Question

2. (a) State the necessary and sufficient conditions for consumer equilibrium. (b) Choose two goods and their corresponding prices, such that the consumer is in disequilibrium, i.e., he or she gets more marginal utility from one good than from the other given the goods prices. Indicate how the consumer will change her spending habits to return to equilibrium. (c) What role does the laws/principle of diminishing marginal utility play in the process you described above? (d) Characterize as best as you can the substitution effect and the income effect on the consumer equilibrium. You may use graphs.

Answer 1

2.

a) i) At the point of Equilibrium, Indifference Curve must be tangent to Budget Line.

ii) At the point of Equilibrium, Slope of Budget Line must be equal to Slope of IC i.e. Px/Py = MRS = MUx/ MUy

iii) At the point of Equilibrium, IC is convex to the origin i.e. diminishing MRS for stable equilibrium.

b), c)

Suppose MRS is not equal to Px/Py.

Let's Assume that:

It means that utility of consumption is increasing by consuming more of good X as he spent an additional dollar but due to the diminishing marginal utility MUx starts falling until .

d) If price decreases of good X then the consumer can substitute it in place of good Y as good X becomes cheaper. This is called Substitution Effect, it is always negative. But now consumer purchasing power also increases due to the reduction in the price of good X so he consumes more of Good. This is called Income Effect.

Price Effect = (Substitution + Income) Effect