Curve Based On Assumption

Curve Based on Assumption

Introduction:

Indifference curve are based on the assumption that there exist only two goods in the market, the curve joins together the level of consumption of two goods where the customer maximises his utility. The budget line is a line that combines the units of two goods that can be possibly purchased given the price of the good and also the consumer’s disposable income. The disposable income is the level of consumer that can be used to buy goods; it is derived by subtracting taxes from the consumer’s income.

Sandy and good A and good B:

We will consider Sandy’s income and the possible purchase of goods of good A and good B, we will assume that they are the only goods available in the market, net we will assume that the two gods price is as follows:

Good A price = 10

Good B price = 15

Curve Based on Assumption

We will also assume that the disposable income for sandy is 150, given this level of disposable income we can derive our budget line by determining the maximum units of each good possible to be bought.

Maximum good A that can be bought is 150 divided by 10 which give us 15 units, for good B the maximum units that Sandy can buy of good B will be given by 150 divided by 15 which give us 10 units. The table below summarises the budget line:

price

income level

maximum units

Good A

Curve Based on Assumption

10

150

15

Good B

15

150

10

Curve Based on Assumption

Our budget line therefore will be represented as follows:

Depending on the price of good it is clear that having a certain level of income it is only possible to buy of good A than Good B whose price is higher than the other good, for this reason the budget line will take the above shape.

Indifference curves;

Indifference curves are curves that give the level of two goods that derive maximum utility, the higher the indifference curves the higher the level of utility, the lower the curve the lower is the level of utility. The diagram below shows indifference curves against good A and good B:

As the diagram above depict the indifference curve has a higher level of utility than any other indifference curve, therefore a rational consumer will be on the highest indifference curve, however this is restricted by the disposable income which in other words determine the budget line.

The most optimal point of consumption is given by the point in which the indifference curve touches the budget line. The diagram below shows Sandy’s most optimal point of consumption of good A and B given the budget constraint;

Curve Based on Assumption

From the above diagram the most optimal point of consumption is given by point P, this is the point where the indifference curve touches the budget line.

Tax on good A:

If we assume that in our above analysis the good a was taxed and good B was not taxed and the prices are as given then an increase in tax on good A will increase the price of the good A, as a result the indifference curve will not shift but the budget line will shift as follows, that is if the price of good A whose price is 10 and the tax increases the price to 15.

The budget line will shift as shown, this is because good one becomes more expensive and the maximum units that can be purchased of good A is now 10 units, the budget line shifts from budget line one to budget line 2.

The new optimal level is as shown below:

From the above diagram it is clear that the consumer shifts from a higher indifference curve to a lower indifference curve, this means that the utility level of the consumer after purchase of good is lower than before the tax, the number of units consumed of good a and good b also reduces as a result of the tax increase.

Assumptions of this analysis are that there exist only two goods in the market e.g. Good A and good B, the other assumption is that the consumer spends all his disposable income on the two goods and finally good A is taxed while good B is not taxed where tax on good a is increased.

The effect of the tax increase is that less of good A and good B are consumed by the consumer, there is also a reduction in the utility level as depicted by the shift from a higher indifference curve to a lower indifference curve. Therefore due to an increase in the tax there are two effects which include: Reduced consumer real income which means that the consumer can only purchase only a few good with his or her income, reduced level of consumption of good A, reduced consumption of good B and reduced utility level as a result of shift from a higher indifference curve.

Curve Based on Assumption

References:

Philip Hardwick (2004) Introduction to Modern Economics, Pearson Press, New York