An important application of indifference curves is to judge the welfare effects of direct and indirect taxes on the individuals. Now, if no food subsidy was given and therefore the price line was PL1, then for buying OA quantity of food, the individual would have spent PN amount of money. Before publishing your Articles on this site, please read the following pages: 1. Now, suppose that instead of excise duty, Government levies a direct tax of the type of lump-sum tax on the individual when the individual is initially at point Q3 on indifference curve IC3. Another point which is worth mentioning in this regard is that indifference curves cannot even meet or touch each other or be tangent to each other at a point. Thus, in this possibility, the effect of equivalent cash subsidy is exactly the same as the effect of food stamp subsidy. The use of the indifference curve will help to judge the welfare effect of direct and indirect taxes on the individuals. And this later substitution effect caused due to the price-distortion by the indirect tax further reduces his welfare. Under price or excise subsidy the Government pays a part of the price of a good and allows the consumer to buy as many units of the good as he desires at the sub-sidised price. It is worth noting that wage rate is the opportunity cost of leisure. It is like a contour map showing the height of the land above sea-level where instead of height, each indifference curve represents a level of satisfaction. set of attainable combinations of two goods X and Y) as shown by the reduced shaded area in Figure 11.7 and therefore in this case the ration limit is only potentially binding on him. It will be seen from Figure 11.9 that ration amounts of Rx and Ry of goods X and Y respectively are greater than OM and ON which the consumer is buying with his price-income situation. Thus, the maximum amount of leisure time that an individual can enjoy per day equals 24 hours. However, such a situation is relevant in case of a poor family whose income is so small that it cannot buy even the rationed quantity. Combination Q has been taken on a higher indifference curve IC2 and combination S on a lower indifference curve IC1. Thus, while income effect of the increase in wage rate causes decrease in labour supply by L2L1, its substitution effect causes increase in labour supply by L0L2. But opting out of some of these cookies may affect your browsing experience. If the amount substituted is imperfect, the marginal rate of substitutionMarginal Rate Of SubstitutionThe marginal rate of substitution (MRS) is the rate at which some units of an item can be replaced by another while providing the same level of satisfaction to the consumer.read more will be constant. Thus PE, is money value of the subsidy to the individual. In particular we are interested in knowing whether it is the ration limits or income of the consumer that is binding, that is, which forces the consumer to consume less amounts of the goods. The indifference curve I1 is the locus of the points L, M, N, P, Q, and R, showing the combinations of the two goods X and Y between which the consumer is indifferent. If a consumer purchases two goods, the budget limitation can be displayed with the help of a budget line on a graph. Property IV: A higher indifference curve represents a higher level of satisfaction than a lower indifference curve: The last property of indifference curve is that a higher indifference curve will represent a higher level of satisfaction than a lower indifference curve. Income OM equals OT multiplied by the hourly wage rate (OM = OT.w) where w represents the wage rate. The cookies is used to store the user consent for the cookies in the category "Necessary". Another important result obtained from our above analysis is that even with food stamps programme the individual increases the consumption of all other goods (i.e. Suppose that under food-subsidy programme, the needed families are entitled to purchase food at half the market price, the other half of the market price is paid by the Government as subsidy. (4) The prices of the two goods are given. It is evident from Fig. Now, if substitution effect had been larger than income effect, work-hours supplied would have increased as a result of rise in wage rate. He is supposed to rank them in his order of preference and can state if he prefers one combination to the other or is indifferent between them. At the old price (before the excise duty was imposed), he could purchase ON quantity of good X for PT amount of money. To do so we take away so much income from the individual that he comes back to the original indifference curve IC1. The indifference curve analysis has also been used to explain producer's equilibrium, the problems of exchange, rationing, taxation, supply of labour, welfare economics and a host of other problems. The indifference curve technique has come as a handy tool in economic analysis. An indifference curve is a curve that represents all the combinations of goods that give the same satisfaction to the consumer. Other uncategorized cookies are those that are being analyzed and have not been classified into a category as yet. It shows the consumers preference for one good over another only if it is equally satisfying. With the imposition of excise duty, the price of good X will rise. Consider Figure 11.5 where on the X-axis, good X and on the F-axis money is measured. Further, if the same amount of revenue is to be raised through lump-sum tax as with the excise duty, then the new price line AB should be drawn at such a distance from the original price line PL1 that it passes through the point Q1. The importance of indifference curve analysis to neoclassical microeconomic consumer theory can hardly be overstated. 