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In: Economics

Describe the scenario where a person's budget constraint is tangent to their indifference curve. Explain what...

Describe the scenario where a person's budget constraint is tangent to their indifference curve. Explain what is happening at this point of tangency.

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Expert Solution

WHEN A PERSON'S INDIFFERENCE CURVE IS TANGENT TO HIS/HER BUDGET CONSTRAINT IT MEANS THAT THE PERSON ATTAINS MAXIMUM UTILITY FROM CONSUMPTION BUNDLES WHICH IS WITHIN HIS/HER BUDGET.....

INDIFFERENCE CURVE GIVES DIFFERENT POINT OF CKNSUMPTION BUNDLES AT WHICH UTILITY REMAINS CONSTANT....

TANGENCY OF BUDGET CONSTRAINT WITH INDIFFERENCE CURVE MEANS THAT THE SLOPE OF BUDGET CONSTRAINT , MEASURED BY THE PRICE RATION (PRICE OF GOOD 1 DIVIDED BY PRICE OF GOOD 2), IS EQUAL TO THE SLOPE OF INDIFFERENCE CURVE , MEASURED BY MARGINAL RATE OF SUBSTITUTION BETWEEN TWO GOODS....

UTILITY OF THE CONSUMER IS MAXIMISED AT THIS TANGENCY POINT....THEREFORE ,OPTIMAL CONSUMPTION BUNDLE IS ATTAINED...THIS TANGENCY POINT MEANS THAT GIVEN A BUDGET CONSTRAINT OF PERSON , HIGHEST LEVEL OF UTILITY THAT CAN BE ACHIEVED WITHIN THIS BUDGET IS ATTAINED AT THIS TANGENCY POINT.....

SO AT THIS TANGENCY POINT ,

MARGINAL RATE OF SUBSTITUTION = PRICE RATIO

MRS = P1 / P2

WHERE , P1 = PRICE OF GOOD 1

P2 = PRICE OF GOOD 2

MRS IS CALCULATED AS THE RATIO OF DERIVATIVE OF UTILITY FUNCTION WITH RESPECT TO GOOD 1 TO THE DERIVATIVE OF UTILITY FUNCTION WITH RESPECT OF GOOD 2....

Rahul Sunny answered 2 years ago
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