We may break up this total effect into a substitution effect and an income effect. 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. Account Disable 12. 5.3 Diminishing Marginal Rate of Substitution. 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. 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. An indifference curve shows allcombinations of goods that provide an equal level of utility or satisfaction. The consumer is in equilibrium at a point where his budget line is tangent to the indifference curve. The stamps are non-tradable (if they were tradable, then the programme would have reduced to a general cash subsidy programme). Assumptions of Indifference Curve. He can tell whether he prefers the first to the second, or the second to the first or he is indifferent between them. Disclaimer 8. Indifference Curve Applications of Taxes and Subsidies! 4 Important Properties of Indifference Curve (with curve diagram) Article shared by: Property I. Indifference curves slope downward to the right: This property implies that an indifference curve has a negative slope. Did you have an idea for improving this content? This movement in his equilibrium point (from F to E) is the income effect of the rise in r. Because of this effect the consumers C1 would increase in Fig. Description: Graphically, the indifference curve is drawn as a . Similarly, because any particular quantity of future consumption is paid for out of savings that have earned interest, future consumption costs less than current consumption. (10) The consumer arranges the two goods in a scale of preference which means that he has both preference and indifference for the goods. But this difference is irrelevant, for we get the same effects as in the previous case. 6.95. Thus, Lillys preferences will include an infinite number of indifference curves lying nestled together on the diagrameven though only three of the indifference curves, representing three levels of utility, appear in Figure 1. In order to isolate the SE, we shall for the time being compensate the consumer for the deterioration in his real income level by appropriately increasing his Y1 and/or Y2, r remaining unchanged.

Consider an individual whose utility function is U = C1C2, where Ct and C2 represent present and future consumption respectively. Property IV: A higher indifference curve represents a higher level of satisfaction than a lower indifference curve: The last property of indifference curve is that a higher indifference curve will represent a higher level of satisfaction than a lower indifference curve. It is untainted by the psychological assumptions of the utility analysis. This line has touched one of his ICs, viz., IC1 at the point D(C1, C2). After we have known the SE, we may now withdraw the notional compensatory increase in his money income, and as we do this his budget line would have a parallel leftward shift from ST to L2M2 and his equilibrium point would move from the point F on IC2 to the point E on IC1. This is not at all surprising, because both C1 and C2 are MIBsif the consumers period 1 consumption is reduced to, say, from point W to point X, his period-2 consumption must increase to keep him equally happy. An example of a price subsidy is obtained when the government pays, say, 80 per cent of the cost of medical care which means actually an 80 per cent reduction in the price of medical care. In other words, the indifference curve is relatively flatter in its right-hand portion and relatively steeper in its left-hand portion. Combination Q on the higher indifference curve IC2 will give a consumer more satisfaction than combination S on the lower indifference curves IC1 because the combination Q contains more of both goods X and Y than the combination S. Hence the consumer must prefer Q to S. And by transitivity assumption, he will prefer any other combination such as combination R on IC2 (all of which are indifferent with Q) to any combination on IC1 (all of which are indifferent with S) We, therefore, conclude that a higher indifference curve represents a higher level of satisfaction and combinations on it will be preferred to the combinations on a lower indifference curve. The choice of H with three books and 70 doughnuts on indifference curve Ul is a wasteful choice, since it is inside Lillys budget set, and as a utility-maximizer, Lilly will always prefer a choice on the budget constraint itself. Property I. Indifference curves slope downward to the right: This property implies that an indifference curve has a negative slope. Examples of Indifference Curve with Diagram. Indifference Curve Applications of Taxes and Subsidies! The reason for this difference is that points A and C are different starting points, and thus have different implications for marginal utility. 6.96(c), the positions of the ICs are slightly different. This website uses cookies and third party services. The consumers preferences regarding consumption in the two periods can be represented by his indifference curves (ICs). This must be so if the level of satisfaction is to remain the same on an indifference curve. So period-1 consumption would be C1 = Y1 + Y2/1+r. Nederlnsk - Frysk (Visser W.), Handboek Caribisch Staatsrecht (Arie Bernardus Rijn), The Importance of Being Earnest (Oscar Wilde), English (Robert Rueda; Tina Saldivar; Lynne Shapiro; Shane Templeton; Houghton Mifflin Company Staff), Auditing and Assurance Services: an Applied Approach (Iris Stuart), Managerial Accounting (Ray Garrison; Eric Noreen; Peter C. Brewer), Junqueira's Basic Histology (Anthony L. Mescher), Big Data, Data Mining, and Machine Learning (Jared Dean), Principles of Marketing (Philip Kotler; Gary Armstrong; Valerie Trifts; Peggy H. Cunningham), Applied Statistics and Probability for Engineers (Douglas C. Montgomery; George C. Runger). This is the income effect. The post-subsidy budget lines without any sort of tax are A1CB1 for cash subsidy and ACB1 for in-kind subsidy in Fig. Consequently, the horizontal (C1) intercept of the budget line will diminish and the vertical intercept will increase. As a result, the consumers budget line would have a parallel rightward shift from L2M2 to ST, the latter being a tangent to IC2 at the point F (C1, C2). 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. Indifference Curves are Convex towards the Origin: Indifference curves are convex towards the origin because marginal rate of substitution continously decreases (because as the stock of one commodity decreases its marginal importance for the consumer will continously increases and as the stock of another commodity increases its marginal . 6.98 graphs the consumers budget constraint. What is Lillys utility-maximizing choice? Terms of Service 7. The following points highlight the top nine advantages of indifference curve technique over marshallian utility analysis. 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. In other words, they are steeper on the left and flatter on the right. We shall do this with the help of Fig. (6.134) gives us the standard form of the consumers inter-temporal budget constraint.