8.8. You also have the option to opt-out of these cookies. Performance cookies are used to understand and analyze the key performance indexes of the website which helps in delivering a better user experience for the visitors. (7) An indifference curve is negatively inclined sloping downward. All other points on the budget line to the left or right of point 'E' will lie on lower indifference curves and thus indicate a . If the purpose is to increase the consumption of food and therefore provide adequate diet to the people, then food stamp subsidy is better than cash subsidy as under the former, the individual is constrained to buy at least a given quantity of food. An important application of indifference curves is to judge the welfare effects of direct and indirect taxes on the individuals. Amount of labour L1 is directly plotted against higher wage rate w, in panel (b) of Fig. You consent to our cookies if you continue to use our website. 200 per week which he can spend on food alone. The latter shows the various combinations of the two commodities such that the consumer is indifferent to those combinations. AB is tangent to indifference curve IC1 at point S at which he supplies TL2 hours for work. Further, as will be seen from Figure 11.2, with a cash grant the individual buys less food and more of other goods relative to the situation under price subsidy with the equivalent monetary cost. The same argument holds good in this case as developed above in the case of intersection of indifference curves. This cookie is set by GDPR Cookie Consent plugin. Now, suppose with the introduction of rationing, ration limit R is fixed for good X and R, for good Y. With these stamps, the recipient can buy food and only food. In order to find the money value of the subsidy to the individual, draw a line EF parallel to PL1 so that it touches the same indifference curve IC where the individual comes to be in equilibrium when subsidy is paid. In the diagram, IC1 and IC2 are the two indifference curves. It's essentially the cost of the next best alternative that has been forgiven. This property follows from assumption I. Indifference curve being downward sloping means that when the amount of one good in the combination is increased, the amount of the other good is reduced. We will explain and compare the effects of two types of subsidies, price subsidy and lump sum cash grant, on consumers welfare. You are free to use this image on your website, templates, etc., Please provide us with an attribution link. This is depicted in Figure 11.17 where at the equilibrium point E a steeper leisure-income line EK than MT has been drawn. An indifference curve is a graphical representation of various combinations or consumption bundles of two commodities. The less the ease with which two goods can be substituted for each other, the greater will be the fall in the marginal rate of substitution. Before the receipt of food stamps the individual is in equilibrium at point E1 on indifference curve IC1 and is consuming OF1 quantity of food and ON1 quantity of other goods per week. The following situations may occur: In conclusion, Jack has the same level of satisfaction and utility in both situations as a consumer. In particular, mention may be made of consumer's equilibrium, derivation of the demand curve and the concept of . When the wage rate rises to W1 (budget constraint becomes TM1 in panel (a) of Fig. That the individual with cash transfer must be better off and his food consumption must be less as compared with price subsidy on food is due to the fact that indifference curves being convex, the budget line CD obtained with cash transfer must intersect the indifference curve IC1 at point R reached with the equivalent price subsidy. This is directly plotted against the wage rate w0 in panel (b) of Fig. Now, the important question is what is the money value of this price subsidy (RM) on food to the individual. The meeting of two indifference curves at a point will also lead us to an absurd conclusion. Another important conclusion from this possible case is that with either food stamp subsidy or cash subsidy the individual buys more of both food and other goods than he buys before the grant of subsidy. You may also have a look at the following articles to learn more , Your email address will not be published. Disclaimer Copyright, Share Your Knowledge The better substitutes the two goods are for each other, the closer the indifference curve approaches to the straight line so that when the two goods are perfect substitutes the indifference curve is a straight line. But the two indifference curves cutting each other lead