Further, income is used to purchase goods, other than leisure for consumption. What is indifference curve importance? Combinations of two goods on the curve provide Jack with the same level of satisfaction (represented by points A, B, C, D in the image). 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. Analytical cookies are used to understand how visitors interact with the website. It means that if combination A is preferable to B, and to C, then A is preferable to C. Similarly, if the consumer is indifferent between combinations A and B, and and C, then he is indifferent between A and C. This is an important assumption for making consistent choices among a large number of combinations. Your Mobile number and Email id will not be published. We shall explain below only few applications. It will be seen from Figure 11.1 that budget line EF touches the indifference curve IC at a point S and is buying OB quantity of food. The cookie is used to store the user consent for the cookies in the category "Performance". Income OM equals OT multiplied by the hourly wage rate (OM = OT.w) where w represents the wage rate. 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. Hence, a consumer prefers to reach the tallest line to attain a higher utility level. These cookies track visitors across websites and collect information to provide customized ads. This is a substitution effect of the rise in wage rate tends to reduce leisure and increase labour supply (i.e. Amount of labour L1 is directly plotted against higher wage rate w, in panel (b) of Fig. 1. In other words, up to wage rate w0 labour supply curve slopes upward and beyond that it starts bending backward. 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. Lastly, out of the two possibilities of the effects of food-stamp subsidy and cash subsidy which is the most common result, that is, the most common outcome of the two possible cases presented in Fig. Therefore, the ration limits in this case are not actually binding since these do not any more constrain his consumption. Introduction to Indifference Curve and Perfect Substitutes. With equivalent food stamp subsidy of B1C the individual has to choose a point which must be on the kinked budget line B1CL2. And this indifference in prices defines the opportunity costs. In the curve, the quantity consumed by B2 will compensate for the increase in the amount consumed by B2. On the other hand, if substitution effect is relatively larger than the income effect, the rise on wage rate will increase labour supply. Suppose now that Government levies an excise duty (an indirect tax) on good X. This happens because the preferences of the individual between food and other commodities are such that he wants to have more than B1C quantity of food which is the quantity of food provided under the food stamp subsidy. With the budget line B1CL2 with food stamp subsidy of B1C, the best that the individual can do is to choose the corner point C of budget line B1CL2 which lies on the highest possible indifference curve IC2 which passes through the point C. Therefore, from the point of individual welfare we reach our earlier conclusion that cash subsidy is superior to in-kind subsidy represented by food stamps programme. It is worth noting that the movement from Q3 on indifference curve IC3 to Q1 on indifference curve IC1 is the combined result of the income effect and substitution effect caused by the excise duty. Thus, the slope of the income-leisure curve OM/OT equals the wage rate. The derivation of supply curve of labour is depicted in 11.18. Only a convex indifference curve can mean a diminishing marginal rate of substitution of X for K If indifference curve was concave to the origin it would imply that the marginal rate of substitution of X for y increased as more and more of X was substituted, for Y. The shaded region bounded by the budget line BL and the coordinate axes represents market opportunity set from which the consumer can make a choice of the two commodities. . bundles which contain more of both or more of at least one. 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. 11.20 where in panel (a) wage offer curve is shown, and in panel (b) supply curve of labour is drawn corresponding to leisure-work equilibrium points in panel (a)Thus, to start with at wage rate w0 (i.e. This increases the consumption of non-food items also. It indicates that the slope of the curve is negative. 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. This must be so if the, level of satisfaction is to remain the same on an, Jomo Kenyatta University of Agriculture and Technology, L.N.Gumilyov Eurasian National University, Kwame Nkrumah University of Science and Technology, Law, Governance, Economy and Society (FOUN 1301), Bachelor of Science in Information Technology (C025), Bachelor of Business Administration (BBA), FOUNDAMENTALS OF NURSING SCIENCE (NRSG 212), Cost and Management Accounting I (AcFn-M2091), Avar Kamps,Makine Mhendislii (46000), Power distribution and utilization (EE-312), PFE Les moyens de preuve dans les contrats lectroniques en Droit Marocain, MCQS Probablity ,Events,laws of probability, Public Goods Vs Private Goods - Difference and Comparison - The Investors Book, Pdfcoffee - the test bank of chapter nine in financial management its important and effective, Leadership and Management MCQS with answer, Applied M I Lnote - Lecture notes All chapters, Written test possible answers for the post of Administrative Officer Grade 12, Business Statistics and Mathematics Solved Past Papers, B.com Part 1 Punjab University 2009-2018, 462802814 Government accounting final examination with answer and solution docx, Assignment 1. This is an important feature of Indifference Curve. read more, theory of exchange, etc. Advertisement cookies are used to provide visitors with relevant ads and marketing campaigns. Only convex curves will lend to the principles of Diminishing Marginal Rate of substitution. The consumer is expected to buy any of the two commodities in a combination. Thus, the cash money equivalent of the price subsidy to the individual is less than the cost of the subsidy to the Government. Save my name, email, and website in this browser for the next time I comment. The individuals preferences between food and other goods are such that with this cash subsidy the individual is in equilibrium at point H where the budget line B2L2 is tangent to his indifference curve IC3. 