Question

Graphically show the consumer's equilibrium (point of maximum utility) using indifference curves. Explain why is that point maximum utility?

Answer 1

Consumer is in equilibrium at a point where the budget line is tangent to the highest possible indifference curve from below.

In the above graph , there are three indifference curves IC1, IC2, IC3. Budgte line is given by PT. And it is tangent to IC2 at point C. This implies that the consumer gets maximum utility or at equilibrium at point C .

The consumer cannot be in equilibrium at any other point on indifference curves. At point R and S ,the consumer is not in equilibrium because it doesn't give him maximum satisfaction as he is on lower indifference curve IC1.

At point U on IC3 , this lies on higher indifference curve but this point lies outside the budget line. Therefore, it is attainable.

As a result, the consumer is in equilibrium at point C only where the budget line tangent to the IC2.

Utility maximisation condition is represented by MRS = price ratio.

MRS (marginal rate of substitution ) is the slope of the indifference curve ).

Price ratio (Px/Py) is the slope of the budget line.

It implies that the rate at which the individual is willing to substitute good X for good Y must equal to the ratio at which he can substitute X for Y in the market at a given price.