6.96(d), the position of the ICs makes the post-subsidy situations qualitatively different from the previous two cases. The utility analysis postulates the law of diminishing marginal utility which is applicable to all types of goods, including money. More generally, for any point on a lower indifference curve, like Ul, you can identify a point on a higher indifference curve like Um or Uh that has a higher consumption of both goods. Content Guidelines 2. The blue curves in the diagram represent indifference curves for Octavio, and are shown as convex from his viewpoint (i.e. The relevant Lagrange function for constrained maximization of the (1) subject to (5) is, The 1st order conditions for constrained maximization of U is. All of the choices on indifference curve Uh are preferred to all of the choices on indifference curve Um, which in turn are preferred to all of the choices on Ul. The earlier economists explained substitutes and complements in terms of cross elasticity of demand. Given these gentle assumptions, a field of indifference curves can be mapped out to describe the preferences of any individual. The numerical slope of the budget line is: The budget constraint of the consumer states that the present value of consumption in the two period should be equal to that of the income of the two periods. We shall see that the typical consumer is better off with an income tax than with a comparable excise tax on a single commodity. (5) The consumers tastes, habits and income remain the same throughout the analysis. That is why the post-income tax budget line of the consumer would be A2B2 it would pass through the point D. Now, the consumer would be in equilibrium at the point of tangency E between the budget line A2B2 and the curve IC2. They are convex to the origin. 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. 6.96 that the effects of the two types of subsidy would depend upon the preference-indifference pattern of the consumer, i.e., upon the position of his indifference curves (ICs). Along with the budget line are shown the three indifference curves from Figure 1. Meaning of Indifference Curve 2. In our case, this amount is BB1 along the horizontal axis. D is, therefore, the consumers initial equilibrium point. IC2 is a higher indifference curve than IC1. We take a situation when the subsidy is not paid in money but the consumers are supplied cereals at concessional rates, the price-difference being paid by the government. 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. Indifference Curve Applications: Income Tax vs. In essence, because the consumer earns interest on current income that is saved, future income is worth less than current income, i.e., the consumer would prefer to have more of current income to more of future income. We may explain the matter with the help of Fig. Marshall justified it on the plea that an individual consumer spends only a small part of his whole expenditure on any one thing at a time. Uploader Agreement. Any points on the highest indifference curve Uh, like F, provide greater utility than any points like A, B, C, and D on the middle indifference curve Um. But he cannot tell by how much he prefers one to the other. Therefore, the consumer here will prefer the in-kind subsidy to the (taxed) cash subsidy. 6.94, where AB is the pre-tax budget line of the consumer. 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. First, the consumers real income has decreased. Report a Violation 11. Plagiarism Prevention 5. Annals of Business Administrative Science, 16(2), 91-102. On the other hand, if he spends all his money income on Y, he would have OA of Y plus he would be able to buy an amount of X with the subsidy which is equal to BB1 or AC. As one moves along a straight-line indifference curve of perfect substitutes, marginal rate of substitution of one good for another remains constant. Thus, because of the imposition of the excise tax, the consumers utility level has worsened. Content Filtration 6. The budget line is AB and the indifference curves I, II, III and IV are a portion of an individual's indifference map. We shall also assume here that Y stands for all the goods other than X, and the consumers money income to be spent on the two goods is M. We shall discuss the effects of the taxes with the help of Fig. Hicks consider this inadequate and explain them after making compensating variation in income. Fig. seen from the bottom left). In Fig. Since, at the optimum point or the point of tangency, the numerical slope of the IC is equal to that of the budget line, and since, the former is equal to MRS of C) for C2 and the latter is equal to 1 + r, the consumers optimum or equilibrium point is characterised by: MRC1 for C2 = 1 + r (6.35). On the other hand, if an equal amount of subsidy is tied to a good, say X, then it is known as a subsidy in kind or an in-kind subsidy. But Fishers model says, instead, that consumption is based on the resources the consumer expects to have over his lifetime. Since the point A (Y1 Y2) is a common point on both the lines, the budget line would rotate now clockwise about the point A from L1M1 to L2M2 as r rises. Let us suppose that the consumer buys only two goods, X and Y. Most people would prefer to increase the quantity or quality of the goods and services they consume. For example, Dalda and Rath Vanaspati, two different brands of cold drink such as Pepsi Cola and Coca Cola are generally considered to be perfect substitutes of each other. Description: Graphically, the indifference curve is drawn as a . A ceteris paribus rise in (real) income would cause a rise in the consumers happiness which is reflected in the fact that the consumers optimum point now would be on a higher IC. Before uploading and sharing your knowledge on this site, please read the following pages: 1. Here is an example to understand the indifference curve better. It means that it cannot be efficient to have total consumption of any good which is less than the output of the good. However, they can, and do, identify what choices would give them more, or less, or the same amount of satisfaction. Each indifference curve (Ul, Um, and Uh) represents one level of utility. This is the income effect of the rise in r. Because of the IE, the consumers C1 has increased in. Consequently, the cash subsidy