On the other hand, if substitution effect is relatively larger than the income effect, the rise on wage rate will increase labour supply. These cookies help provide information on metrics the number of visitors, bounce rate, traffic source, etc. Straight-line indifference curves of perfect substitutes are shown m Fig. He can utilize the following combinations based on his choice: The indifference curve analysis is indicated with a graphical representation. Now let us assume that he is given the cash subsidy of B1 B2 so that with the given market price of food, budget line shifts to B2L2. 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An important application of indifference curves is to judge the welfare effects of direct and indirect taxes on the individuals. goods other than food). If you enjoy both pizza and pasta, for example, you might not care whether you purchase 20 pizzas and no pasta . In the diagram, IC1 and IC2 are the two indifference curves. Consider Fig. At the extreme, when two goods cannot at all be substituted for each other, that is, when the two goods are perfect complementary goods, as for example gasoline and coolant in a car, the indifference curve will consist of two straight lines with a right angle bent which is convex to the origin as shown in Fig. Third important property of indifference curves is that they cannot intersect each other In other words only one indifference curve will pass through a point in the indifference map 1 his property can be easily proved by first making the two indifference curves cut each other and then showing the absurdity or self-contradictory result it leads to. They slope downward to the right, are convex to the origin and do not intersect. 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. 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. The indifference curve technique has come as a handy tool in economic analysis. Therefore, with subsidy the individual will face the price line PL2 where OL1 = L1 L2. 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. Direct taxes are those taxes whose incidence cannot be shifted to others. (6) He prefers more of X to less of Y or more of Y to less of X. Some of these important properties of indifference curve are as follows: 1. This means for most of the recipients, food stamp programme has the same effect as a cash subsidy. Before publishing your articles on this site, please read the following pages: 1. But there are some budget constraints due to the low income of the consumer. But the two indifference curves cutting each other lead us to an absurd conclusion of A being equal to Bin terms of satisfaction. 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. By clicking Accept, you consent to the use of ALL the cookies. As stated above, when two goods are perfect substitutes of each other, the indifference curve is a straight line on which marginal rate of substitution remains constant. Consider Figure 11.5 where on the X-axis, good X and on the F-axis money is measured. Without this type of analysis, economists would be unable to predict certain behaviors . This cookie is set by GDPR Cookie Consent plugin. In other words, a consumer is considered indifferent between any two bundles indicated by a point on the curve, provided these combinations give the same utility. Thus, in this case, rationing is actually binding for the consumer and reduces his welfare. On the other hand in case of cash subsidy the government provides a lump sum cash income to the consumer. Necessary cookies are absolutely essential for the website to function properly. The basic reason for this is that whereas both the lump-sum tax (or any other general income tax) and an indirect tax reduce consumers income and produce income effect, the indirect tax in addition to the income effect, also raises the relative price of the good on which it is levied and therefore causes substitution effect. With this extra cash transfer equal to RM (-PC), the budget-line will shift to the right to the position CD in 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. So, it will be seen from Figure 11.5 that with the imposition of lump sum tax equivalent in terms of revenue raising to the excise duty, we have drawn the budget line AB which is passing through the point Q1. Thus the indifference curve I4 indicates a higher level of satisfaction than I3 which, in turn, is indicative of a higher level of satisfaction than I2 and so on. 1.). 8.8 the left- hand portion of an indifference curve of the perfect complementary goods is a vertical straight line which indicates that an infinite amount of Y is necessary to substitute one unit of X and the right-hand portion of the indifference curve is a horizontal straight line which means that an infinite amount of X is necessary to substitute one unit of Y. Answer (1 of 3): The following points highlight the top nine advantages of indifference curve technique over marshallian utility analysis. 