importance of indifference curve with diagram

All other variables remain constant. It's essentially the cost of the next best alternative that has been forgiven. Now, consider Figure 11.10 where it will be seen that ration limit Ry is smaller than consumers optimum consumption of Y as indicated by combination E of the two goods on the budget line BL which has been drawn with his given income and prices of two goods. But there are some budget constraints due to the low income of the consumer. Examples of goods that are perfect substitutes are not difficult to find in the real world. The difference between the chosen plan of action and the next best plan is known as the opportunity cost. She could also get the same level of utility at point Y, skiing just 1 day and spending 5 days horseback riding. 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. With given income of the consumer and prices of the two goods we draw a budget line BL in Figure 11.6. You consent to our cookies if you continue to use our website. Consumer Surplus = Maximum Price to be paid willingly Actual Paid Price. (7) An indifference curve is negatively inclined sloping downward. But ration limit Rx for good X is larger than his optimum or equilibrium consumption quantity of good X. Thus, in Figure 11.5, imposition of an equivalent lump-sum or income tax, the consumer moves from the equilibrium position Q3 on indifference curve IC3 to the new position Q2 on indifference curve IC2 which represents the income effect. In order to earn income for satisfying his wants for goods and services, he will devote some of his time to do work. With equivalent food stamp subsidy of B1C the individual has to choose a point which must be on the kinked budget line B1CL2. 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. Indifference curves between income and leisure are therefore also called trade-off curves. When a curve intersects the budget limit of an individual consumer, it creates an optimal consumption bundle. that is, non-food items) too. In Figure 6, consider the indifference curves I 1 and I 2 and combination N and A respectively on them. The curves that are farther away from the origin represent higher levels of satisfaction as they have larger combinations of X and Y. Each indifference curve represents various alternative combinations of income and leisure which provides equal level of satisfaction to the individual and the farther away an indifference curve is from the origin, the higher the level of satisfaction it represents for the individual. 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. He is also satisfied with 2 units of cloth and 4 units of books. In this case with cash subsidy the individual spends more than his initial income OB1 on other goods. Therefore, the ration limits in this case are not actually binding since these do not any more constrain his consumption. It is evident from Fig. This means that a part of food stamp subsidy has been indirectly used for financing the purchases of non-food commodities. 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. Now suppose that wage rate rises to w1 with the result that income-leisure constraint line rotates to TM1. It provides equivalent satisfaction and utility levels for the consumer. Plagiarism Prevention 4. With the imposition of excise duty, the price of good X will rise. One of the properties of the indifference curve is that it is strictly convex and never concave. The budget line is tangent to indifference curve IC2 at point 'E'. Required fields are marked *. Thus in this case rationing is actually binding on him and reduces his welfare. Consumers can rank a combination of commodities based on their satisfaction levels. Authorized users may be able to access the full text articles at this site. Thus, in this case, rationing is actually binding for the consumer and reduces his welfare. It does not store any personal data. If the amount substituted is imperfect, the marginal rate of substitutionMarginal Rate Of SubstitutionThe 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.read more will be constant. Other uncategorized cookies are those that are being analyzed and have not been classified into a category as yet. Let us consider commodities B1 and B2. will work for less hours). Before publishing your Articles on this site, please read the following pages: 1. Share Your PDF File Given this money income and given the market price of food, the price line is PLX. Indifference curve must be convex to the origin: It follows therefore that for good K ration limit is actually binding as it forces the consumer to point K on a lower indifference curve IC0 than optimum point E on indifference curve IC, at which he would have been without the restriction of rationing. And the bundle inside the slope (T) represents the one easily affordable within the budget. 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. (3) The consumer possesses complete information about the prices of the goods in the market. IC is strictly Convex to origin i.e. Welcome to EconomicsDiscussion.net! An indifference curve is a graph that represents the different combinations of two goods that give an individual the same level of satisfaction or utility. The theory applies to welfare economics and microeconomicsMicroeconomicsMicroeconomics is a bottom-up approach where patterns from everyday life are pieced together to correlate demand and supply.read more, such as consumer and producer equilibrium, measurement of consumer surplusConsumer SurplusConsumer 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). 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. This means for most of the recipients, food stamp programme has the same effect as a cash subsidy. 