We will explain and compare the effects of two types of subsidies, price subsidy and lump sum cash grant, on consumers welfare. The assumptions of the ordinal theory are the following: (1) The consumer acts rationally so as to maximise satisfaction. (3) The consumer possesses complete information about the prices of the goods in the market. Examples of goods that are perfect substitutes are not difficult to find in the real world. It does not store any personal data. Save my name, email, and website in this browser for the next time I comment. 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. 10 per kg., then with Rs. These cookies track visitors across websites and collect information to provide customized ads. 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. We will now explain the consequences if both the commodities X and Y are rationed. 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. In Figure 11.11 both ration limits Rx and Ry are actually binding and force the individual to consume less of both the commodities than he consumes at his equilibrium position E in the absence of rationing of the two commodities. 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. A higher indifference curves to the right of another represents a higher level of satisfaction and preferable combination of the two goods. that is, non-food items) too. But a glance at Fig.8.5 will show that this is absurd conclusion since combination A contains more of good Y than combination B, while the amount of good X is the same in both the combinations. These cookies help provide information on metrics the number of visitors, bounce rate, traffic source, etc. Let us explain how a receipt of food stamps affects the budget line, consumption of food and welfare of the individual. Image Guidelines 5. This means that a part of food stamp subsidy has been indirectly used for financing the purchases of non-food commodities. He has earned OM1 amount of income by working TL1 hours of work. These cookies ensure basic functionalities and security features of the website, anonymously. It, thus, maintains the same level of consumer satisfaction in all combinations. 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. Each individual axis indicates a single type of economic goods. It will be seen that with ration limit fixed at ORx rationing does not act as a binding at all and prove to be quite ineffective in restricting the consumption of good X which is the objective of the policy. 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. If, for instance, the amount of good X is increased in the combination, while the amount of good Y remains unchanged, the new combination will be preferable to the original one and the two combinations will not therefore lie on the same indifference curve provided more of a commodity gives more satisfaction. Figure 11.11 depicts the case of a relatively rich person who without the binding of rationing is at point E on indifference curves IC1 and is consuming greater quantities of the two goods than the ration amounts. It does not store any personal data. 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. Property I. Indifference curves slope downward to the right: This property implies that an indifference curve has a negative slope. 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. If the government is eager to raise the tax revenue and at that time the government may face the issue regarding whether it . Under food stamp programme, some stamps or coupons are given to the eligible persons or households. Thus, the maximum amount of leisure time that an individual can enjoy per day equals 24 hours. As in case of change in price, rise in wage rate has both the substitution effect and income effect. Consider Figure 11.5 where on the X-axis, good X and on the F-axis money is measured. 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). For instance, a child might be indifferent while having a toy, two comic book, four toy trucks and a single comic book. Plagiarism Prevention 4. IC2 is the higher indifference curve than IC1. Thus the cost of giving subsidies to consumers is always greater than the money equivalent of the subjective gain to the consumers. 1. Thus, he has sacrificed L1 L2 more leisure to do overtime work and earns M1M2 more income than before. This shows that a part of food stamp subsidy is indirectly used to finance the increased consumption of other goods. Share Your PDF File We use cookies to personalise content and ads, to provide social media features and to analyse our traffic. Answer (1 of 7): Indifference curve analysis is very important to the study of economics. Indifference curves between income and leisure are therefore also called trade-off curves. 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. These cookies help provide information on metrics the number of visitors, bounce rate, traffic source, etc. 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. 200 per week which he can spend on food alone. They may represent higher or lower satisfaction of the consumer. The usefulness of the indifference curves: it helps to distinguish between the substitution effects and the incomes effects. An indifference curve is a downward sloping convex line connecting the quantity of one good consumed with the amount of another good consumed. it provides an ordinal measurement of utility. This cookie is set by GDPR Cookie Consent plugin. This cookie is set by GDPR Cookie Consent plugin. With a given money income OB1 of an individual and given market price of food, B1L1 is the budget line whose slope represents the price of food (Note that price of money represented on the X-axis is Re. 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. Income OM equals OT multiplied by the hourly wage rate (OM = OT.w) where w represents the wage rate. You are free to use this image on your website, templates, etc., Please provide us with an attribution link. Therefore, the ration limits in this case are not actually binding since these do not any more constrain his consumption. To break up this wage effect on labour supply, we reduce his money income by compensating variation in income. 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. Required fields are marked *. This has been a guide to What is Indifference Curve and its Definition. When a curve intersects the budget limit of an individual consumer, it creates an optimal consumption bundle. The consumer behavior remains constant in the analysis. We also share information about your use of our site with our social media, advertising and analytics partners who may combine it with other information that youve provided to them or that theyve collected from your use of their services. You also have the option to opt-out of these cookies. Straight-line indifference curves of perfect substitutes are shown m Fig. The consumer is expected to buy any of the two commodities in a combination. This is an important feature of Indifference Curve. These cookies ensure basic functionalities and security features of the website, anonymously. With the imposition of excise duty, the price of good X will rise. He decides to exchange 4 units of books for an additional piece of cloth. (11) Both preference and indifference are transitive. IC2 is a higher indifference curve than IC1. Our assumption regarding diminishing MRSxy and the convexity of indifference curves is based upon the observation of actual behaviour of the normal consumer. Consumers can rank a combination of commodities based on their satisfaction levels. These combinations provide the same level of satisfaction and utility to the consumer. Your Mobile number and Email id will not be published. Amount of labour L1 is directly plotted against higher wage rate w, in panel (b) of Fig. An indifference curve has a negative slope, i.e. Content Filtrations 6. In this case, therefore, B1C, will be equal to 20 kg. 11.8 he is at lower indifference curve IC0 indicating his lower level of welfare. It will be seen from Figure 11.16 that the given income-leisure line MT is tangent to the indifference curve IC2 at point E showing choice of OL1 of leisure and OM1 of income. 