THERE ARE TWO GOODS GOOD 1 AND GOOD 2
PRICES OF TWO GOODS ARE P1 AND P2
QUANTITIES OF TWO GOODS CAN BE REPRESENTED BY X1 AND X2
INCOME OF THE CONSUMER IS M
ANY
COMBINATION OF GOOD 1 AND GOOD 2 IS KNOWN AS BUNDLE.
(GOOD
1,GOOD 2) IN THE
SAME WAY (1,2) (3,4) (5,4) (7,8) (4,3)
ARE KNOWN AS BUNDLES.
BUDGET SET
IT
COMPRISES OF SETS OF BUNDLES WHICH A CONSUMER CAN PURCHASE FROM HIS INCOME.
EQUATION
FOR BUDGET SET
P1 X1 + P2 X2 <= M
BUDGET LINE
IT
COMPRISES OF ALL THOSE BUNDLES WHICH COST THE CONSUMERS EXACTLY EQUAL TO HIS
INCOME.
EQUATION
FOR BUDGET LINE P1 X1 + P2
X2 = M
IT CAN
BE DRAWN WITH THE HELP OF HORIZONTAL INTERCEPT AND VERTICAL INTERCEPT.
HOROZONTAL
INTERCEPT -: WHEN A CONSUMER SPENDS HIS ENTIRE INCOME ON THE PURCHASE OF GOOD
I.
M/ P1
VERTICAL
INTERCEPT -: WHEN THE CONSUMER SPENDS HIS ENTIRE INCOME ON THE PURCHASE OF GOOD
2.
M/P2
•
SLOPE
OF BUDGET LINE
BUDGET
LINE IS DOWNWARD SLOPPING MEANS IN ORDER TO HAVE MORE OF ONE GOOD A CONSUMER
HAS TO GIVE UP SOME UNITS OF OTHER GOOD
.
SLOPE
OF BUDGET LINE DETERMINES BY HOW MUCH AMOUNT GOOD2 IS GIVEN UP IN ORDER TO HAVE
ONE MORE UNIT OF GOOD1.
SUPPOSE
WE WANT TO INCREASE THE CONSUMPTION OF GOOD 1 BY ONE UNIT WE HAVE TO SPEND P1 AMOUNT MORE AND SO , WE HAVE TO REDUCE CONSUMPTION ON GOOD 2 BY THIS P1 AMOUNT.
NOW HOW
MANY UNITS OF GOOD 2 WE CAN PURCHASE FROM P1 ?
WE CAN
PURCHASE P1
UNITS FROM P1. P2
NOW
SUPPOSE PRICE (P1) OF GOOD 1 =Rs 50
PRICE
(P2) OF GOOD 2 =Rs 20
MONOTONIC
PREFERENCES
OUT OF GIVEN TWO
BUNDLES A CONSUMER WILL ALWAYS PREFER THE BUNDLE WHICH HAS MORE OF AT LEAST ONE
GOOD AND THE OTHER GOOD MUST NOT BE DIMINISHING.
FOR EXAMPLE
(4,5) &
(5,5)
(4,5) &
(5,6)
But
in this case -:
(4,5) & (5,4)
No ?
MARGINAL RATE OF
SUBSTITUTION
IN
ORDER TO INCREASE THE CONSUMPTION OF GOOD1 BY ONE UNIT A CONSUMER HAS TO
GIVE UP CERTAIN UNITS OF GOOD2 .
OR
THE
RATE AT WHICH CONSUMER SUBSTITUTE GOOD1 FOR GOOD2 IS KNOWN AS
MARGINAL RATE OF SUBSTITUTION.
DIMINISHING
MARGINAL RATE OF SUBSTITUTION
THR
RATE AT WHICH CONSUMER SUBSTITUTE ONE UNIT OF GOOD1 WITH GOOD2 DIMINISHES AS HE
INCRESES THE CONSUMPTION OF GOOD1.
u
GOOD1 GOOD2 MRS
u
1 20 -
u
2 14 6
u
3 9 5
u
4 5 4
u
5 2 3
AMONG
THESE BUNDLES (1,20) (2,14) (3,9)
(4,5) AND (5,2)
THE
CONSUMER WILL BE INDIFFERENT AS ONE GOOD IS INCREASING BUT OTHER IS
DIMINISHING.ALL
{EACH OF} THESE BUNDLES (1,20) (2,14) (3,9)
(4,5) AND (5,2) GIVES CONSUMER THE SAME LEVEL OF
SATISFACTION.
INDIFFERENCE
CURVE REPRESENTS ALL THOSE BUNDLES AMONG WHICH A CONSUMER REMAINS INDIFFERENT AND GETS THE SAME LEVEL OF SATISFACTION.
CONSUMER'S EQUILIBRIUM
A
CONSUMER IS IN EQUILIBRIUM WHERE THE BUDGET LINE IS TANGENT TO THE INDIFFERENCE CURVE. IT
MEANS THE PREFERENCES OF CONSUMER MATCH WITH HIS PURCHASING POWER.
WHY SO ?
WHY SO ?
WHY NOT
AT THE POINTS WHERE THE INDIFFERENCE
CURVE INTERSECTS THE BUDGET LINE.
POINTS
A,B & C LIES ON THE SAME INDIFFERENCE CURVE.THIS
MEANS ALL THESE POINTS GIVES SAME SATISFACTION TO CONSUMERS.THE EXPENDITURE ON BUNDLE A
AND B IS EQUAL TO THE INCOME AS THEY LIE ON BUDGET LINE. THE EXPENDITURE ON BUNDLE C
COSTS LESS THAN INCOME AS THIS POINT LIES BELOW THE BUDGET LINE.
NOW OUT
OF A ,B &C WHAT THE CONSUMER WILL PREFER TO PURCHASE ?
OFF COURSE C AS IT COSTS LESS THAN A OR B.
BUT THE CONSUMERS WANTS TO SPEND HIS ENTIRE INCOME. SO THE CONSUMER WILL SHIFT TO HIGHER INDIFFERENCE CURVE.
POINT D LIES ON HIGHER INDIFFERENCE CURVE AND IT ALSO COST EQUAL TO INCOME AS IT LIES ON BUDGET LINE .
BUT THE CONSUMERS WANTS TO SPEND HIS ENTIRE INCOME. SO THE CONSUMER WILL SHIFT TO HIGHER INDIFFERENCE CURVE.
POINT D LIES ON HIGHER INDIFFERENCE CURVE AND IT ALSO COST EQUAL TO INCOME AS IT LIES ON BUDGET LINE .
WHEN
COMPARED WITH A AND B CONSUMER WILL PREFER D AS IT LIES ON HIGHER INDIFFERENCE CURVE.
Budget line tangent to IC curve
Slope of indifference curve = Slope of budget line
MRSxy = Px/Py
So we can say that the consumer is in equilibrium when marginal rate of substitution between two goods become equal to price ratio of those two goods.
