If the individual can work for all the 24 hours in a day, he would earn income equal to OM. 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). It is assumed that consumers preferences are monotonic i.e. 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. Consumer Surplus = Maximum Price to be paid willingly Actual Paid Price The cookie is used to store the user consent for the cookies in the category "Other. An indifference curve is a graphical representation of various combinations or consumption bundles of two commodities. it helps to compare the satisfaction of different goods/commodities and enables the consumer to attain the equilibrium. Suppose that under food-subsidy programme, the needed families are entitled to purchase food at half the market price, the other half of the market price is paid by the Government as subsidy. And this indifference in prices defines the opportunity costs. The consumer is rational to maximize the satisfaction and makes a transitive or consistent choice. 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. He is in equilibrium at point E where he consumes quantity of good X which is smaller than the ration amount Rx. This cookie is set by GDPR Cookie Consent plugin. This implies that at higher wage rates, labour supply may be reduced in response to further rise in wage rates. 8.8 two perfect complements are consumed in the ratio, 3X: 27. Jack is satisfied with 1 unit of cloth and 8 units of books. Consumer goods companies and the industry offer a vast range of products that heavily contribute to the global economy. The slope of the indifference curve measuring marginal rate of substitution between leisure and income (MRSLm ) shows the tradeoff between income and leisure. These cookies will be stored in your browser only with your consent. 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. With the imposition of excise duty, the price of good X will rise. . First, he is free to work as many hours per day as he likes. TOS4. They slope downward to the right, are convex to the origin and do not intersect. A customer's marginal utility is the satisfaction or benefit derived from one additional unit of product consumed. The ordinal utility theory or the indifference curve analysis is based on the assumptions as discussed above. CFA And Chartered Financial Analyst Are Registered Trademarks Owned By CFA Institute. Copyright 10. You consent to our cookies if you continue to use our website. That is why at point K in Fig. 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. Analytical cookies are used to understand how visitors interact with the website. We cannot predict the specific result purely on theoretical grounds. 8.6. Thus PE, is money value of the subsidy to the individual. Consider Fig. 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. Also referred to as final products, examples of consumer goods include an Apple cellphone or a box of Oreo cookies. The very important feature of the indifference curves is that they are convex to the origin and they cannot be concave to the origin. Hence the name indifference curve. The use of the indifference curve will help to judge the welfare effect of direct and indirect taxes on the individuals. 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. Usually, the combination with the higher satisfaction level is preferred. The Indifference Map refers to a set of Indifference Curves that reflects an understanding and gives an entire view of a consumers choices. 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. In other words, to increase leisure by one hour, an individual has to forego the opportunity of earning income (equal to wage per hour) which he can earn by doing work for an hour. 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. At the old price (before the excise duty was imposed), he could purchase ON quantity of good X for PT amount of money. However, it is important to note that he . This is substitution effect of rise in wage rate which tends to increase labour supply by L0L1. The slope of the curve at any given point represents utility for any combination of two goods. 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. 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. It Dispenses with Cardinal Measurement of Utility 2. These combinations provide the same level of satisfaction and utility to the consumer. 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. Also, it means the consumer cannot prefer one bundle over another on the same graph. 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. He can utilize the following combinations based on his choice: The indifference curve analysis is indicated with a graphical representation. 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. The usefulness of the indifference curves: it helps to distinguish between the substitution effects and the incomes effects. Similarly, if a country has food surpluses and wants to dispose them of, then the food subsidy to the needy families will be the ideal measure to increase the consumption of food-grains and thereby to dispose of the food surpluses. The cookie is used to store the user consent for the cookies in the category "Performance". Analytical cookies are used to understand how visitors interact with the website. Necessary cookies are absolutely essential for the website to function properly. It will be seen from Figure 11.9 that ration amounts of Rx and Ry of goods X and Y respectively are greater than OM and ON which the consumer is buying with his price-income situation. What is indifference curve importance? 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. On the other hand, if substitution effect is relatively larger than the income effect, the rise on wage rate will increase labour supply. 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. An indifference curve is a graph showing combination of two goods that give the consumer equal satisfaction and utility. 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. 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. 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. This cookie is set by GDPR Cookie Consent plugin. Privacy Policy3. 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. 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 will explain and compare the effects of two types of subsidies, price subsidy and lump sum cash grant, on consumers welfare. In panel (a) of this figure it will be seen that at the wage rate w0(w0= OM0/OT), the wage line or income-leisure line is TM0 and the individual is in equilibrium at point Q where he chooses OL0 leisure time and works for TL0 hours. It is worth noting that price subsidy on a commodity is also generally called excise subsidy. This website uses cookies to improve your experience while you navigate through the website. 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. Thus, the slope of the income-leisure curve OM/OT equals the wage rate. Login details for this Free course will be emailed to you. Welcome to EconomicsDiscussion.net! You can calculate it by, 2. 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 food stamp programme can affect the recipient in two ways. These cookies track visitors across websites and collect information to provide customized ads. In other words, besides analysing consumers demand, indifference curves have several other applications. Therefore, RM is also greater than PE. 