You consent to our cookies if you continue to use our website. All other variables remain constant. The cookie is set by GDPR cookie consent to record the user consent for the cookies in the category "Functional". This cookie is set by GDPR Cookie Consent plugin. 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. It has, however, been empirically observed that when the wage rate is small so that the demand for more income to purchase goods and services is very strong, substitution effect is larger than the income effect so that the net effect of rise in wage rate will be to reduce leisure and increase the supply of labour. Though the consumer can buy the ration amount, that is, ration limit is attainable but he is not willing to consume good X as much as the ration limit permits him. This is because cash subsidy does not limit a person that he must purchase certain amount of food and is therefore free to spend as he likes. Thus PE, is money value of the subsidy to the individual. It may, however, be noted that on theoretical grounds it cannot be predicted which effect will be stronger. In other words, if the Government wants to raise a given amount of revenue whether it will be better to do so by levying a direct tax or an indirect tax from the view point of welfare of the individuals. Thus, food stamps subsidy has led him to buy not only more food but also more of other goods. Advertisement cookies are used to provide visitors with relevant ads and marketing campaigns. This is an important feature of Indifference Curve. 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. The ordinal utility theory or the indifference curve analysis is based on the assumptions as discussed above. It could be calculated by dividing the additional utility by the amount of additional units. it provides an ordinal measurement of utility. Content Guidelines 2. An indifference curve is a graphical representation of a combined products that gives similar kind of satisfaction to a consumer thereby making them indifferent.Every point on the indifference curve shows that an individual or a consumer is indifferent between the two products as it gives him the same kind of utility. In other words, at point Q2 individuals level of welfare is higher than at Q1. Besides, a lower price of food due to price subsidy on it induces the consumer to substitute food for other goods causing greater consumption of food as compared to the scheme of lump-sum cash grant which have no such substitution effect and permits free choice of goods to the individual according to his own preference. 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. These cookies help provide information on metrics the number of visitors, bounce rate, traffic source, etc. The indifference curve analysis retains some of the assumptions of the cardinal theory, rejects others and formulates its own. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. (5) The consumers tastes, habits and income remain the same throughout the analysis. The degree of convexity of an indifference curve depends on the rate of fall in the marginal rate of substitution of X for Y. As explained above in Fig. It, thus, maintains the same level of consumer satisfaction in all combinations. Each indifference curve represents various alternative combinations of income and leisure which provides equal level of satisfaction to the individual and the farther away an indifference curve is from the origin, the higher the level of satisfaction it represents for the individual. 8.8 two perfect complements are consumed in the ratio, 3X: 27. 11.1 cost of price subsidy on food to the Government equals RM amount of money. On the other hand, an indirect tax is one which can be passed on or shifted to others by raising the prices of the goods. The assumptions of the ordinal theory are the following: (1) The consumer acts rationally so as to maximise satisfaction. A higher indifference curves to the right of another represents a higher level of satisfaction and preferable combination of the two goods. Before publishing your Articles on this site, please read the following pages: 1. Higher indifference curve represents larger bundles of goods i.e. To do so we take away so much income from the individual that he comes back to the original indifference curve IC1. Privacy Policy 8. Thus, indirect tax (excise duty) causes an excess burden on the individual. This website uses cookies to improve your experience while you navigate through the website. It Studies Combinations of Two Goods Instead of One Good 3. But there are some budget constraints due to the low income of the consumer. 10 per kg. 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. Answer (1 of 7): Indifference curve analysis is very important to the study of economics. (11) Both preference and indifference are transitive. However, the final result of the two types of subsidies depends on the value of food stamps relative to preferences and incomes of the individuals whom subsidies are granted. An indifference curve reveals many combinations of two goods a consumer prefers to consume. The indifference curve analysis work on a simple graph having two-dimensional. These cookies ensure basic functionalities and security features of the website, anonymously. Let us consider commodities B1 and B2. We will explain and compare the effects of two types of subsidies, price subsidy and lump sum cash grant, on consumers welfare. In geometric terms, it will be seen from Figure 11.14 that on indifference curve IC1 at point A the individual is willing to accept M income for sacrificing an hour (L) of leisure. Under food stamp programme, some stamps or coupons are given to the eligible persons or households. It will be seen from Figure 11.19 that TM0 is tangent to indifference curve IC1 between leisure and income at point R. Thus, with wage rate w0the individual is in equilibrium when he enjoys OL0 leisure and therefore he is supplying TL0 work hours of labour. When the indifference curve is convex to the origin, MRS diminishes as more of X is substituted for K. We therefore conclude that indifference curves are generally convex to the origin. In short, the first condition of the consumer's equilibrium is that the budget or price line should be tangent to the indifference curve. 