Learn 100% online from anywhere in the world. Enroll today!

Indifference Curve

A contour line where utility remains constant across all points on the line

What is an Indifference Curve?

An indifference curve is a contour line where utility remains constant across all points on the line. In economics, an indifference curve is a line drawn between different consumption bundles, on a graph charting the quantity of good A consumed versus the quantity of good B consumed. At each of the consumption bundles, the individual is said to be indifferent.

 

Indifference Curve

 

Summary

  • An indifference curve is a contour line where utility remains constant across all points on the line.
  • The four properties of indifference curves are: (1) indifference curves can never cross, (2) the farther out an indifference curve lies, the higher the utility it indicates, (3) indifference curves always slope downwards, and (4) indifference curves are convex.
  • The optimal consumption bundle is the tangency condition between the indifference curve and the budget line.

 

What is Utility?

When an individual consumes goods and services, the satisfaction gained or lost from consumption is called utility. Consumer preferences are defined by the consumption bundles that consumers face. A collection bundle is a bundle that maximizes the consumer’s total utility, given the consumer’s budget constraints. One unit of utility is known as a util.

 

The Principle of Diminishing Marginal Utility

Marginal utility refers to the utility gained from the consumption of an additional unit of a good or service.

The principle of diminishing marginal utility is illustrated here as the total utility increases at a diminishing rate with additional consumption. It is evidenced by figures D, E, and F having decreased marginal utility. Therefore, the principle of diminishing marginal utility indicates that each additional unit of consumption adds less to the cumulative utility than the previous unit.

 

Diminishing Marginal Utility

 

What Does an Indifference Curve Look Like?

An indifference curve is a contour line where utility remains constant across all points on the line. Each point on an indifference curve represents a consumption bundle, and the consumer is indifferent among all consumption bundles on the indifference curve. In our example, the consumer yields 250 utils.

 

Indifference Curve

 

An entire utility function can be graphically represented by an indifference curve map, where several indifference curves correspond to different levels of utility. In the graph below, there are three different indifference curves, labeled A, B, and C. The farther from the origin, the greater utility is generated across all consumption bundles on the curve.

 

Indifference Curve Map

 

Properties of Indifference Curves

If a good satisfies all four properties of indifference curves, the goods are referred to as ordinary goods. They can be summarized as the consumer requires more of one good to compensate for less consumption of another good, and the consumer experiences a diminishing marginal rate of substitution when deciding between two goods.

  1. Indifference curves never cross. If they could cross, it would create large amounts of ambiguity as to what the true utility is.
  2. The farther out an indifference curve lies, the farther it is from the origin, and the higher the level of utility it indicates. As illustrated above on the indifference curve map, the farther out from the origin, the more utility the individual generates while consuming.
  3. Indifference curves slope downwards. The only way an individual can increase consumption in one good without gaining utility is to consume another good and generate the same amount of utility. Therefore, the slope is downwards sloping.
  4. Indifference curves assume a convex shape. As illustrated above in the indifference curve map, the curve gets flatter as you move down the curve to the right. It illustrates that all individuals experience diminishing marginal utility, where additional consumption of another good will generate a lesser amount of utility than the prior.

 

What Defines the Convexity of Indifference Curves?

As you go down the curve of an indifference curve, the curve becomes flatter as one good is substituted for the other. It is the individual’s marginal rate of substitution, which is defined as the more an individual consumes good A in proportion to good B, the less of good B the individual will substitute for another unit of good A.

 

The Optimal Consumption Bundle

In the graph below, point A illustrates the tangency condition the utility curve has with the budget line constraint.

 

Optimal Consumption Bundle

 

The tangency condition between the indifference curve and the budget line indicates the optimal consumption bundle when indifference curves exhibit typical convexity.

 

Slope of the Budget Line

The slope of the budget line is the relative price of good A in terms of good B, equal to the price of good A as a ratio of the market price of good B. Moreover, the slope of the budget line subtracted by relative price represents the opportunity cost of consumption. There is an opportunity cost because of the consumer’s limited budget. The budget line is shifted outwards by the price of goods becoming proportionally cheaper.

 

Slope of the Indifference Curve

The slope of the indifference curve at any point is the negative marginal utility of good A as a proportion of the marginal utility of good B. It indicates that the optimal consumption bundle – the marginal rate of substation between goods A and B – is the ratio of their prices.

 

Additional Resources

CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Aggregate Supply and Demand
  • Conspicuous Consumption
  • Marginal Propensity to Consume
  • Yield Curve

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes!