Question

Ali is a consumer who consumes two goods only – Food and leisure.

40F + 350L = 5000

60F + 420L = 8000

1. Plotting food on the x-axis and leisure on the y-axis, draw the budget line. Clearly label the y and x intercepts.
2. Which combination of food and leisure can Ali afford to get. Clearly represent it on your graph.
3. It is known that Ali’s preferences exhibit diminishing MRS. What does this mean?
4. Using a set of indifference curves, represent Ali’s optimal choice of consumption at point O.
5. What is the value of MRS at point O? Explain your answer.
6. Now suppose that Ali’s income doubles while all else remains constant. Write Ali’s new budget line?
7. Now suppose the price of food doubles. All above remains constant. Write down Ali’s new budget line. How does Ali’s new budget line compare with the new budget line?

Answer 1

a. The graph is shown below the answer.

b.Ali can afford that combination of good and leisure which are there on the budget line or below the budget line. The set of goods above the budget line could not be afforded by Ali as that will exceed his income.

c. Diminishing MRS means diminishing Marginal Rate of Substitution which says too consume consumption of one good will reduce the marginal utility value of the product thus that will give the consumer less incentive to buy the product. The utility which the consumer gets from consuming the product at the first time, the utility will gradually fall at a lint after consuming a certain amount of the product. From here the marginal utility will be negative and the total utility will fall down. Marginal rate of substitution means the rate at which the consumer will exchange one good with another good. This rate of substituting one good with another good falls down after a certain point. This means a person will exchange less amount of goods with another good after a certain point.

Moreover, it means the indifference curve which Ali has us of convex shaped, as only convex indifference curves exhibits diminishing marginal rate of substitution.

d. Ali's optimal choice of consumption will be at that indifference curve which intersects the budget line. The indifference curve IC3 beyond the budget line will be unaffordable as the that set of items could not be afforded by the consumer as that is out of budget. The consumer will not prefer IC1 as he will not be able to use his whole income. Therefore, the individual will choose IC2 which will intersect the budget line.

e. For the first equation the MRS would be Leisure/Food = 350/50= 8.75.

For the second equation the MRS would be, Leisure/Food = 420/60 =7.

f. If Ali's income doubles other things remaining constant,then in this case, the budget line of Ali will shift towards the right by that amount by which the budget has increased.

g. If only the price of food doubles, other things remaining constant, then in this case, the corner point of leisure will remain the same but the corner point of food will shift downwards. The budget will shrink towards the origin.

In the earlier budget line where the income doubled, the budget set was more for the buyers. In this case, when the price increased the budget set has shrink down. With the increase in the price of food, the aldemsnd for food has reduced.