Question

Question 5 [8] 5.1. With reference to the indifference theory with good Y on the vertical axis and good X on the horizontal axis, graphically illustrate a change in consumer equilibrium due to a change in income. Remember to label the diagram correctly and to indicate the "income consumption curve clearly. 5.2. Referring to the graph above and consumer equilibrium, indicate what will happen to the budget line should there be an increase in the price of good X (on the horizontal axis). 5.3. What does the law of substitution state?

Answer 1

5.1 Indifference curve is the graph which shows the two combinations of two goods which gives equal satisfaction to the consumer. Consumer is indifferent between the combinations. Income consumption curve: income consumption curve shows the locus points of various consumption bundles of two goods at which consumer are in equilibrium position Graph:

Good Y Income consumption curve IC3 в IC BLI BLS BL2 Good X In the above graph, good X on the X-axis and good Y on the Y axis are taken. IC1, IC2, and IC3 are indifference curves and BL 1, BL2 and BL3 are the budget lines. Points A, B C are the consumer equilibrium points. From the above graph, it is clear that when income of the consumer and preferences of the consumer changes, the consumer equilibrium points also changed

Point A indicates that consumer is getting lower level of satisfaction than points B and C. When income of the consumer increases, consumer equilibrium moves from A to B and Bto C. When wejoined the locus points of A, B and C, we get the income consumption curve which shows the various consumer equilibrium combinations of two goods at various level of income with various indifference curves. 5.2 When the price of good X increases:

Good Y Income consumption curve IC3 в IC BLS BL2 Good X From the above graph, we can say that if the consumer is at BL2 budget line initially and at equilibriumposition at point B on IC2 indifference curve. When the price of good X increases, consumer equilibrium shifts from B to Dwhere consumeris afford to buy less of good X and more of good Y at BL2 budget line with IC4 indifference curve

5.3 Law of substitution: is also known as law equi-marginal utility. According to this law, when consumeris going to consume a good, then with every additional consumption of that good, marginal utility of that good will decrease by using all available resources. According to this, the consumer will spend his income on two goods in such a way that the consumption of last units will give him same equal marginal utility