a) A consumer, Mr Aman is in the state of equilibrium consuming two goods X and Y, with given prices Px and Py. What will happen if MUx/Px>MUy/Py?

b) Identify which of the following is not true for the Indifference Curves theory. Give valid reasons for the choice of your answer:

i. Lower indifference curve represents a lower level of satisfaction.

ii. Two indifference curves can intersect each other.

iii. Indifference curve must be convex to the origin at the point of tangency with the budget line at the consumer's equilibrium.

iv. Indifference curves are drawn under the ordinal approach to consumer equilibrium.

OR

A consumer has total money income of 500 to be spent on two goods X and Y with prices of 50 and 10 per unit respectively. On the basis of the given information, answer the following questions:

a. Give the equation of the budget line for the consumer.

b. What is the value of the slope of the budget line?

c. How many units can the consumer buy if he is to spend all his money income on good X?

d. How does the budget line change if there is a 50% fall in the price of good Y?

A consumer is any individual who tries to maximise their satisfaction within the constraints imposed by the budget. A consumer may have unlimited wants. But all the wants cannot be completely satisfied. The consumer will decide how much quantity that they have to purchase based on the marginal utility derived from the good and the price of the good.

A consumer will be in equilibrium when the total utility is maximised by spending the limited income on different goods. The utility is the want-satisfying capacity of any commodity. The consumer will maximise the utility when the equal utility is derived from the last unit of money spent on each commodity. This will make the consumer achieve the equilibrium.

The purchasing behaviour of the consumer is determined by two basic factors. They are:

• The marginal utility of the goods

• Price of the goods

The consumer will maximise the utility and make the purchasing decision by considering the proportion of the marginal utility and prices of different goods. Thus the consumer will make the decision based on the marginal utility of the good with its price, i.e. MU/P ratio. Marginal utility is the addition made to the total utility when an additional unit of a good is consumed. The consumer will purchase more of the commodity when the marginal utility derived from it is higher than the price.

In the case of two commodities, the consumer will be in equilibrium when MUx/Px=MUy/Py. Thus the consumer will allocate the expenditure in such a way that the utility derived from the last rupee spent on each commodity is the same. The consumer will purchase the commodity for which the MU/P ratio is higher as this will give more satisfaction. If the consumer is consuming good X and good Y, and the MUx/Px>MUy/Py, the consumer will increase the consumption of good X and reduce the consumption of good Y. As the quantity of good X rises, the utility gained from each additional unit of consumption of good X falls. Consequently the consumption and the utility from the increased consumption of good Y increases. The consumer will be in equilibrium when MUx/Px=MUy/Py.

(b) ( i)Yes, the statement is true. A lower IC depicts a lower level of satisfaction. A consumer always prefers more commodities compared to lesser commodities. A higher IC would imply a higher basket of good available for consumption by the consumers. Thus a consumer will always prefer the highest attainable IC which gives them more satisfaction. Thus the higher the IC in the IC map, more will be the level of consumer satisfaction. IC3 will give the consumer more satisfaction than IC1 as IC1 is a lower IC compared to IC3.

(ii) No, this is not true. IC does not intersect with each other. Two ICs will not intersect with each other. This is against the logic of consumer preferences. When two ICs intersect, the intersection point will be the same for both the ICs. Since a higher IC represents a higher level of satisfaction, the intersection of ICs will result in a point where the level of satisfaction is the same for both the ICs. This is logically not possible. Also, between two given points, there exists innumerable ICs that does not intersect with one another.

iii At the point of equilibrium, the IC must be convex to the point of origin. This is because of the operation of the diminishing marginal rate of substitution (MRS). MRSxy is the rate at which the consumer is willing to sacrifice one good Y for an extra unit of another good X. As MRS between X and Y diminishes along the IC, it becomes convex i.e. less and less of Y is sacrificed for an additional unit of X. If the IC is concave implying increasing MRS, the consumer would be able to obtain higher amounts of either X or Y. Thus, the consumer will not be in equilibrium.

iv The want-satisfying power of a commodity is called utility. It can be cardinal or ordinal. Cardinal utility is the utility that is described cardinally in terms of numbers. The ordinal utility is the ranking of preferences by the consumer according to the satisfaction derived by the consumer. The main measure under ordinal approach is the indifference curves. IC shows the locus of the combination of two goods that gives the same level of satisfaction to the consumer. Since the consumer is able to only rank his satisfaction, this comes under the purview of the ordinal approach.

OR

a) Budget line is the locus of combinations of two goods that the consumer can purchase with the given income and price of the goods. It determines the commodities that are affordable to the consumers, given the income and prices. The slope of the budget line is equal to price ratios. The equation of the budget line can be stated as 50X+10Y=500.

b) Budget line is the locus of combinations of two goods that the consumer can purchase with the given income and price of the goods. It determines the commodities that are affordable to the consumers, given the income and prices. The equation of the budget line can be stated as 50X+10Y=500. The slope of the budget line is equal to price ratios which are equal to 50/10 = 5.

c) AB = 50X+10Y=500

Number of units of good Y = 0

50X+0Y=500

50X=500

X=500/50=10 units

d) When the price of one commodity falls, the budget line pivots /rotates accordingly. When the price of good Y falls, it becomes cheaper for the consumer. Thus the consumer would be able to purchase more of the commodity. This will result in upward rotation of the price line, the X-intercept remaining the same. The budget line will pivot from its initial points AB to A1B.