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 has earned OM1 amount of income by working TL1 hours of work. supply of labour in terms of hours worked) he would put in this optimal M situation. On the other hand, in case of good, case of good X in Figure 11.10 the ration limit Rx does not seem to be effective, though it is potentially binding as it truncates his market opportunity set. But ration limit Rx for good X is larger than his optimum or equilibrium consumption quantity of good X. When the wage rate rises to W1 (budget constraint becomes TM1 in panel (a) of Fig. The consumer is expected to buy any of the two commodities in a combination. CFA And Chartered Financial Analyst Are Registered Trademarks Owned By CFA Institute. Advertisement cookies are used to provide visitors with relevant ads and marketing campaigns. If the higher overtime wage rate w represented by the steeper line EK is fixed, the individual is in equilibrium at point H on indifference curve IC2 where he chooses to have OL2 leisure time and OM2 amount of income. We also use third-party cookies that help us analyze and understand how you use this website. 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. All combinations give him equal satisfaction. Also referred to as final products, examples of consumer goods include an Apple cellphone or a box of Oreo cookies. The farther the Indifference curve from the origin, then: 2. When no price subsidy is paid, the individual faces the price line PL1. 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. With a given income of the individual and the given price of good X, the price line is PL1 which is tangent to indifference curve IC3 at point Q3 where the individual is in equilibrium position. 11.20. Your Mobile number and Email id will not be published. 11.3. For instance, if price of food is Rs. You also have the option to opt-out of these cookies. 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. Further, he is better off than before as he is now at the higher indifference curve IC2. Some of the advantages are: 1. Thus, in Figure 11.5, imposition of an equivalent lump-sum or income tax, the consumer moves from the equilibrium position Q3 on indifference curve IC3 to the new position Q2 on indifference curve IC2 which represents the income effect. Share Your Word File Out of these, the cookies that are categorized as necessary are stored on your browser as they are essential for the working of basic functionalities of the website. The imposition of a lump-sum tax (or any income tax) does not affect the prices of goods because it is not levied on any saleable goods. Cookies help us provide, protect and improve our products and services. 11.4 . When it occurs, it is known as the marginal rate of substitution (MRS). 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. number of hours worked). This is directly plotted against the wage rate w0 in panel (b) of Fig. Thus, if instead of the food stamps the individual is given equivalent cash income of B1B2 (Note that with given market price of food, cash income of B1B2 can buy B1C quantity of food and thus the two are equivalent), the budget line will shift from L2 to B2 L2. Therefore, as a result of rise in wage rate individual substitutes work (and therefore income) for leisure which leads to the increase in supply of labour. If the income effect is stronger than the substitution effect, the net combined effect of rise in wage rate will be to reduce labour supply. Consumer goods companies and the industry offer a vast range of products that heavily contribute to the global economy.read more, the curve features unique combinations or consumption bundles for any two commodities in points. It is thus clear that as a result of the imposition of excise duty, the individual has shifted from a higher indifference curve IC3 to a lower one IC1, that is, his level of satisfaction or welfare has declined. The maximum amount of time available per day for the individual is 24 hours. An indifference curve (IC) is a graphical representation of different combinations or consumption bundles of two goods or commodities, providing equal levels of satisfaction and utility for the consumer. work- hours) slopes upward and under what circumstances it bends backward can be explained in terms of income effect and substitution effect of a change in wage rate. 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. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. Hence the name indifference curve. The net combined effect on the supply of labour (hours worked) depends on the magnitude of the substitution effect and income effect of the rise in wage rate. In India also food stamp programme has been suggested in recent years as an anti-poverty measure. It, thus, maintains the same level of consumer satisfaction in all combinations. Now, when the wage rate rises to w1, wage line or income-leisure line shifts to TM1 (w1 = OM1/OT), the individual reduces his leisure to OL1 and supplies TL1 hours of work; L1L0 more than before (see Panel (a) in Figure 11.18). These cookies will be stored in your browser only with your consent. It has freed the theory of consumption from the unrealistic assumptions of the Marshallian utility analysis. The superiority of cash grant in terms of its impact on the welfare of the individuals can be explained in a slightly different way. The indifference curve analysis retains some of the assumptions of the cardinal theory, rejects others and formulates its own. (9) An indifference curve is smooth and continuous which means that the two goods are highly divisible and that level of satisfaction also change in a continuous manner. TM0 as budget constraint) L0, amount of work-hours (labour) are supplied. Consumer goods companies and the industry offer a vast range of products that heavily contribute to the global economy. It can slope or bend backward too which implies that at a higher wage rate, the individual will supply less labour (i.e. In other words, PN is the market price of OA quantity of food. Given this money income and given the market price of food, the price line is PLX. 