For instance, a child might be indifferent while having a toy, two comic book, four toy trucks and a single comic book. In particular, mention may be made of consumer's equilibrium, derivation of the demand curve and the concept of . Since the consumer cannot use food stamps to buy non-food items (other goods) he cannot spend more than his initial income OB1 on other goods. This increases the consumption of non-food items also. Necessary cookies are absolutely essential for the website to function properly. Since an indifference curve represents those combinations of two commodities which give equal satisfaction to the consumer the combinations represented by points A and C will give equal satisfaction to the consumer because both lie on the same indifference curve IC2. Prior to grant of any subsidy, and given his budget line B1L1 the individual is in equilibrium at point E1 on indifference curve IC1. Now, the important question is why an indirect tax (an excise duty or a sales tax on a commodity) causes excess burden on the consumer in terms of loss of welfare or satisfaction. 11.3 the individual maximises his satisfaction at point E2 where his budget line is tangent to indifference curve IC2. The indifference curve analysis work on a simple graph having two-dimensional. This website uses cookies to improve your experience while you navigate through the website. 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. A customer's marginal utility is the satisfaction or benefit derived from one additional unit of product consumed. Therefore, this can be interpreted to be the case of a poor family whose optimum consumption basket of the two goods is small because of its low income and therefore remains unaffected if ration limits are set at higher levels. (5) The consumers tastes, habits and income remain the same throughout the analysis. We will further show how much K work effort (i.e. It could be calculated by dividing the additional utility by the amount of additional units. These cookies track visitors across websites and collect information to provide customized ads. (4) The prices of the two goods are given. Hence IC2 curve gives more satisfaction. The preference-maximising point A on indifference curve I 1 shows that . . 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 explains consumer behaviour in terms of his preferences or rankings for different combinations of two goods, say X and Y. 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. On the other hand, the rise in wage rate increases the opportunity cost or price of leisure, that is, it makes enjoyment of leisure relatively more expensive. This means that if individual is paid PE amount of money (say as a cash grant), he reaches the same indifference curve IC (same level of welfare) at which he is when price subsidy is paid by the Government on food. After reading this article you will learn about: 1. 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. In Figure 6, consider the indifference curves I 1 and I 2 and combination N and A respectively on them. However, the actual choice of income and leisure by an individual would also depend upon what is the market rate of exchange between the two, that is, the wage-rate per hour of work. 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 now explain the consequences if both the commodities X and Y are rationed. Each individual axis indicates a single type of economic goods. 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. In other words, the combinations which lie on a higher indifference curve will be preferred to the combinations which lie on a lower indifference curve. That is, income effect of the rise in wage rate on leisure is positive, that is, leads to the increase in the hours of leisure enjoyed (that is, tends to decrease labour supply). Now, with TM1 as new income-leisure constraint line, the individual is in equilibrium at point H at which he supplies TL1 work-hours of labour which are less than TL0. The cookie is used to store the user consent for the cookies in the category "Analytics". An important application of indifference curves is to judge the welfare effects of direct and indirect taxes on the individuals. 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. Income Effect and Substitution Effect of the Change in Wage Rate: Now the supply curve of labour does not always slope upward as is shown in Fig. We have taken only one schedule, but any number of schedules can be taken for the two commodities. It will be seen from Figure 11.2 that with food subsidy RM, the individual is having OA amount of food, whereas with equivalent cash payment of PC the individual purchases OB amount of food which is less than OA. That is, income is earned by sacrificing some leisure. 11.1 cost of price subsidy on food to the Government equals RM amount of money. The greater the amount of this sacrifice of leisure, that is, the greater the amount of work done, the greater income an individual earns. The cookie is used to store the user consent for the cookies in the category "Performance". That is, at wage rate w0he supplies TL0 amount of labour. It does not store any personal data. 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. Therefore, RM is also greater than PE. This is because some part of the income which the individual was spending on food prior to food-stamp subsidy gets released because of the food-stamps being used for its purchase and this released income is spent on non-food items. 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). Disclaimer Copyright, Share Your Knowledge Higher indifference curve represents larger bundles of goods i.e. As in case of change in price, rise in wage rate has both the substitution effect and income effect. An indifference curve is a graph that represents the different combinations of two goods that give an individual the same level of satisfaction or utility. All this means that the two perfect complements are used in a certain fixed ratio and cannot be substituted for each other In Fig. We cannot predict the specific result purely on theoretical grounds. 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. 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. You may also have a look at the following articles to learn more , Your email address will not be published. Save my name, email, and website in this browser for the next time I comment. As one moves along a straight-line indifference curve of perfect substitutes, marginal rate of substitution of one good for another remains constant. Consumer goods companies and the industry offer a vast range of products that heavily contribute to the global economy. The degree of convexity of an indifference curve depends upon the rate of fall in the marginal rate of substitution of X for Y. It allows the consumer to buy within a given budget, i.e., within their current income. Welcome to EconomicsDiscussion.net! This cookie is set by GDPR Cookie Consent plugin. He is also satisfied with 2 units of cloth and 4 units of books. 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. It means that the price ratio of commodity-1 and commodity-2 should be equal to the marginal rate of substitution of commodity-1 for commodity-2. 11.4. A single indifference curve concerns only one level of satisfaction. Privacy Policy3. It is the income that serves as a binding on his consumption choice and not the ration limit. Suppose to begin with the wage rate is w0 and if all the available hours OT are used to do work, OM0 money income is earned. In this figure we measure money income on the Y-axis and leisure (reading from left to right) and labour supply (reading from right to left) on the X-axis. The marginal rate of substitution (MRS) indicates if a consumer is willing to sacrifice one good for another commodity while maintaining the same level of utility. AB is such line obtained after reducing his money income by compensating variation. Content Guidelines 2. Hence the name indifference curve. It will be seen from Figure 11.1 that PE is less than RM which is the amount of money paid by the Government as subsidy. 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. Functional cookies help to perform certain functionalities like sharing the content of the website on social media platforms, collect feedbacks, and other third-party features. This is an important feature of an indifference curve. In the United States it was introduced in 1964 and was amended in 1979 and since then it continues there in the amended form. . 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. 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. In India also food stamp programme has been suggested in recent years as an anti-poverty measure. Irish-born British economist Francis Ysidro Edgeworth first proposed this two-dimensional graph, also known as the iso-utility curve. He now works for TL2 hours per day, TL1 at hourly wage rate w and L1L2 at higher wage rate w. Before publishing your articles on this site, please read the following pages: 1. This is directly plotted against the wage rate w0 in panel (b) of Fig. 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 . Such a situation arises because a consumer consumes a large number of goods and services. Effect of Rationing On Consumers Welfare: Indifference curve analysis can be used to explain under what conditions rationing of goods by the Government can act as binding or a constraint on consumers choices and further how it affects his welfare. 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. 200 per week which he can spend on food alone. Supply curve of labour shows how an individuals work effort responds to changes in the wage rate. As a result of the rise in price of good X, the price line rotates to a new position PL2 which is tangent to indifference curve IC1 at point Q1. The cookie is used to store the user consent for the cookies in the category "Analytics". Now, suppose with the introduction of rationing, ration limit R is fixed for good X and R, for good Y. 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