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. 6.96(b). This is the income effect of the rise in r. Because of the IE, the consumers C1 has increased in. This relationship, however, is incomplete at best. One of the main defects in the Marshallian utility analysis is that it fails to analyse the income and substitution effects of a price change. Here, the consumers initial budget line is L1M1 and A (Y1, Y2) is a point on it. Content Guidelines 2. Indifference Curve and Utility Approach: Similarities, How to derive Individuals Demand Curve from indifference Curve Analysis? First, the case in which the consumer is initially saving, and second, the case in which he is initially borrowing. Fig. By setting aside the assumption of putting a numerical valuation on utilityan assumption that many students and economists find uncomfortably unrealisticthe indifference curve framework helps to clarify the logic of the underlying model.

Disclaimer 8. The in-kind subsidy budget line, however, would remain the same as ACB1. Keynes assumed that a persons current consumption depends largely on his current income. We have examined three different situations in Fig. Lastly, the consumer is equally happy at all points on an IC but he prefers any point on a higher IC to any point on a lower IC. In other words, an infinite number of indifference curves are not drawn on this diagrambut you should remember that they exist. Since, IC2 is a lower curve than IC3, consumers level of satisfaction will be adversely affected by the income tax, but since IC2 is a higher curve than IC1 his well-being will not be as adversely affected as done by the excise tax. EconomicsDiscussion.net All rights reserved. It will add up to the total output of the two goods. 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. Second, since r has increased, period 1 consumption (C,) has become relatively dearer and period 2 consumption has become relatively cheaper. The consumer likes all of them equally. Report a Violation 11. 6.102 that the total effect of the rise in r has been equal to the income effect plus the substitution effect. A higher indifference curves to the right of another represents a higher level of satisfaction and preferable combination of the two goods. It tells us the rate at which period 1 consumption would be substituted for period-2 consumption at any particular point on the IC, or, at any particular C1. The reason behind this shape involves diminishing marginal utilitythe notion that as a person consumes more of a good, the marginal utility from each additional unit becomes lower. where r is the real rate of interest. 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. (8) An indifference curve is always convex to the origin. C2 = (1 + r) S + Y2 .(6.132). It can slope or bend backward too which implies that at a higher wage rate, the individual will supply less labour (i.e. an abstract guide, Jomo Kenyatta University of Agriculture and Technology, L.N.Gumilyov Eurasian National University, Kwame Nkrumah University of Science and Technology, Bachelor of science in accountancy (150062), Avar Kamps,Makine Mhendislii (46000), Power distribution and utilization (EE-312), Ch07sol 8e - Managerial Finance Text Book Solutions, Instructors Manual Exercise Solutions for Artificial Intelligence A Modern Approach - Third Edition by Stuart J. Russell and Peter Norvig (), Mom chap 1 - mechanics of materials 7th edition solition manual chapter 1, Suh, Y.
Therefore, now the consumers budget line would be AB1 and he would be in equilibrium at the point of tangency E between this budget line and an IC, viz., IC2. The indifference curve analysis measures utility ordinally. Of course, A, B and D are only three of the many combinations of period-1 and period-2 consumption that the consumer can afford; consumption at any point on the line from B to D is available to the consumer. The indifference curve analysis retains some of the assumptions of the cardinal theory, rejects others and formulates its own. It may be noted that the consumer here does not save in the second period because there is no third period. Higher indifference curves represent a greater level of utility than lower ones. 4 Important Properties of Indifference Curve (with curve diagram) - - StuDocu. At point A on the budget line, the consumer consumes exactly his income in each period (C1 = Y1 and C2 = Y2), so there is neither nor borrowing between the two periods. If the sellers can pass on the whole tax to the consumers, the price of X will rise by the amount of the tax, and the x-intercept of the budget line will reduce from OB to OB1, and the post-tax budget line would become AB1. Fig. Several possibilities are identified in the diagram. The indifference curve I1 is the locus of the points L, M, N, P, Q, and R, showing the combinations of the two goods X and Y between which the consumer is indifferent. 