The indifference curve analysis retains some of the assumptions of the cardinal theory, rejects others and formulates its own. With TM1 he reaches his old equilibrium position at point H where he supplies TL1 work-hours. (7) An indifference curve is negatively inclined sloping downward. Therefore, the ration limits in this case are not actually binding since these do not any more constrain his consumption. 11.19 that income effect is stronger than substitution effect so that the net result is reduction in labour supply by L0L1 work-hours. Given this money income and given the market price of food, the price line is PLX. 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. Thus, with the rise in wage rate, supply of labour has decreased by L0L1. Such a situation arises because a consumer consumes a large number of goods and services. 11.20. To do overtime work, he will have to sacrifice more leisure-time and therefore to provide him incentive to forego more leisure and thus to work for more hours it is required to pay him higher wage rate. Necessary cookies are absolutely essential for the website to function properly. A higher indifference curves to the right of another represents a higher level of satisfaction and preferable combination of the two goods. He can utilize the following combinations based on his choice: The indifference curve analysis is indicated with a graphical representation. 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. On the other hand, an indirect tax not only reduces the purchasing power or real income of the consumer causing income effect, but also produces price-induced substitution effect and thus forcing him to purchase less of the commodity on which indirect tax has been levied and buy more of the non-taxed commodity. 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. It is the income that serves as a binding on his consumption choice and not the ration limit. (4) The prices of the two goods are given. 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. This means that a part of food stamp subsidy has been indirectly used for financing the purchases of non-food commodities. For instance, if price of food is Rs. In this equilibrium position the individual works for TL1 hours per day (TL1 = OT-OL1). In its analysis, core principles of microeconomics are involved. At this new equilibrium point E2 he is purchasing Of2 quantity of food and ON2 of other goods. Further, he is better off than before as he is now at the higher indifference curve IC2. But there are some budget constraints due to the low income of the consumer. Without this type of analysis, economists would be unable to predict certain behaviors . The very important feature of the indifference curves is that they are convex to the origin and they cannot be concave to the origin. Now, suppose the individual is given food stamps of Rs. Hence, the curve obtained is always convex. Therefore, given that the consumer is free to spend money as he likes, with cash grant his new equilibrium position must be to the left of point R on the budget line CD where it will be tangent to the higher indifference curve than IC2. 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. With the given wage rate, the individual will choose a combination of income and leisure lying on the income-leisure line MT that maximises his satisfaction. will work for less hours). 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. We use cookies to personalise content and ads, to provide social media features and to analyse our traffic. The preference-maximising point A on indifference curve I 1 shows that . Further, these stamps cannot be traded or transferred to the other people. This is an important feature of Indifference Curve. The straight line MT is the budget constraint, which in the present context is generally referred to as income-leisure constraint and shows the various combinations of income and leisure among which the individual will have to make a choice. He is also satisfied with 2 units of cloth and 4 units of books. Usually, the combination with the higher satisfaction level is preferred. Theindifference curve in economicsexamines demand patterns for commodity combinations, budget constraints and helps understand customer preferences. We also use third-party cookies that help us analyze and understand how you use this website. Another important result obtained from our above analysis is that even with food stamps programme the individual increases the consumption of all other goods (i.e. 1. Since lump-sum tax or any income tax does not alter the relative prices of goods it will not result in any substitution effect. 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. Irish-born British economist Francis Ysidro Edgeworth first proposed this two-dimensional graph, also known as the iso-utility curve. Thus, indirect tax (excise duty) causes an excess burden on the individual. "Nothing is more important than my child's safety" is a corner solution in its refusal to admit there might be trade . The budget line is tangent to indifference curve IC2 at point 'E'. We will further show how much K work effort (i.e. By purchasing OA quantity of food, the individual is spending PT amount of money. Consumer Surplus is the difference between the actual price that the customers pay for a product & the maximum price that they are ready to pay (for a single unit). Complements are thus those goods which are used jointly in consumption so that their consumption increases or decreases simultaneously. Jack is satisfied with 1 unit of cloth and 8 units of books. Second, wage rate is the same irrespective of the number of hours he chooses to work. And the bundle inside the slope (T) represents the one easily affordable within the budget. Property II: Indifference curves are convex to the origin: Another important property of indifference curves is that they are usually convex to the origin. TOS 7. Let us consider commodities B1 and B2. Indifference curve analysis can be used to explain an individuals choice between income and leisure and to show why a higher overtime wage rate must be paid if more hours of work are to be obtained from the workers. Higher indifference curve represents larger bundles of goods i.e. IC is strictly Convex to origin i.e. Also referred to as final products, examples of consumer goods include an Apple cellphone or a box of Oreo cookies. Suppose further that price of food is Rs. In other words, an indifference curve shows the different bundles of goods that a person is indifferent between, as they all provide the same level of utility or satisfaction to the individual. This is directly plotted against the wage rate w0 in panel (b) of Fig. 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. Of course, these ration limits narrow down or truncate his market opportunity set at both ends on the X and Y axes, and in this way they are potentially binding but they are not effective in restraining his consumption. 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. 200 provided to him, while spending his entire income OB on other goods. 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. 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. The slope of the indifference curve measuring marginal rate of substitution between leisure and income (MRSLm ) shows the tradeoff between income and leisure. Disclaimer 9. 