Question

1)
a)Explain what is meant by the terms indifference curve, the marginal substitution fraction and the budget condition in consumer theory.

b) The benefit to a consumer depends on the benefits x1 and x2 . Explain why the consumer optimal choice of goods will not change if the prices of the two goods double, if the income at the same time also doubles.

c) A consumer has a utility function that depends on the goods x1 and x2. The goods can purchased at a fixed price in the market, and the consumer has set aside a given amount to buy the gods. Show by a graphic reasoning which good combination the consumer wants choose if the goal is to maximize the benefit. Specify the conditions that characterize the optimal good combination either verbally, or by showing of equations

Answer 1

(a) Indifference curve: Indifference curve, IC, shows different combinations of goods at the same utility level. This means that for a given level of utility an IC will show different combinations of goods which gives us the same utility level.

Marginal substitution fraction: Marginal substitution fraction or we can say that the marginal rate of substitution tells us that if we consume one more unit of a good then how many units of another good we will sacrifice to consume that extra 1 unit.

budget condition: A budget condition in consumer theory says that given prices and income, our expenditure cannot exceed our income. This means that we cannot consume more than our income.

P_x*x + P_y*y =< Income

=< this means less than equals to

Our expenditure should always be less than equals to our income

(b) Let's say our income is $100. We consumer 2 goods x and y. Price of x is $5 and price of y is $5. We can consumer 10 units of x and 10 units of y. Now if we double the prices and income, our prices will be $10 for both goods and income will be $200. Still we can consume 10 units of x and 10 units of y.

This means that if our price and income increases by the same rate then our consumption bundle will remain same. Increased amount of expenditure on goods will becomes equal to inccreased amount of income.

(c) We have to consume at point where our MRS = price ratios or we can say that when IC is tangent to the budget line. This is because an IC shows all the combination of goods that give same level of utility and a budget line shows all the bundles for an income level. So the point where IC is tangent to budget line we get our optimal consumption bundle.