Question

The budget line is given by M = P1Y1 + P2Y2. Explain what each of the variables represents. Explain how the budget line constrains an individual’s choices. What is the economic question that an individual consumer must answer when it comes to making choices on what to purchase? Rephrase that question in terms of utility and budget constraints

Answer 1

In the budget line given, M represents the individual's total income, P1 is the price of good 1, Y1 is the quantity of goid 1 consumed, P2 is the price of good 2, and Y2 is yhe quantity of good 2 consumed. The budget line represents all the possible combinations of good 1 and good 2 that may be consumed given the income M. The individual can only consume on a point on the buget line (if he consumes all his income), or on a point inside the budget line (if he saves a part of his income). In order to consume some additional quantity of either good on the budget line, the consumer has to give up a certain amount of consumption of another good. The consumer has to decide the amount of goid 1 and goid 2 he desires to consume, given the constraint of his budget line. The amount of each good he wishes to consume depends on his utility function that determines hos preferences for good 1 and good 2. However, his preferences are constrained by his budget constraint. Therefore, the optimal amount of both goods consumed is given at the point where the indifference curve (representing the utility function of the consumer) is tangential to the budget line.