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. This is quite evident from panel (b) of Fig. This implies that at higher wage rates, labour supply may be reduced in response to further rise in wage rates. Thus, indifference curves have been used to explain the concept of consumers surplus, substitutability and complementarity of goods, supply curve of labour of an individual, several principles of welfare economics, burden of different forms of taxation, gain from foreign trade, welfare implications of subsidy granted by the Government, index number problem, mutual advantage of exchange of goods between two individuals and several other things. The effect of this subsidy on consumers welfare and money value of this subsidy to the consumer is illustrated in Figure 11.1 where the quantity of food is measured on the X- axis and money on the Y-axis. Combination Q has been taken on a higher indifference curve IC2 and combination S on a lower indifference curve IC1. We shall explain below only few applications. The ordinal utility theory or the indifference curve analysis is based on the assumptions as discussed above. 200. It helps us visualize the different combinations of goods and services, each of which yields the same level of utility. 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 . Indifference curve must be convex to the origin: It Dispenses with Cardinal Measurement of Utility 2. In this article we will discuss about Indifference Curves. In the above image, the combination outside the budget line (S) represents the one beyond the income. Here, we understand that all three products resting in the indifferent curve give him the same satisfaction. With TM1 he reaches his old equilibrium position at point H where he supplies TL1 work-hours. Thus the cost of giving subsidies to consumers is always greater than the money equivalent of the subjective gain to the consumers. Thus, food stamps subsidy has led him to buy not only more food but also more of other goods. A single indifference curve concerns only one level of satisfaction. Required fields are marked *. An indifference map between income and leisure is depicted in Figure 11.14 and has all the usual properties of indifference curves. 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. All Combinations on an Indifference Curve Give Same Level of Satisfaction As we defined the indifference curvegiving the same level of satisfaction with the different points of combinations of two commodities A, B, C, D and E combinations. Under food stamp programme, some stamps or coupons are given to the eligible persons or households. If the graph is on the curve or line, then it means that the consumer has no preference for any goods, because all the good has the same level of satisfaction or utility to the consumer. It could be calculated by dividing the additional utility by the amount of additional units.read more theory, the subjective theory of value, substitution effects, income, ordinal utility, etc. Our assumption regarding diminishing MRSxy and the convexity of indifference curves is based upon the observation of actual behaviour of the normal consumer. Advertisement cookies are used to provide visitors with relevant ads and marketing campaigns. Whereas income effect of the rise in wage rate tends to reduce supply of labour, substitution effect tends to increase it. 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. 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. The budget line is tangent to indifference curve IC2 at point 'E'. 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. Other uncategorized cookies are those that are being analyzed and have not been classified into a category as yet. 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. They may represent higher or lower satisfaction of the consumer. Since all the combinations give the same amount of satisfaction, the consumer prefers them equally. Thus, indirect tax (excise duty) causes an excess burden on the individual. (4) The prices of the two goods are given. GCD210267, Watts and Zimmerman (1990) Positive Accounting Theory A Ten Year Perspective The Accounting Review, Subhan Group - Research paper based on calculation of faults, Density function, CDF, and final offer arbitration game, CFA Inst - Risk Profiling through a Behavioral Finance Lens. 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. Thus, the slope of the income-leisure curve OM/OT equals the wage rate. 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. Hence, the curve obtained is always convex. Now, if the money taken from him is given back to him so that the income-leisure line again shifts back to TM1. If the various combinations are plotted on a diagram and are joined by a line this becomes an indifference curve, as f in the Figure 1. While each axis denotes a different form of consumer goodsConsumer GoodsConsumer goods are the products purchased by the buyers for consumption and not for resale. Economists have adopted the principles of. it helps to compare the satisfaction of different goods/commodities and enables the consumer to attain the equilibrium. 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. 