Application of Indifference Curve on Subsidy

Indifference curve analysis has been also applied to analyze and compare the effects of excise subsidy and income subsidy by policymakers. Suppose that the government of the developing country is planning to raise the living levels of poor families. These questions can be answered using the indifference curve analysis shown below figure:

In the above figure, quantity demanded is measured along the x-axis and income is shown on the y-axis. The consumer is at equilibrium point E1, where initial budget line AB is tangent to the indifference curve IC1 at point E1, where the consumer consumes OX1 units of X and pays ‘AM’ money income. Suppose that the government subsidizes the price of good X, so that price of X falls. As a result, the budget line AB swings to AB1. The budget line AB1 is tangent to the indifference curve ‘IC2’ at point E2. In this case, the consumer consumes OX3 units of X good for which he pays ‘DA’ of his income. In absence of exercise subsidy, the consumer would have paid ‘AP’ income for OX3. AP-AD=DP is the cost of subsidy which the government would pay to the produces of X commodity.

Also, suppose, the government provides income subsidies. As a result, the consumer moves to the higher indifference curve from IC1 to IC2. So income subsidy is just sufficient to maintain the level of consumer’s utility with the price subsidy. The effort of income subsidy is shown by drawing a budget line parallel to initial budget line AB1 and tangent to IC2. The new budget line is A1B3 and the consumer is in equilibrium at point E2 of this budget line on IC2. In this the consumer purchases OX3 units of X for which he pays TS of his income. Out of the A1S amount, A1A is the income subsidy granted by the government.

From the above figure, it is clear that E2K>JK. It shows that the cost of excise subsidy (E2K) is greater than income subsidy (JK) though, both policy measures achieve the same goal of increasing consumer’s welfare to higher-level denoted by IC2. Thus, policymakers should be able to select appropriate and most efficient policy measures.

From the above explanation, it is clear that

Exercise subsidy    DP = E2K

Income subsidy      A1A = JK