Question

For each of the following cases,

(1) graph the budget constraint and at LEAST 2 indifference curves,

(2) indicate the utility maximizing point (and the indifference curve that corresponds with that point),

and (3) SHOW and briefly explain what you would expect to happen if the price of the good changed as indicated, in terms of income and substitution effects.  (Unlike the exam, you MUST show income and substitution effects on the graph.)

In all cases, assume that your intital income is $50 and that the price of each good is $2.

A. Coke and Pepsi are perfect substitutes for me, but I like Coke twice as much as Pepsi.

(Put Coke on the horizontal axis, and assume that the price of Coke rises to $5.)

B. I like my sandwiches to have exactly three slices of ham and two slices of cheese, and I don't like any other combination.

(Put ham on the horizontal axis, and assume that the price of ham falls to $1.)

C. The choice of vegetables is broccoli and carrots. I like broccoli, but I'm indifferent about carrots; I neither like nor dislike them.

(Put carrots on the horizontal axis, and assume that the price of carrots falls to $1.)

D. The choice of vegetables is broccoli and eggplant. I like broccoli, but I hate eggplant. Assume that you have to eat any vegetables that you actually have.

Answer 1

1.Ans.

Budget line is a graphical representation which shows all the possible combinations of the two goods that a consumer can buy with a given income and the prices of commodity

It is also called consumption possibility line.

Indifference Curve is defined as the curve which represents all combination of two commodities which give same level of satisfaction to the consumer so that the consumer becomes indifferent towards these combination.

Consumers equilibrium is defined as the level of consumption where the consumer derives maximum satisfaction from the consumption of commodities and does not have any desire to change from that level of consumption.

2.Ans.) From the above diagram, it is clear that the consumer is in Equilibrium at poit 'E' where the budget line is tangential to the indifference curve. In this particular point, he can buy OX level of commodity 'X' and OY level of commodity 'Y' which is the best choice to the consumer. So the utiltiy Maximisation Point is point ' E'. Point 'C' and point 'D' lies on Indifference Curve1, is not the maximum utility point, eventhough, Budget Line is tangential to the IC.Because a better Indifference curve is availabe which is affordable to the consumer. The Maximum Satisfaction point lies on Indifference Curve 2. But all the points on IC2 doest not give maximum satisfaction. Only Point 'E' is the optimal choice of the consumer. Point 'W' which lies on IC2 is not the maximum utility point because it lies outside the budget line.

3. Ans.)

Income effect

When the price of a commodity falls, the income of the consumer, that is his purchasing power increases. As a result he can now buy more of a commodity. This is called income effect. This causes increase in the quantity demanded of the good whose price falls.

Substitution Effect:

When the price of a commodity falls, it becomes relatively cheaper than other good. This induces the consumer to substitute the relatively cheaper commodity for the other good which is relatively expensive. This is called the substitution effect. This causes increase in the quantity demanded of the commodity whose price has fallen

The Price Effect is the compounded of the income effect and the substituion effect.

Ans. Eg. A )

The Income of the consumer = $50

Price of Coke = $2

Price of Pepsi = $2

Substitution effect means the change in the purchase of a good as consequence of a change in relative price alone, real income remaining the same.

In this example, when the price of Coke increases from $2 to $5, the consumer's purchasing power decreases. Before the rise in price, if the consumer spent his entire income on Coke, he can buy 25 units (bottle) of coke. After the increase in price of Coke the consumer can either substitute it with Pepsi or he can reduce the consumption of Coke.

If the consumer wish to reduce the consumption of Coke, Now he can buy only 10 units of Coke instead of 25 units because the price of Coke increases from $2 to $5 and his money income is only $50.

From the following diagram, it is clear that the quantity demanded for Coke decreases as result of increase in price.

'X' axis represents quntity demanded (Coke) at various prices and 'Y' axis represents the Price of Coke.

Ans. B) The price of Cheese per unit $2

The price of ham per unit $2

Consumer's choice is 3 ham and 2 cheese

When the price of ham decreases fro $2 to $1 the quantity demanded for ham increases from 3 to 6 hams.

The following diagram shows the choice of the consumer and demand curve after the change in price of the one commodity. Here, the price of ham decreases, as a result the purchasing power of the consumer increases and the consumption of ham has increased. This is the income effect from this example.