Application of Indifference Curve
1. Application of indifference curve on tax
2. Application of indifference curve on subsidy
3. Application of indifference curve on the income-leisure choice of worker
1. Application of indifference curve on tax:
To design an appropriate tax rate, an indifference curve may be useful. An important area in which the indifference curve technique has been applied of making choice between direct and indirect taxes. Policymakers are often faced with the question, whether it will be better to levy a direct tax or an indirect tax from the viewpoint of the welfare of the individuals. The conclusion is derived with the help of the below figure:
In the above figure, units of X are measured along the X-axis and the money income of the consumer is measured along Y-axis respectively. Initially, the consumer is at equilibrium at point E1, where the budget line AB is tangent at point E1 where the consumer consumes OX1 units of X by spending AM units of money income. When the government imposes an indirect tax then the price of X good increases as a result, the purchasing capacity of consumers decreases, and the budget line rotate leftward at AB1, which is tangent to IC2. It shows that the welfare of the consumer has declined. Likewise, when the government imposes a direct tax on individuals. This reduces the money income of the consumer. So, the budget line shift towards the left at A1B2, which is parallel to AB, and passes through point E2. The budget line passing through E2 indicates that the consumer pays income tax equivalent to excise duty paid through indirect tax but he moves on higher indifference curve IC3. From the above analysis, it has been proved that direct tax reduces the individual’s welfare less than that of an indirect tax. Here, the indifference curve plays an important tool while making a discussion.
2. 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
3. Application of indifference curve on the income-leisure choice of worker:
The application of indifference curve analysis exists in the case of the income leisure choice of workers. Suppose that the utility function of an individual worker is given as;
M= Money income from work
An individual divides his daily time between work and leisure to maximize his utility function. If an individual increases his hours of work, his income increases but his hours of leisure decrease and vice-versa. So, income and leisure are like substitutes for one another. It is explained by using an indifference curve technique as shown below figure:
In the above figure, hours of leisure are measured along the x-axis, and money is measured along the y-axis respectively. MH is an income leisure line and IL denotes the income-leisure trade-off curve. Suppose the total hours available to the labour is OH and the hourly wages rate is ‘W’. If the labour enjoys no leisure, his income would be OM= OH*W and the wage rate (W)= OM/OH, which is the slope of income- leisure curve MH. The equilibrium of labour is determined at point E where the income-leisure line is tangent with his income-leisure trade-off curve. With the combination of income OP, leisure hours ON and working hours NH, the worker is maximizing his utility function at point E where the labour earns money income ‘OP’ by working ‘NH’ hours and takes leisure hours of ‘ON’.