Question

Explain what an indifference curve is and what a budget constraint is. How do we find Optimal​ consumption?

Answer 1

An indifference curve is a representation of the utility function that shows the possible combination of two goods that the consumer selects for consumption that generate equal utility throughout the indifference curve. It is generally a convex curve that is bowed towards the origin when drawn between vertical and horizontal axis. The utility along the entire indifference curve is same for various consumption bundle selected. The slope of the indifference curve measures the rate at which the consumer is willing to substitute one of the goods with the other and this is called the marginal rate of substitution.

Consumer is bounded by resources which she uses in purchasing any given bundle of these two goods. Budget constraint is a representation of the resources that consumer can use in purchasing this bundle and it shows all the affordable consumption bundles that the consumer can purchase with the given income and the prices of the two goods. The ratio of the two prices is the slope of the budget constraint.

Under constrained optimisation, the optimal consumption is determined by the tangency between the indifference curve and the budget constraint. This indicates that when the marginal rate of substitution between two goods equals the price ratio, the optimal consumption bundle is selected.