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 order to earn income for satisfying his wants for goods and services, he will devote some of his time to do work. Thus, while income effect of the increase in wage rate causes decrease in labour supply by L2L1, its substitution effect causes increase in labour supply by L0L2. It Studies Combinations of Two Goods Instead of One Good 3. The maximum amount of time available per day for the individual is 24 hours. These cookies track visitors across websites and collect information to provide customized ads. These cookies ensure basic functionalities and security features of the website, anonymously. You are free to use this image on your website, templates, etc., Please provide us with an attribution link. 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. 8.8. You consent to our cookies if you continue to use our website. 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. 10 per kg. This is substitution effect of rise in wage rate which tends to increase labour supply by L0L1. When the wage rate rises to W1 (budget constraint becomes TM1 in panel (a) of Fig. The cookie is used to store the user consent for the cookies in the category "Other. Supply curve of labour shows how an individuals work effort responds to changes in the wage rate. 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. 200 he can therefore buy 20 kg of food which is equal to B1C at the given market price. It's essentially the cost of the next best alternative that has been forgiven.read more play a crucial role in the curve analysis. Your Mobile number and Email id will not be published. In other words, PN is the market price of OA quantity of food. Budget Line: Notes on Budget Line, Space, Changes and Slope. The indifference curve technique has come as a handy tool in economic analysis. Empirical research conducted in the USA however reveals that most recipients of food stamp programme represent situation depicted in Fig. 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. bundles which contain more of both or more of at least one. CFA And Chartered Financial Analyst Are Registered Trademarks Owned By CFA Institute. The cookie is used to store the user consent for the cookies in the category "Performance". 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. An important application of indifference curves is to judge the welfare effects of direct and indirect taxes on the individuals. Lump sum tax, proportionate and progressive income taxes, wealth tax, death duty are the examples of direct tax. The latter shows the various combinations of the two commodities such that the consumer is indifferent to those combinations. For instance, the aim of Governments food subsidy programme may be that the needy families should consume more food so that their health and efficiency may be improved. But there are a number of indifference curves, as shown in Figure 2. An important application of indifference curves is to judge the welfare effects of direct and indirect taxes on the individuals. She could also get the same level of utility at point Y, skiing just 1 day and spending 5 days horseback riding. number of hours worked). With equivalent food stamp subsidy of B1C the individual has to choose a point which must be on the kinked budget line B1CL2. Thus, the cash money equivalent of the price subsidy to the individual is less than the cost of the subsidy to the Government. Disclaimer Copyright, Share Your Knowledge Property I. Indifference curves slope downward to the right: This property implies that an indifference curve has a negative slope. Therefore, in economics leisure is regarded as a normal commodity the enjoyment of which yields satisfaction to the individual. Authorized users may be able to access the full text articles at this site. 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. (5) The consumers tastes, habits and income remain the same throughout the analysis. Thus ration limit serves as a binding for him and forces him to consume less of good X and more of good Y than he prefers. 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It is the locus of points representing pairs of quantities between which the individual is indifferent, so it is termed an indifference curve. It is, in fact, an iso-utility curve showing equal satisfaction at all its points. Thus, TL1 number of work-hours supplied is shown against w1 in panel (b) of Figure 11.18. This implies that at higher wage rates, labour supply may be reduced in response to further rise in wage rates. 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. 8.7. He has earned OM1 amount of income by working TL1 hours of work. 11.20. When a curve intersects the budget limit of an individual consumer, it creates an optimal consumption bundle. Combination L contains more of both goods X and Y than combination M on IC1. An Indifference curve shows potential combinations of two items or commodities that, when bought in any order along the curve, leave the buyer equally well off or satisfied. In Figure 11.9 with a given income and prices of the two goods X and Y the consumer is in equilibrium at E buying OM of commodity X and ON of commodity Y. 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. Prohibited Content 3. It is worth noting that wage rate is the opportunity cost of leisure. Now, suppose with the introduction of rationing, ration limit R is fixed for good X and R, for good Y. This means for most of the recipients, food stamp programme has the same effect as a cash subsidy. Thus the cost of giving subsidies to consumers is always greater than the money equivalent of the subjective gain to the consumers. 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. 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. A higher indifference curve shows a higher level of satisfaction. Now, we can bring together the indifference map showing ranking of preferences of the individual between income and leisure, and the income-leisure line to show the actual choice of leisure and income by the individual in his equilibrium position. 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. The difference between the chosen plan of action and the next best plan is known as the opportunity cost. 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. It is, important to note that income is earned by devoting some of the leisure time to do some work. One possibility is that with the food-stamp subsidy and resultant kinked budget line B1CL2, in Fig. The greater the amount of this sacrifice of leisure, that is, the greater the amount of work done, the greater income an individual earns. A budget line reveals all the possibilities in combinations of two goods a consumer can purchase with limited income. If the government is eager to raise the tax revenue and at that time the government may face the issue regarding whether it . set of attainable combinations of two goods X and Y) as shown by the reduced shaded area in Figure 11.7 and therefore in this case the ration limit is only potentially binding on him. It will be seen from Fig. 200 per week which he can spend on food alone. 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. 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. It's essentially the cost of the next best alternative that has been forgiven. 1. You consent to our cookies if you continue to use our website. The slope of the budget line represents the relative pricing of two commodities.

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