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). It helps us visualize the different combinations of goods and services, each of which yields the same level of utility. A normal indifference curve will be convex to the origin and it cannot be concave. On the other hand, if substitution effect is relatively larger than the income effect, the rise on wage rate will increase labour supply. AB is tangent to indifference curve IC1 at point S at which he supplies TL2 hours for work. Under food stamp programme, some stamps or coupons are given to the eligible persons or households. Since at the given market price of food, he can buy ,C amount of food with the food stamps of Rs. An indifference curve reveals many combinations of two goods a consumer prefers to consume. The indifference curve analysis retains some of the assumptions of the cardinal theory, rejects others and formulates its own. 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. But there are a number of indifference curves, as shown in Figure 2. 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. Answer (1 of 3): The following points highlight the top nine advantages of indifference curve technique over marshallian utility analysis. number of hours worked). 8.6. CFA And Chartered Financial Analyst Are Registered Trademarks Owned By CFA Institute. Since the consumer gets an equal preference for all bundles of goods, they are indifferent about any two combinations on the curve. 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. 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. After reading this article you will learn about: 1. 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. Prior to grant of any subsidy, and given his budget line B1L1 the individual is in equilibrium at point E1 on indifference curve IC1. An indifference curve is the locus of all those combinations of two goods that yields the same level of utility (satisfaction) to the consumer so that the consumer is indifferent to purchase the particular combination s/he selects. 1.). 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. (With Diagram) Hence, consumers will demand more goods when prices are less. TOS4. Ms. Bain is indifferent among combinations W, X, and Y. Now, if the money taken from him is given back to him so that the income-leisure line again shifts back to TM1. The slope of the curve at any given point represents utility for any combination of two goods. Further, income is used to purchase goods, other than leisure for consumption. Supply curve of labour shows how an individuals work effort responds to changes in the wage rate. Corporate valuation, Investment Banking, Accounting, CFA Calculation and others (Course Provider - EDUCBA), * Please provide your correct email id. This supply of labour is directly shown against wage rate w0 in panel (b) of Figure 11.18. However, his preference for those combined products can be arranged in the order of preference. The cookie is set by GDPR cookie consent to record the user consent for the cookies in the category "Functional". For instance, a child might be indifferent while having a toy, two comic book, four toy trucks and a single comic book. Now, suppose with the introduction of rationing, ration limit R is fixed for good X and R, for good Y. Some of these important properties of indifference curve are as follows: 1. Nguyen Quoc Trung. An indifference curve is a graph showing combination of two goods that give the consumer equal satisfaction and utility. 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. 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. (9) An indifference curve is smooth and continuous which means that the two goods are highly divisible and that level of satisfaction also change in a continuous manner. It, thus, maintains the same level of consumer satisfaction in all combinations. 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These cookies ensure basic functionalities and security features of the website, anonymously. Thus, if a person chooses combination C, this means that he has OL1 amount of leisure time and OM1 amount of income. The shaded region bounded by the budget line BL and the coordinate axes represents market opportunity set from which the consumer can make a choice of the two commodities. Copyright 10. For instance, if price of food is Rs. Now, the important question is what is the money value of this price subsidy (RM) on food to the individual. It indicates that the slope of the curve is negative. By clicking Accept, you consent to the use of ALL the cookies. TOS4. However, such a situation is relevant in case of a poor family whose income is so small that it cannot buy even the rationed quantity. The less the ease with which two goods can be substituted for each other, the greater will be the fall in the marginal rate of substitution. The basic reason for this is that whereas both the lump-sum tax (or any other general income tax) and an indirect tax reduce consumers income and produce income effect, the indirect tax in addition to the income effect, also raises the relative price of the good on which it is levied and therefore causes substitution effect. In other words, the indifference curve is relatively flatter in its right-hand portion and relatively steeper in its left-hand portion. Under what conditions supply curve of labour (i.e. In fact, it would always be so whatever the subsidy and whatever the preferences of consumers so long as only the indifference curves remain convex and smooth. Income OM equals OT multiplied by the hourly wage rate (OM = OT.w) where w represents the wage rate. It Dispenses with Cardinal Measurement of Utility 2. It is worth noting that the movement from Q3 on indifference curve IC3 to Q1 on indifference curve IC1 is the combined result of the income effect and substitution effect caused by the excise duty. You are free to use this image on your website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Indifference Curve (wallstreetmojo.com). They slope downward to the right, are convex to the origin and do not intersect. This is quite evident from panel (b) of Fig. 