Question

Discuss the theory of consumer choice among two goods using indifference curves and the budget constraint. Show how the result changes if the price of a good changes.

Answer 1

Within a given budget and two goods, the consumer has to maximize total utility subject to budget constraint. In the theory of consumer choice, total utility is represented by indifference curves (IC) and the budget constraint is represented by budget line. Utility is maximized at point of tangency between IC and budget line, where slope of budget line (= Price ratio) equals the slope of IC (= Marginal rate of substitution).

In following graph, AB is the budget line and IC0 is the IC which is tangent to AB at point E, which is the optimality point with utility-maximizing combination of good X and good Y being X0 and Y0 respectively.

If price of good X increases, budget line shifts inward to AC and new IC is IC1 which is tangent to AC at point F with new combination of X and Y being X1 and Y1 respectively. On the other hand, if price of good X decreases, budget line shifts outward to AD and new IC is IC2 which is tangent to AD at point G with new combination of X and Y being X2 and Y2 respectively. Similar analysis can be conducted for a change in price of good Y.