us to an absurd conclusion of A being equal to Bin terms of satisfaction. An indifference curve is a graph showing combination of two goods that give the consumer equal satisfaction and utility. Thus above the horizontal line B1C1 the combinations of other goods and food are not attainable when he is given the food stamps of Rs. It is assumed that consumers preferences are monotonic i.e. The straight line MT is the budget constraint, which in the present context is generally referred to as income-leisure constraint and shows the various combinations of income and leisure among which the individual will have to make a choice. As will be seen from Figure 11.5, as a result of income effect of the indirect tax the consumer moves from point Q3 on indifference curve IC3 to point Q2 on lower indifference curve IC2 and as a result of substitution effect he is further pushed to point Q1 on still lower indifference IC1. This shows with rise in wage rate from w0 to w1 resulting in leisure becoming relatively expensive, he substitutes work (i.e. The slope of the indifference curve measuring marginal rate of substitution between leisure and income (MRSLm ) shows the tradeoff between income and leisure. How the effect of rise in wage rate is split up into income effect and substitution effect is shown in Fig. However, it is important to note that he . This leads us to income-leisure constraint which together with the indifference map between income and leisure would determine the actual choice by the individual. You can calculate it by, These cookies ensure basic functionalities and security features of the website, anonymously. She could also get the same level of utility at point Y, skiing just 1 day and spending 5 days horseback riding. Second, wage rate is the same irrespective of the number of hours he chooses to work. . In this article we will discuss about Indifference Curves. Here we discuss the properties of the indifference curve and how to analyze it, along with examples and assumptions. Thus the food subsidy has induced the individual to consume more food than in case of cash payment. Share Your PPT File. 11.3 and Fig. The cookie is set by GDPR cookie consent to record the user consent for the cookies in the category "Functional". 200 he can therefore buy 20 kg of food which is equal to B1C at the given market price. The consumer is expected to buy any of the two commodities in a combination. The cookie is used to store the user consent for the cookies in the category "Analytics". Hence, a consumer prefers to reach the tallest line to attain a higher utility level. It will be observed that binding by rationing lowers his level of welfare as he is forced to come to the point L on a lower indifference IC0 where he consumes less of good Y and more of good X than he prefers. The below diagram shows an indifference map with three indifference curves. In other words, up to wage rate w0 labour supply curve slopes upward and beyond that it starts bending backward. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. Consumer goods companies and the industry offer a vast range of products that heavily contribute to the global economy. Introduction of rationing limits forces him to come to point K on the lower indifference curve IC0 and consume less amounts of both the goods than he would do without the restriction of rationing. supply of labour in terms of hours worked) he would put in this optimal M situation. Likewise, the combinations B and C will give equal satisfaction to the consumer; both being on the same indifference curve IC1. Under food stamp programme, some stamps or coupons are given to the eligible persons or households. It does not store any personal data. The Indifference Map refers to a set of Indifference Curves that reflects an understanding and gives an entire view of a consumers choices. This property of indifference curves follows from assumption 3, which is that the marginal rate of substitution of X for Y (MRSxy) diminishes as more and more of X is substituted for Y. An indifference curve is a downward sloping convex line connecting the quantity of one good consumed with the amount of another good consumed. Let us explain how a receipt of food stamps affects the budget line, consumption of food and welfare of the individual. The superiority of cash grant in terms of its impact on the welfare of the individuals can be explained in a slightly different way. We will further show how much K work effort (i.e. Under what conditions supply curve of labour (i.e. Therefore, the ration limits in this case are not actually binding since these do not any more constrain his consumption. Examples of goods that are perfect substitutes are not difficult to find in the real world. Before publishing your articles on this site, please read the following pages: 1. A higher indifference curves to the right of another represents a higher level of satisfaction and preferable combination of the two goods. The consumer is rational to maximize the satisfaction and makes a transitive or consistent choice. We also use third-party cookies that help us analyze and understand how you use this website.

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