Question

1. What do we mean by a budget constraint? Assuming your income is $72, P records = $6, and the P gas=$2, draw your budget Show what happens when your income drops to $60. Show what happens if P records drops to $3 and your income is $72. Illustrate with graphs.
2. What is an indifference curve? Draw an indifference map for bagels and Why are indifference curves shaped this way?
3. Can indifference curves ever intersect? Why or why not?
4. Using an indifference map and a budget constraint, show at what point a consumer will be at equilibrium. What makes this point so special?
5. What is meant by price elasticity of demand? What importance does this have for a producer when deciding whether or not to change price?

Answer 1

Ans.

a) Budget constraint is the expenditure on consumption of two goods at given prices where the expenditure should not exceed the income.

b) Suppose demand for records is x and gas is y,

Then budget contraint is,

6x + 2y = 72

With drop in income to $60, budget constraint will parallaly shift inwards to AB

If price of records fall to $3, then the budget line will pivot outwards around the point of maximum consumption of gas i.e. where all the income is being spent to consume gas to CD

b) Indifference curves downward sloping because to increase consumption of one good, the consumption of other good must be decrease and indifference curves are convex because of diminishing marginal utility i.e. as the consumption of one good increases, its marginal utility decreases and as we move towards right the utility on each indifference curve increases because preferences are monotonic.

c) No, indifference curves cannot intersect. This is because each indifference curve shows a different level of utility, so, if two indifference curves intersect then the point of intersection will represent two level of utilities which is not possible.

d) Consumer will be at equilibrium where indifference curve is tangent to the budget line. This is because here the marginal utility per dollar soent on bot the goods is same and thus, total utility of the consumer is maximised.

e) Price elasticity of demand ia the %change in quantity demanded due to 1% change in price level.

f) If price elasticity of demand is less than 1 then it means that a 1% increase in price will lead to a decrease in quantity demanded by less than 1%. Thus, total revenue of the producer will increase. Thus, to determine whether to increase the price and what impact does the increase in price will have on the total revenue, the producer uses price elasticity of demand.

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