be able to compare the utility he
derives from different goods and services.
To determine consumer equilibrium and compare utilities following two approaches
are used:
1. Cardinal Approach
2. Ordinal Approach
The cardinal approach postulates (says) that utility can be measured.
The ordinal approach postulates (says) that utility is not measurable but is
of an ordinal magnitude.

Cardinal Approach
This approach says utility is measurable in monetary units (i.e., the amount of
money) a consumer is prepared to pay for another unit of a commodity.
This approach is based on two assumptions:
(i) Axiom of diminishing marginal utility
(ii) The total utility of a ‘basket of goods’ depends on the quantities of
individual commodities. If there are ‘n’ commodities in the bundle with
quantities 𝐪𝟏 , 𝐪𝟐 , 𝐪𝟑 ….𝐪𝐧 , the total utility is:

U= f (𝐪𝟏 , 𝐪𝟐 , 𝐪𝟑 ….𝐪𝐧 )
The theory states that the condition for the equilibrium of the consumer is the
equality of the ratios of MU of the individual commodities to their prices, i.e.,
 𝑴𝑼𝒙 𝑴𝑼𝒚 𝑴𝑼𝒏
= =….=
𝑷𝒙 𝑷𝒚 𝑷𝒏

The utility derived from spending an additional unit of money must be the same for all
the commodities. If the consumer derives greater utility from one commodity, he can
increase his level of satisfaction by spending more on that commodity and less on the
others until the above equilibrium condition is fulfilled.

Weaknesses of this approach:

1. The assumption of cardinal measurement of utility is highly doubtful. Utility is a
subjective phenomenon, as such it cannot be measured in any objective
numbers.
2. The axiom of Diminishing Marginal Utility has been established from
introspection.

Diamond- water paradox

Adam Smith wrote about his famous diamond – water paradox but was not able to
solve as the concept of Marginal utility and tools of demand and supply were not
known to him.

According to Smith, there was nothing more important than water, but it has no
price, while diamond is hardly of any value to us and still dictates a high price.

FROM DEMAND SIDE

A man cannot live without water and so the total utility of water is very high but since
it is consumed in large quantities its marginal utility declines due to the law of
Diminishing Marginal Utility.

And the price a consumer is willing to pay for a commodity is determined by

its marginal utility, not the total utility.

And because the marginal utility of water is low, the price at which the market supply
of water will come to the market has to be low.

Now diamonds are not essential to life like water but consumers possess few so the
marginal utility of diamond is high so they are willing to pay high prices for diamonds.
FROM SUPPLY SIDE
The marginal cost that is the additional cost of producing one more unit of output of
water is low because additional amount of water can be produced easily.

So the demand and supply curves of water intersect where,

Marginal price is low and

Marginal Volume is large

And the demand and supply curves of diamond intersect where,

Marginal price is high and

Marginal Volume is low

Ordinal Utility
This approach says utility is not measurable. Utility is an ordinal magnitude. (The
consumer needn’t know in specific units the utility of various commodities to make his
choice. It is sufficient if he is able to rank the various ‘basket of goods’ according to
the satisfaction that each bundle gives him. He must be able to determine his order of
preference among different bundles of goods.)

The ordinal approach employs the device of indifference curves for the purpose of
determination of consumer equilibrium.

A set of indifference curves plotted in an ‘indifference map’ determine the

consumer’s order of preference.

With the market prices of commodities and the money income to be spent on them,
we can locate the attainable combinations of commodities. These can be plotted in
the form a straight line, called the Budget Line.

Assumptions of the Theory of Indifference Curves:

1. Non-satiety: ( Non- Satisfied )
A larger basket of goods is always preferred to a smaller basket.
2. Rationality:
Consumer aims at the maximization of his utility, given the market prices and money
income. He is assumed to have all relevant information.
3. Consistency:
The consumer is consistent in his choice. If he prefers a commodity basket A over
commodity basket B in one period of time he will not prefer B over A in another
period of time.
4. Transitivity:
If commodity basket A is preferred to B and B is preferred to C then, A is preferred to
C.
5. Diminishing Marginal Rate of Substitution:
(Marginal Rate of Substitution= it is the rate at which the consumer is willing to
substitute one good for another without changing the level of satisfaction)

Indifference Curves (Also known as ISO-Utility Curve)

An indifference curve is the locus of points-particular combinations of baskets of two
commodities- which give the same level of satisfaction (or utility) to the consumer, so
that he is indifferent as to the particular combination he consumes.
Indifference Schedule:
Combination Biscuits Apples
A 1 12
B 2 8
C 3 5
D 4 3
E 5 2
Indifference Curve:
Y

12
8
Apples 5

3 IC

2
O 1 2 3 4 5 X

Biscuits
This schedule shows that a household gets equal satisfaction from all the five
combinations A,B,C,D and E.
At combination ‘A’, the household has 1 unit of biscuit and 12 units of apples. At
combination ‘B’ the household has 2 units of biscuits and 8 units of apples. In order to
have one more unit of biscuit he has to sacrifice some amount of apples that is 4
units in this case in such a way that there is no change in the level of satisfaction
from each combination.
This is what is also termed as Marginal rate of Substitution. The amount of apples
the household substitutes to consume additional units of biscuits is the marginal rate
of substitution for the household. So at combination ‘B’ the marginal rate of
substitution is 1:4, at ‘C’ 1:3 and so on.

Indifference Map
An indifference map is a group or set of indifference curves each one of which
represents a given level of satisfaction.

Good Y 𝑰𝑪𝟒

𝐼𝐶3

𝐼𝐶2
𝐼𝐶1

O X

Good X

The figure above shows an indifference map consisting of various indifference curves
𝑰𝑪𝟏 , 𝑰𝑪𝟐 , 𝑰𝑪𝟑 and 𝑰𝑪𝟒 and each of these curves represent a different level of
satisfaction.
The more the distance of the curve from the origin, the higher is the level of
satisfaction.
Marginal Rate of Substitution
Marginal rate of substitution (MRS) is the rate at which the consumer is willing to
substitute one good for another without changing the level of satisfaction. The MRS of
Y for X is (𝑴𝑹𝑺𝒚𝒙 ) and is defined as the amount of Y, the consumer is willing to give

up to get one additional unit of X so that the same level of satisfaction is maintained.

Budget Line

Indifference curves tell us what choices the household would like

to make and the budget line tells us what the household can do.

To find out what quantities of two goods will be purchased by the

household, we must know how much expenditure the household wants to
incur on the commodities and what are their prices.

Combinations of Clothing and Food

Units of Units of Expenditure
Clothing Food
5 0 5 x 40 + 0 x 20 = 200
4 2 4 x 40 + 2 x 20 = 200
3 4 3 x 40 + 4 x 20 = 200
2 6 2 x 40 + 6 x 20 = 200
1 8 1 x 40 + 8 x 20 = 200
0 10 0 x 40 + 10 x 20 = 200

Suppose the consumer has Rs.200 to spend on food and clothing. The
price of food is Rs.20 per unit and the price of clothing is Rs.40 per unit,
so we get the above combinations of both the commodities.
These combinations represent the maximum amount that can be
purchased with an expenditure of Rs.200 and at the given prices the
same can be plotted graphically.
Y

5 A

4 B G
C A combination like G is not
attainable as it lies outside
Clothing 3
the Budget space.

2 H D

A combination like H is
1 attainable as money E
income is not spent
completely F
X
0 2 4 6 8 10

Food

BUDGET LINE

A budget line therefore shows various combinations of two commodities

which can be purchased with a given budget at given prices of the two
commodities.