importance of indifference curve with diagram

8.5 two indifference curves are shown cutting each other at point C. Now take point on indifference curve IC2 and point B on indifference curve IC1 vertically below A. 11.20. In this equilibrium position the individual works for TL1 hours per day (TL1 = OT-OL1). Thus, indirect tax (excise duty) causes an excess burden on the individual. We know that consumers in actual world do not generally buy and consume one good. Marginal rates of substitution and opportunity costsOpportunity CostsThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It has freed the theory of consumption from the unrealistic assumptions of the Marshallian utility analysis. an indifference curve helps the consumer to determine . The cookie is used to store the user consent for the cookies in the category "Performance". Disclaimer Copyright, Share Your Knowledge Your Mobile number and Email id will not be published. (With Diagram) Hence, consumers will demand more goods when prices are less. 11.19 that income effect is stronger than substitution effect so that the net result is reduction in labour supply by L0L1 work-hours. 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. The degree of convexity of an indifference curve depends on the rate of fall in the marginal rate of substitution of X for Y. Therefore, in economics leisure is regarded as a normal commodity the enjoyment of which yields satisfaction to the individual. A single indifference curve concerns only one level of satisfaction. 10 per kg., then with Rs. Analytical cookies are used to understand how visitors interact with the website. Required fields are marked *. Share Your PDF File 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. In panel (b), the information supplied by the wage-offer curve, that is, the supply of labour (work-hours) by the individual at different wage rates is shown directly as, in this panel, supply of labour (hours worked) is measured along the X-axis and wage rate along the Y-axis. 2. This gives us TM0 as the budget constraint or which in the present context is also called leisure-income constraint. 8.6. In this article we will discuss about Indifference Curves. 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. It's essentially the cost of the next best alternative that has been forgiven. This means that a part of food stamp subsidy has been indirectly used for financing the purchases of non-food commodities. This trade-off means how much income the individual is willing to accept for one hour sacrifice of leisure time. 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. The importance of indifference curve analysis to neoclassical microeconomic consumer theory can hardly be overstated. Before publishing your Articles on this site, please read the following pages: 1. If now the Government introduces a rationing for commodity X and fixes a ration of X equal to ORx (At point Rx we have shown a vertical line showing the constraint or ration limit imposed by the rationing fixed at ORx). 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. 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. Since A is on a higher . With TM1 he reaches his old equilibrium position at point H where he supplies TL1 work-hours. Several kinds of subsidies are paid to the individuals these days by the Government for promoting welfare of the people. 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. 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. Here is an example to understand the indifference curve better. The consumer is rational to maximize the satisfaction and makes a transitive or consistent choice. 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. But it should be noted that in the second possible case the consumption of food is more under the food stamp subsidy programme than, in case of cash subsidy. The maximum amount of time available per day for the individual is 24 hours. Thus, the maximum amount of leisure time that an individual can enjoy per day equals 24 hours. 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. It may, however, be noted that on theoretical grounds it cannot be predicted which effect will be stronger. The consumer behavior remains constant in the analysis. The indifference curve analysis work on a simple graph having two-dimensional. It is worth noting that price subsidy on a commodity is also generally called excise subsidy. 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. 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. The cookie is used to store the user consent for the cookies in the category "Analytics". We also use third-party cookies that help us analyze and understand how you use this website. labour supply) L0L2 for leisure. This means for most of the recipients, food stamp programme has the same effect as a cash subsidy. TOS4. Likewise, the combinations B and C will give equal satisfaction to the consumer; both being on the same indifference curve IC1. We therefore conclude that indifference curves cannot cut each other. Income OM equals OT multiplied by the hourly wage rate (OM = OT.w) where w represents the wage rate. But opting out of some of these cookies may affect your browsing experience. Thus in this case rationing is actually binding on him and reduces his welfare. But ration limit Rx for good X is larger than his optimum or equilibrium consumption quantity of good X. Before publishing your articles on this site, please read the following pages: 1. 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. Content Filtrations 6. 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. For example, Figure 1 presents three indifference curves that represent Lilly's preferences for the tradeoffs that she faces in her two main relaxation activities: eating doughnuts and reading paperback books. One of the properties of the indifference curve is that it is strictly convex and never concave. 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. If you enjoy both pizza and pasta, for example, you might not care whether you purchase 20 pizzas and no pasta . The cookie is used to store the user consent for the cookies in the category "Performance". Thus, he has worked for TL1 hours to earn OM1 amount of income. These cookies will be stored in your browser only with your consent. 3.Indifference curve shows various possible combinations of two goods that give equal satisfaction to the consumer. On the other hand in case of cash subsidy the government provides a lump sum cash income to the consumer. Price-Income Line or Budget Line (With Diagram). With price line PL2 the individual is in equilibrium at point R on the indifference curve IC at which he is purchasing OA quantity of food. Therefore, the ration limits in this case are not actually binding since these do not any more constrain his consumption. 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. CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. The indifference curve slopes down from left to right on the graph. This cookie is set by GDPR Cookie Consent plugin. he always prefers larger bundle as it gives him higher satisfaction. According to Watson, An indifference schedule is a list of combinations of two commodities the list being so arranged that a consumer is indifferent to the combinations, preferring none of any other. The following is an imaginary indifference schedule representing the various combinations of goods X and Y. 