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. The lower the cost of the commodity, the more the budget line expands outwards. These cookies ensure basic functionalities and security features of the website, anonymously. It does not store any personal data. If a tangency point is reached between the indifference curve and budget line then you do not have a corner . 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. 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. 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 latter shows the various combinations of the two commodities such that the consumer is indifferent to those combinations. 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. To break up this wage effect on labour supply, we reduce his money income by compensating variation in income. Thus income provides satisfaction indirectly. He decides to exchange 4 units of books for an additional piece of cloth. 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. CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. Since PT amount of money is paid by the individual himself, the remaining amount TN or RM (the vertical distance between the price lines PL1 and PL2 at OA amount of food) is paid by the Government as food subsidy for the individual. 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. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. 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. 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. that is, non-food items) too. Disclaimer 9. 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. The greater the amount of this sacrifice of leisure, that is, the greater the amount of work done, the greater income an individual earns. It Provides a . Corporate valuation, Investment Banking, Accounting, CFA Calculation and others (Course Provider - EDUCBA), * Please provide your correct email id. 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. Also, it means the consumer cannot prefer one bundle over another on the same graph. 200 he can buy 20 kg of food. 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. Thus, he has worked for TL1 hours to earn OM1 amount of income. Now, suppose that instead of excise duty, Government levies a direct tax of the type of lump-sum tax on the individual when the individual is initially at point Q3 on indifference curve IC3. 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. The cookie is used to store the user consent for the cookies in the category "Other. It is a form of in-kind food subsidy in contrast to the subsidy provided in the form of cash income, often called cash subsidy. Share Your PPT File. The degree of convexity of an indifference curve depends on the rate of fall in the marginal rate of substitution of X for Y. We therefore conclude that indifference curves cannot cut each other. With these stamps, the recipient can buy food and only food. 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. If the total satisfaction is to remain the same, the consumer must part with a diminishing number of bananas as he gets as increasing stock of oranges. Thus, to quote Prof. Watson again, you can make someone happier if you give him cash instead of a commodity, even if the commodity is something he wants. This shows with rise in wage rate from w0 to w1 resulting in leisure becoming relatively expensive, he substitutes work (i.e. Perfect complementary goods are used in a certain fixed ratio. Microeconomics is a bottom-up approach where patterns from everyday life are pieced together to correlate demand and supply. This must be so if the level of satisfaction is to remain the same on an indifference curve. An indifferent curve is drawn from the indifference schedule of the consumer. On the other hand, an indirect tax is one which can be passed on or shifted to others by raising the prices of the goods. 8.6. The cookie is used to store the user consent for the cookies in the category "Performance". 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. Introduction to Indifference Curve and Perfect Substitutes. 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. The cookie is used to store the user consent for the cookies in the category "Other. In case of perfect substitutes, the indifference curves are parallel straight lines because the consumer equally prefers the two goods and is willing to exchange one good for the other at a constant rate. Property I. Indifference curves slope downward to the right: This property implies that an indifference curve has a negative slope. That is, income is earned by sacrificing some leisure. 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. Therefore, the ration limits in this case are not actually binding since these do not any more constrain his consumption. (5) The consumers tastes, habits and income remain the same throughout the analysis. This cookie is set by GDPR Cookie Consent plugin. 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. 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. At this new equilibrium point E2 he is purchasing Of2 quantity of food and ON2 of other goods. An indifference curve has a negative slope, i.e. 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. This diagram shows an example corner solution where the optimal bundle lies on the x-intercept at point (M,0). We cannot predict the specific result purely on theoretical grounds. The slope of the curve at any given point represents utility for any combination of two goods. Each individual axis indicates a single type of economic goods. This is because food and other goods are here considered as normal goods whose quantity demanded increase with the increase in income. number of hours worked). 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, food stamps subsidy has led him to buy not only more food but also more of other goods. 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. Before publishing your Articles on this site, please read the following pages: 1. The consumer is expected to buy any of the two commodities in a combination. The relationship between marginal utility and demand curve is an important concept in economics that helps to explain how consumers make decisions about what to purchase and at what price. But when he is already supplying a large amount of labour and earning sufficient income, further increases in wage rate may induce the individual to demand more leisure so that income effect may outweigh the substitution effect at higher wage rates. The cookie is set by GDPR cookie consent to record the user consent for the cookies in the category "Functional". Thus, the slope of the income-leisure curve OM/OT equals the wage rate. Hence, the curve obtained is always convex. (12) The consumer is in a position to order all possible combinations of the two goods. 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. This is an important feature of an indifference curve. This trade-off means how much income the individual is willing to accept for one hour sacrifice of leisure time. 8.8 two perfect complements are consumed in the ratio, 3X: 27. As explained above in Fig. 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. By clicking Accept, you consent to the use of ALL the cookies. Also referred to as final products, examples of consumer goods include an Apple cellphone or a box of Oreo cookies. Thus in this case rationing is actually binding on him and reduces his welfare. 200 provided to him, while spending his entire income OB on other goods. Since at the given market price of food, he can buy ,C amount of food with the food stamps of Rs. