Economics - Indifference Curve

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The willingness of consumers to purchase a product or service is the fundamental source of profit for any business. Understanding consumer behavior is the first step in making profitable pricing, advertising, product design and production decisions. In order to make marketing decisions, managers need to know how consumers choose the bundle of goods and services they actually purchase from all possible bundles that they could purchase. Managers should be aware of the consumer-choice process when estimating the demand for the firms’ products, forecasting future demand, and making advertising decisions.

Consumer Preferences

From all the goods or services available to them, buyers choose a combination of items we call a market basket. Consumption of the bundle of goods in a market basket brings satisfaction to the buyer. Buyers choose between different bundles of goods, different market baskets, on the basis of the satisfaction they are expected to bring. A model of consumer's as buyers is based on three assumptions.

1.Axiom of Completeness

Given two market baskets, A and B, a consumer will know whether she prefers A to B (written as A » B), does not prefers A to B (A « B) or is indifferent between them (A I B).

When confronted with a choice between two market baskets, both of which contain desirable goods, a consumer will definitely know which is preferred, or will definitely know that s/he would be equally happy with either, nor does it imply that the consumer finds both baskets undesirable. Rather, indifference implies that both baskets are equally desirable. This state of indifference plays a crucial role in the model of consumer choice.

2.Axiom of Non-Satiation

Given two market baskets, A and B, the consumer will always prefer the basket that has more of at least one item and no less of the other items.

3.Axiom of Consistency

Given any three market baskets, A, B, and C, if a consumer indicates that A » B, and B » C, then, logically, the consumer will indicate that A » C.

Consumers choose in a consistent, predictable way, and that their preferences do not change in "mid choice", as it were.

Utility function

Economists name the benefits consumers obtain the goods and services they consume utility. Consumer preferences can be represented as a utility function. A utility function shows an individual’s perception of the level of utility that would be attained from consuming each conceivable bundle or combination of goods and services:

U = f(X,Y)

The actual numbers assigned to the levels of utility are arbitrary. It is inconceivable that anyone could actually assign specific numbers for the amount of utility received from consuming every possible combination of goods. Therefore, a utility function is a theoretical concept that proves useful in analysis.

Indifference curve

An Indifference curve shows all the consumption bundles of goods and services, each of which yields the same level of total utility. Utility is then a device to represent preference relations rather than something from which preferences are derived (Geanakoplis, 1987, p. 117). The main use of indifference curves is in the representation of prospectively observable demand patterns for individual consumers as to commodity bundles (Böhm and Haller, 1987, p. 785).

Indifference curve is typically represented to be:

1.Indifference curves do not intercept. This is a consequence of the assumption that consumers will always prefer to have more of either good than to have less.

2.Indifference curves are downward-sloping. This assumption reflects the fact that the consumer obtains utility from both goods. For example, if more X is added, some Y must be taken away in order to maintain the same level of utility.

3.Indifference curves are convex to the origin. This sharp requires that as the consumption of X is increased relative to consumption of Y, the consumer is willing to accept...
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