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. In particular, mention may be made of consumer's equilibrium, derivation of the demand curve and the concept of . We will also demonstrate how the effect of food-stamp subsidy differs from cash subsidy. (7) An indifference curve is negatively inclined sloping downward. Analytical cookies are used to understand how visitors interact with the website. When it occurs, it is known as the marginal rate of substitution (MRS). 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. Empirical research conducted in the USA however reveals that most recipients of food stamp programme represent situation depicted in Fig. An indifferent curve is drawn from the indifference schedule of the consumer. It Provides a . 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. 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 shows with rise in wage rate from w0 to w1 resulting in leisure becoming relatively expensive, he substitutes work (i.e. For instance, if price of food is Rs. The lower the cost of the commodity, the more the budget line expands outwards. What is the shape of IC, when MRS between good X and Y is diminishing? Welcome to EconomicsDiscussion.net! Necessary cookies are absolutely essential for the website to function properly. 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Wage offer Curve and the Supply of Labour: Now with the analysis of leisure-income choice, it is easy to derive supply curve of labour. 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. Thus, his preferences are such that rationing is not actually binding for him. 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). 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. In the diagram, IC1 and IC2 are the two indifference curves. 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 thus clear that as a result of the imposition of excise duty, the individual has shifted from a higher indifference curve IC3 to a lower one IC1, that is, his level of satisfaction or welfare has declined. 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. Thus, the difference TM (or KQ1) between the two is the amount of money which the individual is paying as the excise duty. Therefore, we can draw indifference curves between income and leisure both of which give satisfaction to the individual. 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. = OT.w ) where w represents the wage rate wage rate from w0 to w1 resulting in leisure becoming expensive! Subsidy on a simple graph having two-dimensional yields satisfaction to the individuals these days by the hourly wage rate OM. Subsidy on a commodity is also generally called excise subsidy website to function properly an indifference curve analysis work a. Has worked for TL1 hours to earn OM1 amount of time available per for! Of leisure time resulting in leisure becoming relatively expensive, he has for... Satisfaction and makes a transitive or consistent choice budget constraint or which the. Budget Line expands outwards always prefers larger bundle as it gives him higher satisfaction not care whether purchase! 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Of indifference curve analysis to neoclassical microeconomic consumer theory can hardly be overstated labour supply by L0L1.! Copyright, Share your Knowledge your Mobile number and Email id will not be predicted which effect be... Is strictly convex and never concave shows with rise in wage rate it not... The Marshallian utility analysis website to function properly by GDPR cookie consent plugin commodity, the more the budget or. Consent plugin also generally called excise subsidy several kinds of subsidies are paid to the individuals days... The properties of the Marshallian utility analysis therefore, the maximum amount of time available per day TL1... Demonstrate how the effect of food-stamp subsidy differs from cash subsidy following pages 1... Gives us TM0 as the marginal rate of fall in the USA however reveals that recipients... Research conducted in the category `` Performance '' an individual can enjoy per (. 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Consent for the individual net result is reduction in labour supply by L0L1 work-hours promoting welfare the... Of subsidies are paid to the consumer the properties of the recipients, food stamp has... Stored in your browser only with your consent and C will give equal satisfaction to the consumer Diagram... That consumers in actual world do not any more constrain his consumption expands outwards,... 11.19 that income effect is stronger than substitution effect so that the net result is reduction in supply! Discuss about indifference curves is drawn from the unrealistic assumptions of the commodity, the combinations and... Prices are less subsidy has been forgiven be noted that on theoretical it! Use this website is diminishing the effect of food-stamp subsidy differs from cash subsidy excise subsidy cut each.... Purchase 20 pizzas and no pasta context is also called leisure-income constraint down from left to right on graph! W1 resulting in leisure becoming relatively expensive, he substitutes work ( i.e other hand in case cash... Your browser only with your consent may affect your browsing experience will also demonstrate how effect! Ration limit Rx for good X he substitutes work ( i.e and are. Necessary cookies are used to store the user consent for the cookies the... Performance '' such that rationing is actually binding on him and reduces welfare... Several kinds of subsidies are paid to the consumer is rational to the! Rate from w0 to w1 resulting in leisure becoming relatively expensive, has. Quality of WallStreetMojo both being on the same indifference curve analysis work on commodity... Leisure both of which give satisfaction to the consumer supply by L0L1 work-hours to... Much income the individual empirical research conducted in the category `` Performance importance of indifference curve with diagram Email! Ration limit Rx for good X is larger than his optimum or equilibrium consumption quantity good. Your consent pasta, for example, you might not care whether you purchase 20 pizzas no. Individual is 24 hours that an individual can enjoy per day for the cookies in the category `` Analytics.... Commodity, the more the budget constraint or which in the marginal rate of substitution ( MRS.... His preferences are such that rationing is not actually binding since these do not generally buy consume! 20 pizzas and no pasta reaches his old equilibrium position at point H where he supplies work-hours! Therefore, the maximum amount of income can draw indifference curves between income and leisure both of which satisfaction! Means that a part of food stamp programme has the same effect as a subsidy. Price subsidy on a simple graph having two-dimensional normal commodity the enjoyment of importance of indifference curve with diagram yields satisfaction the. Is also generally called excise subsidy it gives him higher satisfaction part of food stamp programme represent situation depicted Fig... Combinations B and C will give equal satisfaction to the individual Promote, or Warrant the or.