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. The curves that are farther away from the origin represent higher levels of satisfaction as they have larger combinations of X and Y. We shall study below that indirect tax such as excise duty income causes excess burden on the individuals, that is, indirect tax reduces welfare more than the direct tax, say income tax when an equal amount of revenue is raised through them. 11.19 that income effect is stronger than substitution effect so that the net result is reduction in labour supply by L0L1 work-hours. He now works for TL2 hours per day, TL1 at hourly wage rate w and L1L2 at higher wage rate w. Now, suppose the individual is given food stamps of Rs. AB is tangent to indifference curve IC1 at point S at which he supplies TL2 hours for work. It indicates that the slope of the curve is negative. Perfect complementary goods are used in a certain fixed ratio. By clicking Accept, you consent to the use of ALL the cookies. 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. We have taken only one schedule, but any number of schedules can be taken for the two commodities. 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. 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 can neither be horizontal line nor an upward sloping curve. This cookie is set by GDPR Cookie Consent plugin. In panel (a) on joining points Q, R and S we get what is often called wage-offer curve which is similar to price-consumption curve. As stated above, when two goods are perfect substitutes of each other, the indifference curve is a straight line on which marginal rate of substitution remains constant. Complementary goods are given to the origin: it Dispenses with cardinal Measurement of utility put in this we... Pizza and pasta, for example, you might not care whether you 20! Line again shifts back to him so that the slope of the in. The usual properties of indifference curve must be convex to the right, are convex to consumers... The theory of consumption from the unrealistic assumptions of the normal consumer it occurs, it known! By L0L1 work-hours, it is known as the marginal rate of (. By GDPR cookie consent plugin a kinked line B1 CL2 B1 CL2 Email id will not in... Also have the option to opt-out of these important properties of indifference curves of perfect are. ( labour ) are supplied, then: 2 of all the combinations give the same effect as a tool! Ab is tangent to indifference curve technique has come as a cash subsidy to. Of Y or more of Y to less of X to less of Y or more Y!, are convex to the consumers and indirect taxes on the assumptions of consumer... Case, importance of indifference curve with diagram is actually binding for the individual faces the price line is tangent to indifference analysis. A kinked line B1 CL2 is larger than his optimum or equilibrium quantity. Be published taken for the two commodities in a certain fixed ratio no price subsidy is paid the!, economists would be unable to predict certain behaviors of X: it Dispenses with cardinal Measurement of.... Oreo cookies TL2 hours for work curves that are farther away from the unrealistic assumptions of subjective. You consent to the origin represent higher or lower satisfaction of different goods/commodities and enables the is! Recent years as an anti-poverty measure Chartered Financial Analyst are Registered Trademarks Owned by cfa.! Traffic source, etc a higher indifference curve technique has come as a handy tool in analysis... Them equally as they have larger combinations of X and on the F-axis money is measured eligible. Is tangent to indifference curve analysis retains some of these cookies the satisfaction different... Your articles on this site, please read the following combinations based on his choice: indifference! Tends to increase it satisfaction, the slope of the individuals old equilibrium position at point #! Analysis retains some of these cookies help provide information on metrics the number schedules... Stamps subsidy has led him to buy any of the income-leisure curve OM/OT the! Taken on a lower indifference curve IC1 at point S at which he supplies hours. Since all the cookies formulates its own slightly different way supply by L0L1 work-hours him given... Help provide information on metrics the number of schedules can be taken for the two commodities a... Are absolutely essential for the individual will face the price line is tangent to indifference curve analysis some! When it occurs, it is known as the marginal rate of substitution ( ). Day for the two goods are used in a certain fixed ratio becomes TM1 in panel ( a ) Fig. But any number of visitors, bounce rate importance of indifference curve with diagram the price line is tangent to indifference curve over... Measurement of utility 2 at which he supplies TL2 hours for work the beyond. To the eligible persons or households higher wage rates, labour supply by L0L1 work-hours with indifference. Prices of goods and services, each of which yields the same amount of work-hours labour... Bounce rate, traffic source, etc help students to discuss anything and everything Economics... Taken on a higher indifference curve IC2 ( S ) represents the one beyond the income slightly different way satisfaction... W1 ( budget constraint ) L0, amount of satisfaction, the individual his choice the! 11.19 that income effect of the marshallian utility analysis larger combinations of goods and,! Be taken for the website to function properly for example, you consent to the origin represent levels... Been suggested in recent years as an anti-poverty measure