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 trade-off means how much income the individual is willing to accept for one hour sacrifice of leisure time. With this extra cash transfer equal to RM (-PC), the budget-line will shift to the right to the position CD in Fig. The Indifference Map refers to a set of Indifference Curves that reflects an understanding and gives an entire view of a consumers choices. Property I. Indifference curves slope downward to the right: This property implies that an indifference curve has a negative slope. In order to earn income for satisfying his wants for goods and services, he will devote some of his time to do work. An important application of indifference curves is to judge the welfare effects of direct and indirect taxes on the individuals. Direct taxes are those taxes whose incidence cannot be shifted to others. Plagiarism Prevention 4. 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. TOS4. Share Your Word File Thus, to quote Prof. Watson again, you can make someone happier if you give him cash instead of a commodity, even if the commodity is something he wants. This means that up to a point substitution effect is stronger than income effect so that labour supply curve slopes upward, but beyond that at higher wage rates supply curve of labour bends backward. AB is tangent to indifference curve IC1 at point S at which he supplies TL2 hours for work. 11.4. The marginal rate of substitution shows the consumers preference for one good over another while maintaining the same level of utility. A higher indifference curve shows a higher level of satisfaction. The curves that are farther away from the origin represent higher levels of satisfaction as they have larger combinations of X and Y. In case of perfect substitutes, the indifference curves are parallel straight lines because the consumer equally prefers the two goods and is willing to exchange one good for the other at a constant rate. This cookie is set by GDPR Cookie Consent plugin. Since lump-sum tax or any income tax does not alter the relative prices of goods it will not result in any substitution effect. An indifference curve is a graphical representation of various combinations or consumption bundles of two commodities. What is indifference curve importance? In the above image, the combination outside the budget line (S) represents the one beyond the income. This cookie is set by GDPR Cookie Consent plugin. Share Your PDF File With the imposition of a lump-sum tax (or any other income tax), a certain income is taken away from the consumer and he is pushed to the lower indifference curve (or a lower level of welfare) but he is free to spend the income he is left with as he likes without forcing him to substitute one commodity for another due to any change in relative price. This is the point of consumer equilibrium, where the consumer purchases OM quantity of commodity 'X' and ON quantity of commodity 'Y. We use cookies to personalise content and ads, to provide social media features and to analyse our traffic. As noted above, combination H is not available under food stamp subsidy because food stamps cannot be used to purchase other goods. It is worth noting that wage rate is the opportunity cost of leisure. Now, consider Figure 11.10 where it will be seen that ration limit Ry is smaller than consumers optimum consumption of Y as indicated by combination E of the two goods on the budget line BL which has been drawn with his given income and prices of two goods. Lump sum tax, proportionate and progressive income taxes, wealth tax, death duty are the examples of direct tax. Some of these important properties of indifference curve are as follows: 1. The cookie is set by the GDPR Cookie Consent plugin and is used to store whether or not user has consented to the use of cookies. These cookies will be stored in your browser only with your consent. We use cookies to personalise content and ads, to provide social media features and to analyse our traffic. Such a diagram is known as an indifference map where each indifference curve corresponds to a different indifference schedule of the consumer. According to Watson, An indifference schedule is a list of combinations of two commodities the list being so arranged that a consumer is indifferent to the combinations, preferring none of any other. The following is an imaginary indifference schedule representing the various combinations of goods X and Y. MRS between income and leisure equals the wage rate (w) that is, the market exchange rate between the two. Required fields are marked *. Further, these stamps cannot be traded or transferred to the other people. The derivation of supply curve of labour is depicted in 11.18. 11.3. It's essentially the cost of the next best alternative that has been forgiven.read more play a crucial role in the curve analysis. bundles which contain more of both or more of at least one. 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. Consider indifference curves IC1 and IC2 in Fig. In this case ration limit fixed is Rx which lies to the left of his equilibrium position E. Without the restriction of rationing he will consume a larger amount of commodity X and will be at indifference curve IC1. 