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. With the imposition of lump sum tax, the price line will shift below but will be parallel to the original price line PL1. Empirical research conducted in the USA however reveals that most recipients of food stamp programme represent situation depicted in Fig. Effect of Subsidies to Consumers: Price Subsidy Vs. Cash Subsidy: An important application of indifference curves is to analyse with its aid the effect of subsidies to the consumers. 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. Property III: Indifference curves cannot intersect each other: 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. The indifference curve indicates the various combinations of two goods that yield equal satisfaction to the consumer. It explains consumer behaviour in terms of his preferences or rankings for different combinations of two goods, say X and Y. These cookies will be stored in your browser only with your consent. That is, income is earned by sacrificing some leisure. Consumer Surplus = Maximum Price to be paid willingly Actual Paid Price "Nothing is more important than my child's safety" is a corner solution in its refusal to admit there might be trade . In this case with cash subsidy the individual spends more than his initial income OB1 on other goods. Content Guidelines 2. But there are a number of indifference curves, as shown in Figure 2. 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). Lump sum tax, proportionate and progressive income taxes, wealth tax, death duty are the examples of direct tax. 11.3 where along the X-axis we measure quantity of food and along the F-axis we measure money which represents all other goods, (i.e. 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. 11.3. 11.19 that income effect is stronger than substitution effect so that the net result is reduction in labour supply by L0L1 work-hours. . What is the shape of IC, when MRS between good X and Y is diminishing? 1. 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. Let us suppose that the individual has OP money income. The theory of consumption is based on the scale of preference and the ordinal ranks or orders of one's preferences. Consumer Surplus = Maximum Price to be paid willingly Actual Paid Price. Hence IC2 curve gives more satisfaction. You may also have a look at the following articles to learn more , Your email address will not be published. The cookie is used to store the user consent for the cookies in the category "Other. An indifference curve is the locus of all those combinations of two goods that yields the same level of utility (satisfaction) to the consumer so that the consumer is indifferent to purchase the particular combination s/he selects. that is, non-food items) too. It provides equivalent satisfaction and utility levels for the consumer. 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. With the imposition of excise duty, the price of good X will rise. 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 superiority of cash grant in terms of its impact on the welfare of the individuals can be explained in a slightly different way. Since the consumer gets an equal preference for all bundles of goods, they are indifferent about any two combinations on the curve. When no price subsidy is paid, the individual faces the price line PL1. Now, suppose with the introduction of rationing, ration limit R is fixed for good X and R, for good Y. 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. As one moves along a straight-line indifference curve of perfect substitutes, marginal rate of substitution of one good for another remains constant. 11.4 . all of which provide satisfaction to the individual. Though both the lump-sum cash transfer and price subsidy on a commodity produces income effect making the individual better off, under cash grant the individual is free to buy different goods according to his own tastes and preferences which ensures a higher level of welfare as compared to the policy of price subsidy on food which imposes a certain pattern of consumption favouring food. Required fields are marked *. (11) Both preference and indifference are transitive. These cookies track visitors across websites and collect information to provide customized ads. Before publishing your articles on this site, please read the following pages: 1. You are free to use this image on your website, templates, etc., Please provide us with an attribution link. Indifference curve must be convex to the origin: 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 further show how much K work effort (i.e. It Studies Combinations of Two Goods Instead of One Good 3. It comprises individual choices, marginal utilityMarginal UtilityA customer's marginal utility is the satisfaction or benefit derived from one additional unit of product consumed. The 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. 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