budget line, net of tax, will be A2B2it would be to the left of A1B1 but parallel to it because the prices remain unchanged. Report a Violation 11. Content Guidelines 2. We shall first examine this constraint in some detail. He has moved from a higher IC (IC2) to a lower IC (IC1). Some of the advantages are: 1. Lilly would have more utility at a point like F on the higher indifference curve Uh, but the budget line does not touch the higher indifference curve Uh at any point, so she cannot afford this choice. Let us now suppose that r rises, Y1 and Y2 remaining unchanged. Account Disable 12. (10) The consumer arranges the two goods in a scale of preference which means that he has both preference and indifference for the goods. Content Filtration 6. We shall do this with the help of Fig. The consumers income at any point H on his pre-tax budget line is equal to the money he spends on x and Y which is, therefore, equal to FH.px + OF.py. This is not measurability but transitivity. At this point, the slope of the indifference curve equals the budget line, so that. 6.96(c), the positions of the ICs are slightly different. The consumers equilibrium point now would move from the point D (C1, C2) on IC2 to the point E(C, C) on a lower IC, viz., IC1, indicating that the consumers real income has decreased. 4.3 Indifference Curves are convex to the origin. Each point on the indifference curves represents the same level of satisfaction. An indifference curve is a curve that represents all the combinations of goods that give the same satisfaction to the consumer. In this article we will discuss about Indifference Curves. Image Guidelines 4. 4.1 Indifference Curves are negatively sloped. 8.6. This is equivalent to two-thirds reduction in the price of food. In the indifference curve technique when the price of a good falls, the real income of the consumer increases. 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. Food stamp Programme in the USA (after 1979) is an example of in-kind subsidy. The indifference curve analysis retains some of the assumptions of the cardinal theory, rejects others and formulates its own. In making this trade off, households must look ahead to the income they expect to receive in the future and to the consumption of goods and services they hope to be able to afford. 5.1 Rationality. The goods are homogenous and divisible. The entire utility analysis assumes that utility is a cardinally measurable quantity which can be assigned weights called untils. There are two cases to consider. The indifference curve technique explains consumers equilibrium in a similar but better way than the Marshallian proportionality rule. The point A (Y1, Y2) lies on the budget line L1M1. Some of these important properties of indifference curve are as follows: 1. It will add up to the total output of the two goods. The following points highlight the top nine advantages of indifference curve technique over marshallian utility analysis. Terms of Service 7. Let us now suppose that r rises, Y1 and Y2 remaining unchanged. An indifference curve shows allcombinations of goods that provide an equal level of utility or satisfaction. The indifference curve Um has four points labeled on it: A, B, C, and D (see Figure 1). The following points highlight the top nine properties of Indifference Curve. 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. Therefore, the amount he pays in tax is equal to (FH.px + OF.py) (FD.px + OF.pY) = (FH FD)px = DH.px. Nguyen Quoc Trung. 6.101. 4.2 Higher IC represents a higher satisfaction level. Lillys preferences are shown by the indifference curves. The consumer has a fixed money income and wants to spend it completely on the goods X and Y. (11) Both preference and indifference are transitive. Therefore we need to restrict attention to consumption bundles for the individuals. Uploader Agreement. In other words, the consumers face a constraint on how much they can spend, which is called a budget constraint. The utility analysis assumes constant marginal utility of money. An IC shows the combinations of period-1 and period-2 consumption that make the consumer equally happy so that he would be indifferent between these combinations. 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. Here, the consumers initial budget line is L1M1 and A (Y1, Y2) is a point on it. Therefore, in both types of subsidy, the effect would be the same type of improvement in the utility level of the consumer, and he would be indifferent between them. Image Guidelines 4. But the two indifference curves cutting each other lead us to an absurd conclusion of A being equal to Bin terms of satisfaction. Hicks have explained the concept of consumers surplus by dispensing with the unrealistic assumption of the marginal utility of money. Therefore, in this case, both the subsidies will improve the consumers utility level in the same way, i.e., the effects of both types of subsidy will be identical. C2 = (1 + r) S + Y2 .(6.132). Therefore, the consumer will be indifferent between the two types of subsidy. It may be noted that the consumer here does not save in the second period because there is no third period. We shall assume here that the prices of goods X and Y remain unchanged as also the consumers initial money income, throughout our analysis. The concept of indifference curve analysis was first propounded by British economist Francis Ysidro Edgeworth and was put into use by Italian economist Vilfredo Pareto during the early 20 th century. On the other hand, with in-kind subsidy, untaxed, the consumer is in equilibrium at the corner point C which lies on IQ. The indifference curve analysis measures utility ordinally. It Dispenses with Cardinal Measurement of Utility 2. When the consumer receives a cash subsidy this would boost up his income, the prices of the goods remaining unchanged. In order to isolate the SE, we shall, for the time being, withdraw the improvement in the consumers real income that has been caused by the rise in r. We may do this by curtailing appropriately Y1 and/or Y2, r remaining unchanged at its new higher level. Disclaimer 8. The amount of cash subsidy here is BB1.px, or, AA1.py. Before uploading and sharing your knowledge on this site, please read the following is an to... 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