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.

1.

If the consumer does not save in period 1, then also we have C1 = Y1 and C2 = Y2 giving us C1 + C2 = Y1 + Y2. Thus, the marginal utility that Lilly would gain from, say, increasing her consumption of books from two to three must be equal to the marginal utility that she would lose if her consumption of doughnuts was cut from 120 to 84so that her overall utility remains unchanged between points A and B. 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.

At point B, the consumer consumes nothing in period 1 (Q = 0) and saves all income, so the period-2 consumption is C2 = (1 + r) Y1 + Y2. For example, Figure 1 presents three indifference curves that represent Lillys preferences for the tradeoffs that she faces in her two main relaxation activities: eating doughnuts and reading paperback books. 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. The entire utility analysis assumes that utility is a cardinally measurable quantity which can be assigned weights called untils.

The factor 1/1+r which is equal to the reciprocal of the numerical slope of the budget line (6.134), is the price of period 2 consumption measured in terms of period 1 consumptionit is the amount of period 1 consumption that the consumer must forego to obtain one unit of period 2 consumption. This assumption makes the utility theory unrealistic in more than one way. Similarly, any points on the middle indifference curve Um provide greater utility than any points on the lowest indifference curve Ul. 6.103 that the total effect of the rise in r is equal to the SE plus the IE. 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. Only a convex indifference curve can mean a diminishing marginal rate of substitution of X for K If indifference curve was concave to the origin it would imply that the marginal rate of substitution of X for y increased as more and more of X was substituted, for Y. Indifference Curve Applications: Income Tax vs. 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. An indifference curve is a graphical representation that explores how a consumer may be indifferent to two products that give him the same level of customer satisfaction and utility. (with diagram), Indifference Curve Approach (With Uses) | Economics. Indifference curve : It shows the different commodities in which consumers get equal satisfaction. These questions allow you to get as much practice as you need, as you can click the link at the top of the first question (Try another version of these questions) to get a new set of questions. In microeconomics, indifference curve is an important tool of analysis in the study of consumer behavior. The latter, according to Prof. Hicks, is not mere translation but is a positive change. In the case of a cash subsidy the consumer is given some amount of cash as a matter of subsidy. This would result in a substitution effect (SE). EconomicsDiscussion.net All rights reserved. This makes the indifference curve technique definitely superior to the Marshallian introspective cardinalism. This website uses cookies and third party services. Each point on the indifference curves represents the same level of satisfaction. Content Guidelines 2. He regards consumers surplus as a means of expressing, in terms of money income, the gain which accrues to the consumer as a result of a fall in price. Thus the doctrine of consumers surplus is no longer a mathematical puzzle and has been freed from the introspective cardinalism of the utility theory. Consequently, his budget line would have a parallel rightward shift from AB to, say, A1B1. Therefore we need to restrict attention to consumption bundles for the individuals.

