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In this article we will discuss about the applications of indifference curve approach. The applications:- 1. Consumer’s Equilibrium 2. Theory of Production (Producer’s Equilibrium) 3. Measurement of Consumer’s Surplus 4. Application in the Theory of Exchange and a Few Others.
Indifference curve approach is free from all the criticism levelled against cardinal approach or utility analysis as developed by Professor Alfred Marshall.
This approach has various applications and importance in economic analysis as given below:
(1) Consumer’s Equilibrium:
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The indifference curve approach is used in the theory of consumer behaviour and helps each consumer in maximisation of his satisfaction which is his ultimate and basic objective.
Maximisation of total satisfaction with given income is attained if the following conditions are met:
(2) Theory of Production (Producer’s Equilibrium):
Indifference curve technique is also used in the theory of production or producer’s equilibrium. A producer aims at maximisation of output and minimisation of cost. He attains his equilibrium with the help of Iso-product curve at the point where factor price line is touched by this curve. Iso-product curve shows the different combinations of two factors of production showing the same amount of output.
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He can attain his equilibrium when marginal rate of technical substitution of labour for capital is equal to their price ratio and another condition is that total resources of producer should be equal to multiplication of the quantity of two factors and their prices.
Both these conditions are given below:
MRTS is marginal rate of technical substitution, L is labour, C is capital, W and R are wages and rate of interest, QL is quantity of labour and QC is quantity of capital.
The diagram shows that units of labour and capital are shown on OX-axis and OY-axis respectively. IQ is the original isoquant curve while the producer’s equilibrium is at E point where isoquant curve (IQ1) touches factor price line AB. This is the producer’s equilibrium where he employs OC of capital and OL of labour and getting 40 units of output.
(3) Measurement of Consumer’s Surplus:
Professor Alfred Marshall has defined consumer’s surplus as the difference between the price of a commodity for which a consumer is ready to pay and the price he actually pays. Prof. J.R. Hicks has used indifference curve for the measurement of this surplus. The fall in the price of commodity increases the real income of the consumer’s surplus can be measured by treating this increase in his real income as an increase in his money income.
In the diagram quantity of commodity X is shown on OX-axis while money income of OY-axis. Consumer is in equilibrium at IC at point B1 buying OX units of commodity X and spending AA2 money income. If price of X falls and the new budget line AB consumer reaches to IC1, and his new equilibrium is at point E and he is spending AA1 money income for the quantity of X commodity. Hence, difference between AA2 and AA1 is the consumer’s surplus.
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Solution:
Total consumer’s surplus = AE1B1A2 – AE1EA1
Per unit consumer’s surplus = AA2 – AA1 = A1A2
Or
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E1E — EB1
(4) Application in the Theory of Exchange:
Indifference curve technique can also be used in the theory of exchange wherein both buyers and sellers exchange commodities. English economist Edgeworth used this tool for the first time and for which box- diagram technique and contract curve were used to identify the balance exchange rate between two persons. The two commodities are exchanged with each other until their marginal rate of substitution become equal for both the exchanging partners.
It can be expressed in the following way:
MRSxy for Ram = MRsxy for Mohan
(5) Use of Indifference Curves in Rationing:
In rationing system a fixed quantity of goods is made available to the consumers at a fixed price. It curtails the satisfaction of consumers because they do not get the desired quantity of the goods. The effect of rationing can be studied with the help of indifference curves. We can see the state of rationing before the introduction of rationing and after the rationing with the help of indifference curves.
The diagram shows that before rationing the consumer was in equilibrium on IC at point E with OQx commodity X and was saving OY1 money. But after rationing he is at equilibrium on E1 point of IC1 where he was OQx1 of commodity X and saves money OY2. It means after rationing he saves more money but he is on the longer indifference curve which means his level of satisfaction has decreased.
(6) Application of Indifference Curves in Public Finance:
Indifference curves can be used to study the effects of direct and indirect taxes. There are bad effects on the demand for goods when indirect tax (excise duty) is levied by finance ministry than the direct tax in the form of income tax.
We take an example of income tax and excise duty and their effects on the demand for a commodity as shown in the Diagram 23. AB is the original budget line where consumer is in equilibrium at point E and purchases OQx of community X. When income tax is levied the budget line shifts below to A1B1 where the consumer is in equilibrium at point E1 and purchases OQx1 of commodity X.
If excise duty is levied in place of income tax then the consumer’s budget line will shift downward to AB2 and the consumer will be in equilibrium at E2 point with the amount of OQX2 of commodity X. OQx2 is lesser than OQX1. Hence the impact of excise duty (indirect tax) on the demand for a good is bad than the impact of income tax (direct tax).
Similarly, the effect or impact of government subsidy can also be studied with the help of indifference curves. The subsidy makes the goods cheaper and its effect is just like the effects of price effect.
(7) Use of Index Numbers with the Help of Indifference Curves:
If the indifference curve technique is used with the theory of index numbers then we can say whether consumer is in the better state or worse state or neither better off nor worse off. If a consumer purchases two commodities in two different periods, namely, 1998 and 1999. We have to find out whether he is better off or worse off in 1999 in comparison to the year 1998. It can be studied with the help of indifference curves.
The preferences of commodity X and commodity Y have been shown by the indifference curves (IC, IC1 and IC2). In the diagram the price line for the year 1998 is AB. Consumer is in equilibrium at point E on IC and he purchases OY1 of commodity Y and OQx of commodity X. In 1999 the price line of consumer is changed to A1B1 and he attains equilibrium at point E1 which is on IC1 where he has OQx1 and OY2 of Y.
The new equilibrium of the consumer is on IC1 which is higher than the IC. Hence, we can conclude that the consumer is better off in 1999 than that of the year 1998. His level of standard has risen.
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