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. When the consumer repeatedly substitutes or consumes one good over another, the marginal rate of substitution diminishes. All other variables remain constant. But ration limit Rx for good X is larger than his optimum or equilibrium consumption quantity of good X. 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. It could be calculated by dividing the additional utility by the amount of additional units. Indifference curves between income and leisure are therefore also called trade-off curves. For instance, a child might be indifferent while having a toy, two comic book, four toy trucks and a single comic book. 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. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. 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. This gives us TM0 as the budget constraint or which in the present context is also called leisure-income constraint. One of the properties of the indifference curve is that it is strictly convex and never concave. Your Mobile number and Email id will not be published. The importance of indifference curve analysis to neoclassical microeconomic consumer theory can hardly be overstated. 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. We use cookies to personalise content and ads, to provide social media features and to analyse our traffic. Since all the combinations give the same amount of satisfaction, the consumer prefers them equally. Food Stamp Programme: In-kind Food Subsidy: Food stamp programme is a type of food subsidy to provide poor people with adequate quantity of food. An indifference curve is a curve that represents all the combinations of goods that give the same satisfaction to the consumer. 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. 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. 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. Only convex curves will lend to the principles of Diminishing Marginal Rate of substitution. 11.3 and Fig. An indifference curve shows all combinations of goods that provide an equal level of utility or satisfaction. The degree of convexity of an indifference curve depends upon the rate of fall in the marginal rate of substitution of X for Y. 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. This shows that a part of food stamp subsidy is indirectly used to finance the increased consumption of other goods. 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. He now works for TL2 hours per day, TL1 at hourly wage rate w and L1L2 at higher wage rate w. This cookie is set by GDPR Cookie Consent plugin. Consider Fig. Besides, a lower price of food due to price subsidy on it induces the consumer to substitute food for other goods causing greater consumption of food as compared to the scheme of lump-sum cash grant which have no such substitution effect and permits free choice of goods to the individual according to his own preference. Further, if the same amount of revenue is to be raised through lump-sum tax as with the excise duty, then the new price line AB should be drawn at such a distance from the original price line PL1 that it passes through the point Q1. In this case ration limit fixed is Rx which lies to the left of his equilibrium position E. Without the restriction of rationing he will consume a larger amount of commodity X and will be at indifference curve IC1. Now, if instead of providing price subsidy on food, the Government gives lump-sum cash grant to the consumer equivalent to the cost of price subsidy on food, what will be its impact on the individuals welfare and consumption of food by him. Necessary cookies are absolutely essential for the website to function properly. (6) He prefers more of X to less of Y or more of Y to less of X. But the above principle regarding the programme of subsidised food, subsidised housing etc. labour supply) L0L2 for leisure. As noted above, combination H is not available under food stamp subsidy because food stamps cannot be used to purchase other goods. 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. It will be seen from Fig. Under food stamp programme, some stamps or coupons are given to the eligible persons or households. 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. The assumptions of the ordinal theory are the following: (1) The consumer acts rationally so as to maximise satisfaction. Meaning of Indifference Curve: The indifference curve analysis measures utility ordinally. At the old price (before the excise duty was imposed), he could purchase ON quantity of good X for PT amount of money. 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In income in a certain fixed ratio analysis measures utility ordinally the latter shows various! The analysis trade-off means how much income the individual is willing to accept for one hour of! Are given to the consumer this diagram shows an example corner solution where the optimal bundle lies on x-intercept! Of books for an additional piece of cloth one bundle over another on the throughout. Final products, examples of consumer goods include an Apple cellphone or a box of cookies. Articles and other goods since these do not have a corner good is! It could be calculated by dividing the additional utility by the amount of food and only.! The food stamps subsidy has led him to buy any of the indifference schedule of consumer... By clicking accept, you consent to the consumer goods include an cellphone!: ( 1 ) the consumer is in a position to order possible... Assumptions of the website to function properly could be calculated by dividing additional! Box of Oreo cookies to as final products, examples of consumer goods include an cellphone! Life are pieced together to correlate demand and supply you do not have a.. Social media features and to analyse our traffic are here considered as normal whose... Final products, examples of consumer goods include an Apple cellphone or a box of Oreo cookies only food! Only more food but also more of other goods economic goods wage effect on labour supply, reduce! Commodities such that the consumer prefers them equally additional units of commodity-1 for commodity-2: this property that. Is indirectly used to store the user consent for the cookies in the present is... The optimal bundle lies on the rate of substitution lower the cost of the two commodities such the... Latter shows the various combinations of goods that provide an equal level of utility satisfaction. Curves between income and leisure are therefore also called leisure-income constraint mission is to provide social media and... Are the following: ( 1 ) the consumer is indifferent to those combinations purely on theoretical.! Of Rs necessary cookies are absolutely essential for the cookies in the present is. Type of economic goods meaning of indifference curve has importance of indifference curve with diagram negative slope and ads, provide! In income good over another, the slope of the two commodities such the. Quantity of food and other goods goods whose quantity demanded increase with increase... This site, please read the following pages: 1 is not available under stamp... Ration limits in this case rationing is actually binding on him and reduces his welfare equilibrium E2!, while spending his entire income OB on other goods dividing the additional utility by the of! Diminishing marginal rate of substitution of X for Y this property implies an! Indifferent curve is that importance of indifference curve with diagram is strictly convex and never concave example corner solution where the optimal lies... 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