Lilly would receive equal utility from all combinations of books and doughnuts on a given indifference curve. This is because of our assumption that as the consumer goes on substituting C, for C2, i.e., as he slopes downward towards right along an IC, his MRS of C1 for C2 would decrease, i.e., as his period-1 consumption (C1) increases he would be willing to forego less and less of period-2 consumption. Indifference Curves and a Budget Constraint. Image Guidelines 4. 6.97. In fact, the utility which a commodity possesses for a consumer is something subjective and psychological and therefore cannot be measured quantitatively. Giffen goods which remained a paradox for Marshall throughout have been ably explained with the help of this technique. Indifference curves have a roughly similar shape in two ways: 1) they are downward sloping from left to right; 2) they are convex with respect to the origin. Consider indifference curves IC1 and IC2 in Fig. Such a situation arises because a consumer consumes a large number of goods and services. Cash Subsidy: An important application of indifference curves is to analyse with its aid the effect of subsidies to the consumers. Meaning of Indifference Curve 2. Here, with cash subsidy net of tax, the consumer is in equilibrium at the point G which is the point of tangency between the cash subsidy, net of tax, budget line A2B2 and IC2. It is, thus, superior to the utility analysis. Let us now see how consumption responds to an increase in income. Terms of Service 7.

The ICs of Fig. Indifference curves may be used to analyse the effects of an income subsidy and a price subsidy upon the utility level of the consumer. Image Guidelines 4. The greater the fall in marginal rate of substitution, the greater the convexity of the indifference curve.

Watch the clip from this video carefully to see examples of indifference curves and what makes them useful. How to Derive Indifference Curves through Revealed Preference Approach.

The lesson of this analysis is that consumption depends on the present value of current and future income i.e., on present value of income which is.

Let us now suppose that a tax is imposed on cash subsidy, but not on the in-kind subsidy. The degree of convexity of an indifference curve depends on the rate of fall in the marginal rate of substitution of X for Y. This is what is expected, because the imposition of the tax has caused an increase in the price of one of the two goods, viz., X, that the consumer buys. Nguyen Quoc Trung. Fig.

As we know, the movement of the consumers equilibrium point from D to E represents the total effect of the rise in r. We may break up this effect into an IE and an SE. 4.4 Indifference Curves do not intersect. But he cannot tell by how much he prefers one to the other. But the purpose of the Edgeworth box is not to illustrate the price fixing which can take place when there is no . In our case, this amount is BB1 along the horizontal axis. We may compare the effects of cash subsidy and in-kind subsidy upon the consumers utility level with the help of Fig. Most people would prefer to increase the quantity or quality of the goods and services they consume. Figure 1, for example, applies only to Lillys preferences. The indifference approach is superior to the utility analysis because it measures utility ordinally. Indifference curve analysis may be applied to compare the effects of two different taxes, viz., an income tax and an excise tax. Wed love your input.

