Question

IUVIU. Q 4. Explain the conditions that are met when a consumer has found the best affordable combination of goods to buy. (Use the terms Budget line, Marginal Rate of Substitution and Relative Price in your Explanation) Also graphically illustrate the best affordable combination. [4 Marks]

Answer 1

Consumer's equilibrium is a state where the consumer has found the best combination of two goods that it will buy given the income level and the prices of the two goods. This combination of two goods gives him maximum satisfaction and the consumers are not willing to further switch to any other combination.

The consumer is in equilibrium at the point where its indifference curve is tangent to the budget line. An indifference curve is a curve that shows different combinations of two goods that give the consumer an equal level of satisfaction. The slope of the indifference curve is the marginal rate of substitution which tells us the rate at which one good is substituted over another. The budget line shows the combination of two goods that consumers will buy given the income level and the price of the two goods. The slope of the budget line is represented by the price ratios of two goods.

Marginal rate of substitution = change in good Y/ change in good X = MUx/MUy

Here we are taking two goods, X and Y. MUx is the marginal utility of goods X and MUy is the marginal utility of good Y.

Marginal utility is the additional utility derived from an additional unit consumed of the good. Marginal utility decreases as the number of goods consumed increases.

The budget line is given by the following formula: M = PxQx + PyQy

Here, M is the income level, Px is the price of good X, Qx is the quantity of good X, Py is the price of good Y and Qy is the quantity of good Y.

The slope of the budget line is: Px/Py

Consumer's equilibrium is at the point where the indifference curve is tangent to the budget line, which means the slope of both the indifference curve and the budget line should be equal.

The slope of indifference curve = marginal rate of substitution = MUx/MUy

The slope of budget line = Px/Py

Thus, the consumer will be in equilibrium when:

MUx/MUy = Px/Py

The above condition is the first condition of consumer's equilibrium. The second condition is that the indifference curve should be convex to the origin at the time of tangency.

The diagram above shows the indifference curve is represented by IC. AB is the budget line, we have quantity of good X on the horizontal axis and quantity of good Y on the vertical axis.

We can see that the consumer is at the equilibrium at point E, where the indifference curve is tangent to the budget line. Also, the indifference curve is convex to the origin at the point of tangency.

The consumer will consume X units of good X and Y units of good Y as represented in the diagram at the consumer equilibrium (point E).