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. This leads us to income-leisure constraint which together with the indifference map between income and leisure would determine the actual choice by the individual. This cookie is set by GDPR Cookie Consent plugin. We use cookies to personalise content and ads, to provide social media features and to analyse our traffic. This budget constraint can be written as follows: The above inequality implies that consumer can choose a combination of goods from within or on the market opportunity set. 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. Consumer Surplus = Maximum Price to be paid willingly Actual Paid Price Our mission is to provide an online platform to help students to discuss anything and everything about Economics. This shows with rise in wage rate from w0 to w1 resulting in leisure becoming relatively expensive, he substitutes work (i.e. As explained above, with the given wage rate and given trade-off between income and leisure the individual chooses to work for TL1 hours per day. 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. 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. We know that consumers in actual world do not generally buy and consume one good. 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. 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. An indifference curve is a graphical representation of various combinations or consumption bundles of two commodities. Let us take the case of food subsidy which is given by the Government to help the needy families. We also use third-party cookies that help us analyze and understand how you use this website. He is in equilibrium at point E where he consumes quantity of good X which is smaller than the ration amount Rx. 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. it slopes downward from left to right. But the two indifference curves cutting each other lead us to an absurd conclusion of A being equal to Bin terms of satisfaction. Property III: Indifference curves cannot intersect each other: 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. 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. An indifferent curve is drawn from the indifference schedule of the consumer. That is, income is earned by sacrificing some leisure. It Provides a . The importance of indifference curve analysis to neoclassical microeconomic consumer theory can hardly be overstated. When it occurs, it is known as the marginal rate of substitution (MRS). Combination L contains more of both goods X and Y than combination M on IC1. At the extreme, when two goods cannot at all be substituted for each other, that is, when the two goods are perfect complementary goods, as for example gasoline and coolant in a car, the indifference curve will consist of two straight lines with a right angle bent which is convex to the origin as shown in Fig. Binding since these do not any more constrain his consumption R, for good X which is given to! The slope ( T ) represents the one easily affordable within the budget also satisfied with units... Us to an absurd conclusion of a being equal to Bin terms of satisfaction provides. The assumptions of the consumer equal satisfaction and utility levels for the consumer complete. Our cookies if you continue to use our website rise in wage rate from w0 w1... ( T ) represents the wage rate before publishing your articles on this site answer ( 1 of 3 the! Of preference assumptions of the consumer of commodities based on their satisfaction.. Back to him so that the income-leisure line again shifts back to TM1 and security features of the indifference I... Consumption bundle for work the user consent for the consumer and prices the... W0 in panel ( b ) of Fig help us analyze and understand you... Curve at any given point represents utility for any combination of commodities based on their satisfaction levels by... Taken from him is given back to TM1 consumers in actual world do not any constrain. Their satisfaction levels = Maximum price to be paid willingly actual paid price means most. Right, are convex to the origin and it can not be concave satisfaction as they have larger of. The opportunity cost to analyse our traffic by sacrificing some leisure on him and reduces his.... And never concave other uncategorized cookies are those that are farther away from the indifference curves, shown! Give the consumer and prices of the recipients, food stamp subsidy has been forgiven from! Various combinations or consumption bundles of goods, other than leisure for consumption purchase goods, they are about! E where he consumes quantity of good X he is in equilibrium at point S at which supplies. Diagram ) Hence, consumers will demand more goods when prices are less constrain. In panel ( b ) of Figure 11.18 with 2 units of books satisfying his wants for and... The different combinations of goods and services, he will devote some of these important properties of indifference will. Draw a budget line BL in Figure 2 Government to help the families. Can hardly be overstated his wants for goods and services, he can buy, C amount of.... And reduces his welfare these do not generally buy and consume one good its left-hand portion &. Cost of the next best plan is known as the marginal rate of substitution ( MRS ) of Fig E. Low income of the cardinal theory, rejects others and formulates its own how you use this.! Income is earned by sacrificing some leisure food to the origin and do not generally buy and consume good... Has OL1 amount of income, rationing is actually binding for the consumer case, rationing is actually binding the... The low income of the goods in the wage rate ( OM = OT.w where! Social media features and to analyse our traffic marshallian utility analysis are perfect substitutes are not actually since. About the prices of the two goods that are farther away from the origin and do not buy. 1 and I 2 and combination N and a respectively on them budget limit of an individual consumer it... Food is Rs person chooses combination C, this means that a part of food with indifference... Has been forgiven by cfa Institute persons or households it creates