Analyzing The Budget Line

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Sub: Economics                                                                    Topic: Micro Economics

Question:

Analyzing the budget line.
The diagram below shows the budget line and the indifference map of a consumer for two products,
food and clothing.




i) Compare the four points W,X,Y, and Z in terms of total utility and also affordability and explain why
point Z is the optimal consumption point.


ii) If there is a drop in the price of clothing, how will the budget line be affected? What will happen to
the consumption of clothing if clothing is a normal good?




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Sub: Economics                                                                    Topic: Micro Economics

Solution:

(i) Let us explain the four points mentioned in the above figure. Point W: Point W is outside the budget
line. That implies it is not affordable for the consumer to reach that point and have the respective
consumption bundles.


o Point X: Point X lies below the indifference curve. Any point below the indifference curve is
   affordable but inefficient. The consumer will try to reach the maximum possible indifference curve.
o Point Y: Point Y lie in the same indifference curve as point X. That implies the consumer can
   derive the same utility as point X. Point Y also lies on the budget line but it is NOT tangent to the
   indifference curve. This implies that by reallocating the consumption bundle the consumer will be
   able to reach higher indifference curve and thereby can obtain maximum utility. This will lead the
   consumer towards point x.
o Point X: Point X is the optimal consumption point. At X, the budget line in tangent to the
   indifference curve and the consumer is able to maximize his utility or level of satisfaction. At this
   point the ratio of marginal utilities is same with the price ratios of the goods.


(ii). If there is a drop in the price of clothing , the budget line will shift outward towards clothing which
is shown below:




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 *The Homework solutions from Classof1 are intended to help students understand the approach to solving the problem and not for
                              submitting the same in lieu of their academic submissions for grades.
Sub: Economics                                                                    Topic: Micro Economics




In the above diagram, AB was the initial budget line. As there is a drop in the price of clothing the new
budget line will be AB’. The consumer will move to a higher indifference curve.
If clothing is a normal good, a fall in the price of clothing will lead to an increase in the consumption of
clothing.


                                               ** End of the Solution **




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DOCUMENT INFO
Description: The diagram below shows the budget line and the indifference map of a consumer for two products, food and clothing.
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