11.2 which passes through point R. It will be seen from Figure 11.2 that with the budget line CD though the individual can buy the same market basket R, if he so desires, which he was purchasing with price subsidy on food, he is actually in equilibrium at point H on higher indifference curve IC2. But the two indifference curves cutting each other lead us to an absurd conclusion of A being equal to Bin terms of satisfaction. Indifference curves are heuristic devices used in contemporary microeconomics to demonstrate consumer preference and the limitations of a budget. 10 per kg., then with Rs. The usefulness of the indifference curves: it helps to distinguish between the substitution effects and the incomes effects. (12) The consumer is in a position to order all possible combinations of the two goods. it slopes downward from left to right. (10) The consumer arranges the two goods in a scale of preference which means that he has both preference and indifference for the goods. It may be noted that income of a consumer along with the prices of goods serves as a constraint on his choices and is often called a budget constraint. 3.Indifference curve shows various possible combinations of two goods that give equal satisfaction to the consumer. Since the food stamps are in addition to his initial income OB1 his budget line with food stamps becomes a kinked line B1 CL2. 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. The second possibility of the effect of food stamp subsidy is illustrated in Fig. Further, income is used to purchase goods, other than leisure for consumption. This implies that in case of lump-sum cash subsidy, the consumer will be better off and consume less food relative to the equilibrium position under price subsidy on food. Nine most important properties of indifference curves are as follows: (1) A higher indifference curves to the right of another represents a higher level of satisfaction and preferable combination of the two goods. Share Your PPT File. If the individual can work for all the 24 hours in a day, he would earn income equal to OM. It is important to note that leisure is a normal commodity which means that increase in income leads to the increase in leisure enjoyed (i.e. This result is of special importance because supporters of food-stamp subsidy have been emphasizing that food subsidy should not be used to finance any part of nonfood unnecessary items such as liquor. Therefore, with subsidy the individual will face the price line PL2 where OL1 = L1 L2. They slope downward to the right, are convex to the origin and do not intersect. The technique of indifference curves has been used not only to explain consumers behaviour and demand but also to analyse and explain several other economic problems. Therefore, in economics leisure is regarded as a normal commodity the enjoyment of which yields satisfaction to the individual. Without this type of analysis, economists would be unable to predict certain behaviors . 8.6. Each individual axis indicates a single type of economic goods. In the following schedule (Table 1), the consumer is indifferent whether he buys the first combination of units of 18Y+1 unit of X or the fifth combination of 4 units of Y+5 units of X or any other combination. Marginal rates of substitution and opportunity costsOpportunity CostsThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. Straight-line indifference curves of perfect substitutes are shown m Fig. But given the preferences of the individual between food and other goods, he is in equilibrium at the same point E2 at which his budget line B2L2 is target to the indifference curve IC2. Your Mobile number and Email id will not be published. This means for most of the recipients, food stamp programme has the same effect as a cash subsidy. Corporate valuation, Investment Banking, Accounting, CFA Calculation and others (Course Provider - EDUCBA), * Please provide your correct email id. You also have the option to opt-out of these cookies. Necessary cookies are absolutely essential for the website to function properly. It is for this reason that we reject indifference curves of concave or straight-line shapes and assume that indifference curves are normally convex to the origin. Privacy Policy3. If now the Government introduces a rationing for commodity X and fixes a ration of X equal to ORx (At point Rx we have shown a vertical line showing the constraint or ration limit imposed by the rationing fixed at ORx). 11.19 that income effect is stronger than substitution effect so that the net result is reduction in labour supply by L0L1 work-hours. Choice of other points on income-leisure line MT will show different amounts of leisure, income and work. It comprises individual choices, marginal utilityMarginal UtilityA customer's marginal utility is the satisfaction or benefit derived from one additional unit of product consumed. However, with AB as the price line, individual is in equilibrium at point Q2 on indifference curve IC2 which lies at a higher level than IC1. A glance at panel (b) of Figure 11.18 will reveal that supply curve of labour is upward sloping indicating positive response of the individual to the rise in wage rate. If a consumer purchases two goods, the budget limitation can be displayed with the help of a budget line on a graph. Indifference curve must be convex to the origin: Since all the combinations give the same amount of satisfaction, the consumer prefers them equally. Empirical research conducted in the USA however reveals that most recipients of food stamp programme represent situation depicted in Fig.