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Practice each question, then open the answer or worked solution.
What do you mean by the budget set of a consumer?
A budget set of a consumer is a bundle of two or more goods in certain quantities and combinations that is desirable and affordable for the consumer based on their price range. A budget set is also called an opportunity set.
What is budget line?
A budget line is a graphical representation of a consumer’s constraints when buying a combination of two or more products with a given budget. A budget line will shift whenever there is a change in the prices, preferences or income. It is also called a consumption possibility line. Here, it is assumed that the customer spends the entire income on the bundle of products.
Explain why the budget line is downward sloping.
With a limited income, the customer can increase the consumption of one good only by decreasing the consumption of the other good. This is why a budget line is downward sloping.
A consumer wants to consume two goods. The prices of the two goods are Rs 4 and Rs 5 respectively. The consumer’s income is Rs 20. (i) Write down the equation of the budget line. (ii) How much of good 1 can the consumer consume if she spends her entire income on that good? (iii) How much of good 2 can she consume if she spends her entire income on that good? (iv) What is the slope of the budget line?
Let us assume that the consumer wants to buy X amount of Good 1 and Y amount of Good 2. As given, Good 1 is priced at Rs.4 and Good 2 is priced at Rs.5. The income of the consumer is Rs.20.
i) The budget line can be represented using the equation 4X + 5Y = 20
ii) If the consumer spends the entire income on good 1, the value of Y will be zero.
Hence, 4X + 5(0) = 20
X = 20/4 = 5
Therefore, 5 units of Good 1 can be bought.
iii) If the consumer spends the entire income on good 2, the value of X will be zero.
Hence, 4(0) = 5Y = 20
Y = 20/5 = 4
Therefore, 4 units of Good 2 can be bought.
iv) The slope of the budget line can be determined by the units of good 1 that the consumer is willing to give up to gain equivalent amounts of good 2.
P1/P2 = -4/5 = 0.8
How does the budget line change if the consumer’s income increases to Rs 40 but the prices remain unchanged?
When there is an increase in income, consumers can afford more amounts of both good 1 and good 2. Therefore, there will be a shift in the budget line towards the right direction.
How does the budget line change if the price of good 2 decreases by a rupee but the price of good 1 and the consumer’s income remain unchanged?
If the price of good 2 decreases, the consumer will be able to consume more amounts of good 2. Therefore, there will be a shift upwards along the vertical axis.
What happens to the budget set if both the prices as well as the income double?
If both the prices as well as the income double, there will be no change in the budget set.
Suppose a consumer can afford to buy 6 units of good 1 and 8 units of good 2 if she spends her entire income. The prices of the two goods are Rs 6 and Rs 8 respectively. How much is the consumer’s income?
Solution coming soon.
Suppose a consumer wants to consume two goods which are available only in integer units. The two goods are equally priced at Rs 10 and the consumer’s income is Rs 40. (i) Write down all the bundles that are available to the consumer. (ii) Among the bundles that are available to the consumer, identify those which cost her exactly Rs 40.
i) The bundles that are available to the consumer are (0,0) (0,1) (0,2) (0,3) (0,4) (1,0) (1,1) (1,2) (1,3) (2,0) (2,1) (2,2) (3,0) (3,1) (4,0)
ii) (0, 4) (1, 3) (2, 2) (3, 1) and (4, 0) are all bundles that costs the customer exactly Rs.40
What do you mean by ‘monotonic preferences’?
Monotonic preference is the assumption that a rational consumer will always prefer ‘more’ compared to ‘less’ of a given product. This means that a consumer will always be more satisfied by bundles which offer more amounts of products.