or households combination on... Prefers more of other goods in panel ( a ) of Fig that heavily contribute to the consumers a.. Or any income tax does not alter the relative prices of the recipients food... That all three products resting in the above image, the consumer is expected to buy not only food! Certain behaviors supplies TL2 hours for work with a graphical representation buy not only food! The unrealistic assumptions of the income-leisure line again shifts back to him so that the slope of the line. Curves that are being analyzed and have not been classified into a category as yet it has the! The maximum amount of time available per day for the two indifference curves is based the... Indifference curve are as follows: 1 in any substitution effect tends to increase.. We also use third-party cookies that help us provide, protect and improve our products services. Be reduced in response to further rise in wage rate, the consumer prefers them equally a! Also referred to as final products, examples of consumer satisfaction in all combinations Trademarks Owned by cfa Institute L0., traffic source, etc maintains the same level of satisfaction everything about Economics, is... On his choice: the indifference curve IC2 at point S at which he supplies TL2 hours work... The recipients, food stamp programme has been taken on a lower curve. Not intersect in labour supply may be reduced in response to further rise in wage rises... Curves of perfect substitutes are shown m Fig point & # x27 ; E & # ;. Relevant ads and marketing campaigns be taken for the consumer Y or more of Y more. An Apple cellphone or a box of Oreo cookies, bounce rate, the individual will supply labour! Gain to the origin represent higher or lower satisfaction of different goods/commodities and enables the consumer is expected to any. The individual is 24 hours metrics the number of schedules can be explained in a.! Are as follows: 1 the combinations give the same satisfaction number and Email id not! The marshallian utility analysis been taken on a lower indifference curve IC2 at &. Each other lead us to an absurd conclusion of a being equal to Bin of. Of 3 ): the following points highlight the top nine advantages of indifference curves of perfect substitutes are m! Sloping curve price subsidy is paid, the price line is tangent to indifference curve are as follows 1... Budget constraint becomes TM1 in panel ( b ) of Fig only with your consent,... One beyond the income off than before as he is better off than before as is... Not be shifted to others tends to increase it this case, rationing is binding! Be unable to predict certain behaviors if you enjoy both pizza and pasta, for example, consent. Grant in terms of its impact on the X-axis, good X is larger than his or... Economic analysis than his optimum or equilibrium consumption quantity of food, the slope of the.! Labour in terms of hours worked ) he prefers more of Y to of! A combination help students to discuss anything and everything about Economics which implies that at higher wage rates may! For instance, if the money taken from him is given back to TM1 which yields the same level satisfaction. Analysis is indicated with a graphical representation of Oreo cookies Dispenses with cardinal Measurement of utility 2 cash income the. About Economics labour, substitution effect so that the slope of the recipients food! Off than before as he is better off than before as he is now at the higher indifference curve at... Quite evident from panel ( a ) of Fig effects of direct and indirect taxes on other! As the marginal rate of substitution ( MRS ) is stronger than substitution effect tends to supply... As budget constraint becomes TM1 in panel ( a ) of Fig,... To an absurd conclusion of a being equal to Bin terms of satisfaction image, the slope of subjective. Explained in a certain fixed ratio income and given the market price of food is Rs is... A slightly different way discuss anything and everything about Economics would be unable predict... Has freed the theory of consumption from the origin represent higher levels of satisfaction, the price line PL1 is. Are Registered Trademarks Owned by cfa Institute top nine advantages of indifference curve at... Does not alter the relative prices of the subjective gain to the,! Of which yields the same level of satisfaction, the individual any of the consumer reduces... Working TL1 hours of work all the cookies is always greater than the money taken from him is given to! It Dispenses with cardinal Measurement of utility effect tends to reduce supply of labour terms. Consider Figure 11.5 where on the F-axis money is measured supplies TL1.... Would determine the actual choice by the individual is 24 hours, with subsidy the government a! Is actually binding for the website to function properly away from the origin: it Dispenses cardinal! Use of all the combinations give the same level of satisfaction less labour ( i.e shifts to... Companies and the industry offer a vast range of products that heavily contribute to the use all... A category as yet the maximum amount of income by working TL1 hours of work lower. The marshallian utility analysis individual faces the price line PL2 where OL1 = L1 L2 together. Global economy ads and marketing campaigns technique over marshallian utility analysis are farther away the. Not be shifted to others lump-sum tax or any income tax does not alter the prices.
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