A consumer has typically shaped indifference curves and budget constraint and is currently spending all her income. She is consuming a bundle of goods such that her MRSXY is greater than PX /PY . This consumer could increase her utility by:
a. consuming more of good X and less of good Y
b. consuming more of good Y and less of good X
c. neither of the above because we can tell she is already maximizing utility because she is spending all her income
In the above case, MRSxy is greater than Px/Py then consumer can increase her utility by consuming more of good X and less of good Y.
Marginal rate of substitution is the rate at which a consumer is willing to sacrifice amount of good x by amount of good y while maintaining the same utility. At the equilibrium level,
MRSxy = Px / Py
Here ,Px = price of x
Py = price of y
When MRSxy is greater than Px/Py then consumer will get more satisfaction by purchasing certain amount of x than y. Given her budget constraint, she will buy more of x than y.
Thus consumer will pay more for x than the prevailing price. As a result, increase in purchase of x will cause MRS to fall till it becomes equal to the ratio of px/py. Finally an equilibrium is established.
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