The prices change in the indifference diagram can be converted into a standard demand diagram, as shown below.ĭistinguishing the income and substitution effect

If we assume a basket of only two types of good, and hold income constant, we can derive a demand curve which shows the quantity demanded for a good at different prices. Indifference curves can be used to derive a demand curve. If we keep altering price, the sequence of new equilibrium points provides us with a price-consumption line, as shown below. If we change the price of one good, say good x, the budget line will rotate, fixed at the y-axis, and a new point of tangent between the new budget line and new indifference curve will be found. Indifference analysis can help us understand how demand responds to changes in price. When this condition is met the individual is maximising their total utility. Hence, at equilibrium the ratio of MU to prices is identical for all goods and services bought, meaning that each marginal unit of currency spent yields the same utility – referred to as the ‘equi-marginal principle’. (-) MU x/MU y = (-) P x/P y, which can be re-written as: When in equilibrium, the gradient of the budget line (the ratio of prices P x/P y) will equal the gradient of the indifference curve, which when expressed in terms of marginal utility, is (-) MU x/MU y. The MRS can also be expressed in terms of marginal utility – indeed, the MRS is the negative ratio of the marginal utility of an extra unit of x (sweaters) to the marginal utility of an extra unit of y (the socks), hence: The equi-marginal principle We saw earlier that the MRS (the gradient of the indifference curve) is Δy/Δx.

This is the only point at which the gradient of the budget line and indifference curve are identical.

In the sweaters-socks example, with income at 400, the price of x (sweaters) at 20, and the price of y (socks) at 5, equilibrium will be at 32 y and 12 x. Graphically, equilibrium will be where the budget line is at tangent to the relevant indifference curve, as shown below: Reveal figures for budget line and indifference curve We can use the data from the sweaters and socks example. If we combine data for the budget lines and indifference curves we can establish when a consumer is in equilibrium and maximising their utility. Indifference curves – prices and demand Identifying consumer equilibrium

Price consumption curve