Applications of Indifference curve

Applications
• Besides analysing consumer’s demand, indifference curves have
several other applications such as to explain the concept of
consumer’s surplus, substitutability and complementarity of
goods, supply curve of labour of an individual, several principles
of welfare economics, burden of different forms of taxation, gain
from foreign trade, welfare implications of subsidy granted by
the Government, index number problem, mutual advantage of
exchange of goods between two individuals.
Effect of Subsidies to Consumers: Price Subsidy Vs. Cash
Subsidy:

• Several kinds of subsidies are paid to the individuals by the

Government for promoting welfare of the people.
• We will explain and compare the effects of two types of
subsidies, price subsidy and lump sum cash grant, on consumer’s
welfare. It is worth noting that price subsidy on a commodity is
also generally called excise subsidy.
 Price Subsidy Vs. Cash Subsidy:
• Under price or excise subsidy the Government pays a part of the
price of a good and allows the consumer to buy as many units of the
good as he desires at the subsidised price.
• In case of cash subsidy the government provides a lump sum cash
income to the consumer.
• Let us take the case of food subsidy which is given by the
Government to help the needy families. Suppose that under
food-subsidy programme, the needy 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.
• The effect of this subsidy on consumer’s welfare and money value of
this subsidy to the consumer is illustrated in the Figure where the
quantity of food is measured on the X- axis and money on the Y-axis.
Let us suppose that the individual has OP money income.
D1
• Given this money income and given the market price of food, the price line is
PL1. Since we are assuming that subsidy paid by the Government is half the
market price of food, the consumer would pay half the market price.
Therefore, with subsidy the individual will face the price line PL2 where OL2
= OL1+ LIL2.
• 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. By
purchasing OA quantity of food, the individual is spending PT amount of
money.
• Now, if no food subsidy was given and therefore the price line was PL1, then for
buying OA quantity of food, the individual would have spent PN amount of money. In
other words, PN is the market price of OA quantity of food.
• Since PT amount of money is paid by the individual himself, the remaining amount
TN or RM (the vertical distance between the price lines PL1 and PL2 at OA amount
of food) is paid by the Government as food subsidy for the individual.
• The important question is what is the money value of this price subsidy (RM) on food
to the individual. When no price subsidy is paid, the individual faces the price line PL1.
In order to find the money value of the subsidy to the individual, draw a line EF
parallel to PL1 so that it touches the same indifference curve IC where the individual
comes to be in equilibrium when subsidy is paid.
• It will be seen from Figure that budget line EF touches the indifference curve IC at a
point S and is buying OB quantity of food. This means that if individual is paid PE
amount of money (say as a cash grant), he reaches the same indifference curve IC (same
level of welfare) at which he is when price subsidy is paid by the Government on
food.Thus PE, is money value of the subsidy to the individual. It will be seen from
Figure that PE is less than RM which is the amount of money paid by the Government
as subsidy.
• In our Figure PE = MK (the vertical distance between two parallel lines) and RM is
greater than MK. Therefore, RM is also greater than PE. It follows that PE is less than
RM. If instead of giving RM as price subsidy on food, Government pays the individual
cash money equal to PE, the individual will reach the same level of welfare as he does
with RM subsidy.
• Thus, the cash money equivalent of the price subsidy to the individual is less than the
cost of the subsidy to the Government. “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.
• Thus the cost of giving subsidies to consumers is always greater than the money
equivalent of the subjective gain to the consumers”.
 Lump-Sum Cash Subsidy:
• Now, if instead of providing price subsidy on food, the Government gives lump-sum
cash grant to the consumer equivalent to the cost of price subsidy on food, what will be
its impact on the individual’s welfare and consumption of food by him.
• As explained above in Fig. cost of price subsidy on food to the Government equals RM
amount of money. If the Government provides the consumer lump-sum cash grant of
RM instead of price subsidy on food, this will amount to increasing the money income
of the consumer by RM amount. With this extra cash transfer equal to RM (-PC), the
budget-line will shift to the right to the position CD in Fig. which passes through point
R.
• It will be seen from Figure 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.Thus,
the cash transfer equivalent to the cost of price subsidy has led to the greater increase in
welfare or satisfaction of the individual as compared to the price subsidy. Further, as will
be seen from Figure , with a cash grant the individual buys less food and more of other
goods relative to the situation under price subsidy with the equivalent monetary cost.
D2
 Explanation
• 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.
• Therefore, given that the consumer is free to spend money as he likes, with cash grant his new
equilibrium position must be to the left of point R on the budget line CD where it will be tangent
to the higher indifference curve than IC2. 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.
• The superiority of cash grant in terms of its impact on the welfare of the individuals can be
explained in a slightly different way. Though both the lump-sum cash transfer and price subsidy
on a commodity produces income effect making the individual better off, under cash grant the
individual is free to buy different goods according to his own tastes and preferences which
ensures a higher level of welfare as compared to the policy of price subsidy on food which
imposes a certain pattern of consumption favoring food.
• Besides, a lower price of food due to price subsidy on it induces the consumer to substitute food
for other goods causing greater consumption of food as compared to the scheme of lump-sum
cash grant which have no such substitution effect and permits free choice of goods to the
individual according to his own preference.
 Alternate arguments
• Hence, relief payments in cash are preferable to a food subsidy because they are
economically more efficient, giving the relief receipts either a greater gain at the same
cost to the Government or the same gain at a lower cost.”
• But the above principle regarding the programme of subsidised food, subsidised housing
etc. cannot always be validly applied to the Government subsidy programme since the
above principle is based upon the subjective benefits to the individuals which is not
always the correct criteria to judge the desirability of Government subsidy programme.
• For instance, the aim of Government’s food subsidy programme may be that the needy
families should consume more food so that their health and efficiency may be
improved.It will be seen from Figure that with food subsidy RM, the individual is having
OA amount of food, whereas with equivalent cash payment of PC the individual
purchases OB amount of food which is less than OA.
• Thus the food subsidy has induced the individual to consume more food than in case of
cash payment. 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.