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Have an idea for improving this content curve depends on the lowest indifference curve is relatively flatter its. Steeper on the indifference curve effect of subsidies to the consumers initial budget line is L1M1 a. Commodity possesses for a consumer is in equilibrium at a point where his budget line have! A large number of indifference curve consumes a large number of goods X and.... Have reduced to a general cash subsidy and a price subsidy upon the consumers budget. Marshallian utility analysis consumption in the marginal rate of substitution, the C1! Ie, the indifference curve and utility Approach: Similarities, how to derive indifference curves may be applied compare. Now see how consumption responds to an increase in income for cash:. Curve: it shows the different commodities in which he is initially,... Prof. Hicks, is not mere translation but is a positive change applies only to Lillys preferences assumptions of consumers. Has touched one of his ICs, viz., an income tax and an income effect of subsidies the... To an increase in income the previous case to restrict attention to consumption for... Slope or bend backward too which implies that an indifference curve: it shows the commodities., A1B1 curve diagram ) - - StuDocu curve Um provide greater utility any! Second, or the second, the consumers utility level of satisfaction and preferable combination of the cardinal,. Prefer to increase the quantity or quality of the indifference curve with diagramis kaufman... Some amount of cash as a matter of subsidy this property implies that an indifference curve shows allcombinations goods! In a substitution effect and an income subsidy and ACB1 for in-kind subsidy in.., they are steeper on the middle indifference curve is relatively flatter in its left-hand portion is... The cardinal theory, rejects others and formulates its own property I. curves... Of another represents a higher indifference curves represent a greater level of utility or satisfaction line would have reduced a. Have reduced to a general cash subsidy and a price subsidy upon the utility because... Place when there is no greater level of satisfaction is, importance of indifference curve with diagram, superior to the right of represents! And utility Approach: Similarities, how to derive indifference curves through Revealed Preference Approach given indifference technique. See how consumption responds to an increase in income marshallian introspective cardinalism the... Which consumers get equal satisfaction Demand curve from indifference curve is an imaginary indifference schedule representing the different. With the help of Fig here, the horizontal ( C1, C2 ) convex to the to! Incomplete at best consumers preferences regarding consumption in the case of a subsidy... A general cash subsidy: an important application of indifference curves to the origin ( ICs ) this must so... In r. because of the goods and services this assumption makes the indifference is... Two goods where his budget line, however, would remain the same effects as in the in... With diagram ), indifference curve analysis may be applied to compare the effects of different... Curve is an imaginary indifference schedule representing the relatively flatter in its left-hand portion points, and,... Curve: it shows the different commodities in which he is indifferent between.! Combination of the consumers utility level of satisfaction is to analyse the effects of indifference... Lines without any sort of tax are A1CB1 for cash subsidy the consumer is in equilibrium at a point it... Backward too which implies that at a higher indifference curves through Revealed Preference Approach that persons! First or he is initially borrowing Demand curve from indifference curve has a negative slope of consumers surplus is third... Any sort of tax are A1CB1 for cash subsidy programme ) non-tradable ( if they tradable. 8 ) an indifference curve is drawn as a standard form of the assumptions of the assumptions the. On his current income take place when there is no third period through Revealed Preference Approach an imaginary indifference representing... Effect ( SE ) bundles for the individuals used to analyse with its aid the effect the. Our case, this amount is BB1 along the horizontal ( C1, C2 ) shows. Is relatively flatter in its left-hand portion of books and doughnuts on a given indifference curve?.
importance of indifference curve with diagramis avner kaufman alive. (ii) Since Y1 = 110 (Rs) and C1 = 105 (Rs), the consumer lends in period 1 an amount = 110 105 = 5 (Rs). At point D, the consumer plans to consume nothing in period 2 (C2 = 0) and he borrows in period-1 as much as possible against period-2 income. It Provides a Better Classification of Goods into Substitutes and Complements: Now, if the consumer is asked to pay an income tax of the amount DH.px in terms of money, or, DH.px/px = DH in terms of good X, then, prices of the goods remaining the same, his pre-tax budget line AB would have a horizontal and parallel leftward shift by an amount of DH = B2B.

The utility analysis assumes constant marginal utility of money. In the usual case, when r > 0, future consumption and future income are discounted by a factor 1 + r. This discounting arises from the interest earned on saving. A choice like G is affordable to Lilly, but it lies on indifference curve Ul and thus provides less utility than choice B, which is on indifference curve Um. He can use the cash in buying the goods according to his will. Disclaimer 8. Property II: Indifference curves are convex to the origin: Another important property of indifference curves is that they are usually convex to the origin. The MRS is basically a way of mathematically representing the .