Using practical examples, explain how the concept of Indifference curve helps managers in the decision making.

Question

Using practical examples, explain how the concept of Indifference curve helps managers in the decision making.

Answer

Businesses have to make numerous decisions, including identification of which goods/services to provide and appropriate levels of production (Seal, Garrison, and Noreen, 2011). The production level should provide for market demands while ensuring a suitable profit for the firm. One useful tool is an indifference curve; a graph which shows how a combination of two different goods may provide consumers with equal levels of satisfaction and utility (Nellis and Parker, 2006). The indifferent curve is drawn on a graph, where the x and y axis represent two different product groups (Friedman, 1990). The curve will be a downward sloping convex. It is this shape due to the concept of diminishing marginal utility; the more an individual has of one good, the lower the level of utility gained (Pindyck and Rubinfeld, 2009). For example, on a rainy day a consumer may gain significant utility buying an umbrella, it will keep them dry, but they will gain little, if any, utility buying a second umbrella. The indifference curve is useful as all positions on the curve show points where there is an equal level of utility/satisfaction for consumers (Friedman, 1990). This can be used when determining which products to produce, and the levels. For example, if a farmer is considering which crops to grow, and is considering what combination of peas and carrots, they may use the utility curve to determine an optimal mix. If the farmer knows the cost of production, and potential sale price for the carrots and the peas, they can then identify the point on the graph where they can maximise their profits. In a larger context, firms may look at the total market production and demands in order to identify the products they should or could produce.

References

Friedman, D., 1990. Price Theory: An Intermediate Text. [online] Mason, OH: South-Western. Available at: . Nellis, J.G., and Parker, D., 2006. Principles of the Business Economics. Harlow: Prentice Hall. Pindyck, R.S., and Rubinfeld, D.L., 2009. Microeconomics. Seventh ed. Upper Saddle River, NJ: Pearson Education Inc. Seal, W.,, Garrison, R.H., and Noreen, E.W., 2011. Management Accounting. London: McGraw-Hill Higher Education.