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. If instead of giving RM as price subsidy on food, Government pays the individual cash money equal to PE, the individual will reach the same level of welfare as he does with RM subsidy. Prohibited Content 3. As explained above in Fig. While leisure yields satisfaction to the individual directly, income represents general purchasing power capable of being used to buy goods and services for satisfaction of various wants. 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 budget constraint can be written as follows: The above inequality implies that consumer can choose a combination of goods from within or on the market opportunity set. The indifference curve analysis retains some of the assumptions of the cardinal theory, rejects others and formulates its own. This cookie is set by GDPR Cookie Consent plugin. Hence, relief payments in cash are preferable to a food subsidy because they are economically more efficient, giving the relief receipts either a greater gain at the same cost to the Government or the same gain at a lower cost.. An indifferent curve is drawn from the indifference schedule of the consumer. In this case with cash subsidy the individual spends more than his initial income OB1 on other goods. An indifferent curve is drawn from the indifference schedule of the consumer. Meaning of Indifference Curve 2. Here, we understand that all three products resting in the indifferent curve give him the same satisfaction. When a consumer wants to have more of a commodity, he/she will have to give up some of the other commodity, given that the consumer remains on the same level of utility at constant income. 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. 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. Disclaimer Copyright, Share Your Knowledge Thus, movement from point S to H and as a result the decrease in labour supply by L2 L1 represents the income effect of the rise in wage rate. Several kinds of subsidies are paid to the individuals these days by the Government for promoting welfare of the people. Here we discuss the properties of the indifference curve and how to analyze it, along with examples and assumptions. 4 Important Properties of Indifference Curve (with curve diagram), Copyright 2023 StudeerSnel B.V., Keizersgracht 424, 1016 GC Amsterdam, KVK: 56829787, BTW: NL852321363B01, This property implies that an indifference curve, 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. 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. This trade-off means how much income the individual is willing to accept for one hour sacrifice of leisure time. Property II: Indifference curves are convex to the origin: Another important property of indifference curves is that they are usually convex to the origin. That is, income is earned by sacrificing some leisure. Therefore, in economics leisure is regarded as a normal commodity the enjoyment of which yields satisfaction to the individual. 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. It is assumed that consumers preferences are monotonic i.e. Let us consider commodities B1 and B2. Meaning of Indifference Curve: The indifference curve analysis measures utility ordinally. It Dispenses with Cardinal Measurement of Utility 2. Thus PE, is money value of the subsidy to the individual. 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. 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. it slopes downward from left to right. 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. At this new equilibrium point E2 he is purchasing Of2 quantity of food and ON2 of other goods. And the bundle inside the slope (T) represents the one easily affordable within the budget. This is an important feature of an indifference curve. Here, of course, is a special case of general principle that, apart from considerations of etiquette and sentiments, you can make someone happier if you give him cash instead of a commodity even if the commodity is something he wants. 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. 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. Likewise, Professor Scitovsky remarks, one can make a man happier by giving him cash and letting him spend it as he thinks best than by forcing him to take all his relief in the form of one commodity. It may, however, be noted that on theoretical grounds it cannot be predicted which effect will be stronger. The indifference curve analysis enables us to understand consumer's general demand behaviour with respect to various types of goods which Marshall treated as special cases. 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. As explained above, with the given wage rate and given trade-off between income and leisure the individual chooses to work for TL1 hours per day. When the consumer repeatedly substitutes or consumes one good over another, the marginal rate of substitution diminishes. 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. When no price subsidy is paid, the individual faces the price line PL1. CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. 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. Privacy Policy3. 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. The curves that are farther away from the origin represent higher levels of satisfaction as they have larger combinations of X and Y. Some of these important properties of indifference curve are as follows: 1. Authorized users may be able to access the full text articles at this site. Thus in this case rationing is actually binding on him and reduces his welfare. He can utilize the following combinations based on his choice: The indifference curve analysis is indicated with a graphical representation. Since we are assuming that subsidy paid by the Government is half the market price of food, the consumer would pay half the market price. 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. Supply curve of labour shows how an individuals work effort responds to changes in the wage rate. If the individual wants to buy more food-grains than B1C, then he will spend some part of his initial income to purchase additional food. Suppose now that Government levies an excise duty (an indirect tax) on good X. Combination L contains more of both goods X and Y than combination M on IC1. Share Your PPT File. But there are a number of indifference curves, as shown in Figure 2. He is also satisfied with 2 units of cloth and 4 units of books. Since at the given market price of food, he can buy ,C amount of food with the food stamps of Rs. We cannot predict the specific result purely on theoretical grounds. These cookies will be stored in your browser only with your consent. 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. Now suppose that wage rate rises to w1 with the result that income-leisure constraint line rotates to TM1. It comprises individual choices, marginal utilityMarginal UtilityA customer's marginal utility is the satisfaction or benefit derived from one additional unit of product consumed. 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. 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. (7) An indifference curve is negatively inclined sloping downward. Ration limit is potentially binding here because due to ration limit the consumer cannot buy any set of two commodities lying in the region SLRX, if he so desires though his price-income situation permits him to do so. In our Figure PE = MK (the vertical distance between two parallel lines) and RM is greater than MK. The maximum amount of time available per day for the individual is 24 hours. TOS 7. With the further increase in wage rate to w2, the income-leisure constraint rotates to TM2 and the individual is in equilibrium when he supplies L2 work-hours which are smaller than L1. 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.