The following assumptions about the consumer psychology are implicit in this analysis:
Transitivity: If a consumer is indifferent to two combinations of two goods, then he is unaware of the third combination also.
Diminishing marginal rate of substitution: The scarcer a good the greater is its substitution value.
Rationality: The consumer aims to maximise his total satisfaction and has got complete market information.
Ordinal Utility: Utility in this approach is not measurable. A consumer can only specify his preference for a particular combination of two goods, he cannot specify how much.
The Indifference Curve
If a consumer is asked whether he prefers combination 1 of two goods X and Y (assuming that the market price of X and Y are fixed) or combination 2, he may give one of the following answers:
he prefers combination 1 to 2
he prefers combination 2 to 1
he is indifferent about combinations 1 and 2.
The third answer implies that the consumer prefers 1 as much as 2. There may be some more combinations of goods X and Y which are equally preferable to him. There may be five different combinations of X and Y such that each combination gives him the same satisfaction.
The Consumer’s Equilibrium
If we superimpose the indifference map and budget line as in Figure shown above, we find that a consumer has to decide to purchase a particular combination (C) as it falls on his budget line, though a different combination (D) would be more desirable as it will give a higher level of satisfaction. At his point of equilibrium C, the price line is touching the indifference line tangentially meaning that the slopes are equal. The slope of indifference curve indicates the marginal rate of substitution between X and Y, and the slope of budget line indicates the ratio of price of X to that of Y. Thus the principle of consumer’s equilibrium works out; the marginal rate of substitution between X and Y must be proportional to the ratio of price of X to that of Y.
Changes in Price
According to the price consumption curve, if the price of X falls, the new budget or price line becomes M-L1, as more of X can be brought out of the given budget and thus C1 becomes the new equilibrium point. If the price of X falls again, the price of Y and budget remaining same, the new equilibrium point shifts to C11. The line connecting such successive equilibrium points at C, C1 and C11 is called PCC or price consumption curve.