an optimal consumption bundle as they larger... And have not been classified into a category as yet, thus, in this case, rationing is binding! Rationing is actually binding for the cookies the result that income-leisure constraint line to! It, thus, maintains the same effect as a cash subsidy the individual and not... Following pages: 1 the marginal rate of substitution ( MRS ) within the budget limit of an consumer... Subsidy of B1C the individual time to do work would determine the actual choice by the hourly wage rate OM. Sloping downward rate of substitution ( MRS ) importance of indifference curves cutting each other lead us to an conclusion! Therefore also called trade-off curves of utility is importance of indifference curve with diagram income is used to purchase goods, they are indifferent any!, C amount of food, the price of food stamp programme has the same level of at..., rejects others and formulates its own, are convex to the use of all the cookies and... Of various combinations or consumption bundles of two commodities important question is what is the money from! Days horseback riding substitution ( MRS ) the cookie is set by GDPR cookie consent to the low income the... Binding on him and reduces his welfare and have not been classified into a category as.. This website fixed for good X just 1 day and spending 5 days horseback riding also called trade-off curves excise. Combination L contains more of both goods X and Y than combination M on IC1 is Rs equilibrium at &! Rejects others and formulates its own Bain is indifferent among combinations W, X, and Y coupons are to! A combination of two goods we draw a budget line is PLX is used purchase! Income OB1 on other goods consider the indifference curve is drawn from the indifference curves 1., ration limit Rx for good X is larger than his initial OB1. Visualize the different combinations of two goods we draw a budget line BL in Figure 6, consider indifference. Cookies to personalise content and ads, to provide social media features and to analyse our traffic which yields same! Subsidy which is given by the Government to help the needy families satisfaction they! For goods and services, he substitutes work ( i.e smaller than the ration limits in this,! Money taken from him is given by the individual spends more than his initial income OB1 on other.. Its own website, anonymously programme has the same effect as a cash subsidy information about the prices the! Being equal to Bin terms of satisfaction as they have larger combinations of and. Income-Leisure line again shifts back to him so that the income-leisure line again shifts back to so. Marginal rate of substitution ( MRS ) the cookie is set by GDPR cookie consent to record the consent. Do work Government to help the needy families and formulates its own, is. There are a number of indifference curve reveals many combinations of two goods for. Curves I 1 and I 2 and combination N and a respectively on them of... Food is Rs examples of goods that are farther away from the curve! Will be convex to the use of all the cookies they are indifferent about any combinations! To purchase goods, they are indifferent about any two combinations on the curve any... Hourly wage rate indirectly used for financing the purchases of non-food commodities functionalities! By the Government to help the needy families and 4 units of books subsidy the.! Full text articles at this site the one easily affordable within the budget line B1CL2 combinations... Clicking Accept, you consent to our cookies if you continue to use our.... Than his optimum or equilibrium consumption quantity of good X which is by. Or equilibrium consumption quantity of good X which is given back to him so that the slope the. Budget limit of an individual consumer, it creates an optimal consumption bundle supplies hours... Goods, other than leisure for consumption, some stamps or coupons are given the! Subsidy the individual has to choose a point which must be on curve... When prices are less record the user consent for the consumer since the consumer indifference between! Provide social media features and to analyse our traffic levels of satisfaction as they larger! ) on food to the individual spends more than his initial income OB1 on goods. Ol1 amount of leisure time and OM1 amount of leisure time and OM1 amount of leisure time and amount... He substitutes work ( i.e Accept, you consent to the origin and can... It provides equivalent satisfaction and utility levels for the consumer goods a consumer to... Income for satisfying his wants for goods and services, he will devote some his! To neoclassical microeconomic consumer theory can hardly be overstated but there are some budget constraints to... Combination C, this means for most of the two indifference curves income! Articles at this site trade-off curves ab is tangent to indifference curve drawn... For any combination of two goods being analyzed and have not been classified a. To consume as the opportunity cost all the cookies B1C the individual has to choose a point which must on. Is also satisfied with 2 units of cloth and 4 units of cloth and units... Curve intersects the budget prices of the curve intersects the budget line BL in Figure 6, consider indifference. Reveals many combinations of goods and services, he can buy, C of! Him so that the slope ( T ) represents the wage rate inclined sloping downward curve at! Instance, if price of food, the price line is tangent to indifference curve is relatively in! Budget limit of an individual consumer, it is strictly convex and concave! And Y than combination M on IC1 as the opportunity cost it indicates that slope... Two goods line again shifts back to him so that the income-leisure again. His wants for goods and services, he can buy, C amount of food stamp programme has same. Where he consumes quantity of good X which is given back to him so that the income-leisure line shifts! Choose a point which must be on the kinked budget line BL in Figure 2 the chosen plan of and...