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 excise duty, sales tax are the examples of indirect tax. 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. 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. Indifference curves between income and leisure are therefore also called trade-off curves. Income OM equals OT multiplied by the hourly wage rate (OM = OT.w) where w represents the wage rate. You also have the option to opt-out of these cookies. It is thus clear that for an individual supplier of labour income effect and substitution effects work in opposite directions. By using our website, you agree to our use of cookies (. Property I. Indifference curves slope downward to the right: This property implies that an indifference curve has a negative slope. In other words, at point Q2 individuals level of welfare is higher than at Q1. 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. it provides an ordinal measurement of utility. he always prefers larger bundle as it gives him higher satisfaction. TOS4. Another point which is worth mentioning in this regard is that indifference curves cannot even meet or touch each other or be tangent to each other at a point. Here, we understand that all three products resting in the indifferent curve give him the same satisfaction. 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. This is a substitution effect of the rise in wage rate tends to reduce leisure and increase labour supply (i.e. Consumers can rank a combination of commodities based on their satisfaction levels. As explained above in Fig. When the consumer repeatedly substitutes or consumes one good over another, the marginal rate of substitution diminishes. An important application of indifference curves is to judge the welfare effects of direct and indirect taxes on the individuals. Share Your PPT File. Since lump-sum tax or any income tax does not alter the relative prices of goods it will not result in any substitution effect. IC2 is the higher indifference curve than IC1. Suppose further that price of food is Rs. It is for this reason that we reject indifference curves of concave or straight-line shapes and assume that indifference curves are normally convex to the origin. 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. 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. CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. 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. 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. Now, suppose the individual is given food stamps of Rs. The assumptions of the ordinal theory are the following: (1) The consumer acts rationally so as to maximise satisfaction. This website includes study notes, research papers, essays, articles and other allied information submitted by visitors like YOU. The curves that are farther away from the origin represent higher levels of satisfaction as they have larger combinations of X and Y. will work for less hours). That is, income is earned by sacrificing some leisure. Combination L contains more of both goods X and Y than combination M on IC1. Also referred to as final products, examples of consumer goods include an Apple cellphone or a box of Oreo cookies. The degree of convexity of an indifference curve depends upon the rate of fall in the marginal rate of substitution of X for Y. Such a diagram is known as an indifference map where each indifference curve corresponds to a different indifference schedule of the consumer. 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. 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. Save my name, email, and website in this browser for the next time I comment. AB is such line obtained after reducing his money income by compensating variation. 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. The consumer behavior remains constant in the analysis. 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. Direct taxes are those taxes whose incidence cannot be shifted to others. 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. 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. The following points highlight the top nine properties of Indifference Curve. If the higher overtime wage rate w represented by the steeper line EK is fixed, the individual is in equilibrium at point H on indifference curve IC2 where he chooses to have OL2 leisure time and OM2 amount of income. An indifference curve shows all combinations of goods that provide an equal level of utility or satisfaction. 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). Since all consumption bundles give an equal amount of utility, the consumer is indifferent to all combinations. It is worth noting that wage rate is the opportunity cost of leisure. When the wage rate rises to W1 (budget constraint becomes TM1 in panel (a) of Fig. 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. That the individual with cash transfer must be better off and his food consumption must be less as compared with price subsidy on food is due to the fact that indifference curves being convex, the budget line CD obtained with cash transfer must intersect the indifference curve IC1 at point R reached with the equivalent price subsidy. 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. By clicking Accept, you consent to the use of ALL the cookies. 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. MRSxy is always diminishing. Now, if substitution effect had been larger than income effect, work-hours supplied would have increased as a result of rise in wage rate. The slope of the budget line represents the relative pricing of two commodities. 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. 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. However, as seen above, in practice it is difficult to make a plan that will increase the consumption of subsidised food and will not affect the consumption of other goods. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. 10 per kg., then with Rs. This website uses cookies to improve your experience while you navigate through the website. (6) He prefers more of X to less of Y or more of Y to less of X. A higher indifference curves to the right of another represents a higher level of satisfaction and preferable combination of the two goods. The indifference curve technique has come as a handy tool in economic analysis. However, his preference for those combined products can be arranged in the order of preference. Thus, TL1 number of work-hours supplied is shown against w1 in panel (b) of Figure 11.18. It is important to note that in this possible case, the effect of food stamp subsidy is exactly the same as would be the case if cash subsidy is granted to the individual. 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. To the global economy: the indifference curves is to judge the welfare effects of two that... Includes study notes, research papers, essays, articles and other allied information submitted visitors! His money income by compensating variation equal to OM individual supplier of labour income effect and effects. Ordinal theory are the examples of consumer goods include an Apple cellphone or a of. 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