Question

a) The Indifference Curve (IC) shows the level of satisfaction. Now discuss the properties of indifference curve elaborately. Why is the concept of Marginal Rate of Substitution (MRS) important for measuring the level of satisfaction? Design your answer by using graphs and relevant examples.

b) Distinguish between nominal income and real income. Suppose, the price of good X is Tk. 20 and the price of good Y is Tk. 30. If the nominal income of consumer is Tk. 1000, then plot a budget line. What does this budget line show? If the price of X and Y increases by 25% and 30%, respectively, what would be the effect on the budget line? Show in graphs.

Answer 1

a) The indifference curves depicts the different combination of two goods which provides same level of satisfaction. And which is why individual is indifferent between different combinations of goods lying on same IC.Thus, any point on an indifference curve will provide same utility to the individual as depicted in diagram below-

The properties of indifference curves are as follows-

• The indifference curves are downward sloping from left to right. As we know that any point in the indifference curve (IC) provides same level of satisfaction, which is why to increase consumption of one good need to decrease the consumption other good in order to remain on same indifference curve, which results in downward sloping IC (as shown in diagram below, if increase one is not compensated by decrease of other good it will result in moving to point B, that is, point above the given IUa)

• The indifference curves are Convex to origin. This property can be explained with the help of property of diminishing return states that as you consume more and more given good it lower the utility deriving from consumption of additional unit of given good.

And the slope of indifference curve is the rate at which willing to substitute one good for an additional unit of other good, which is called as MRS (Marginal Rate of Substitution). It is computer as -

MRS = - MUx/MUy

Where, MUx is marginal utility derived from good X and MUy is the marginal utility derived from good Y.

Negative sign depicts the IC is downward sloping

Thus, the diminishing return property is satisfied only in the case of IC convex to origin. Because as you move from left to right along Convex IC. The slope of IC, that is, MRS is decreasing as you from left to right implies that is possible either MUx is decreasing or MUy is increasing,

That is as we from left to right diminishing MRS states MUx falls and MUy rises which is when consumption of Good X is increased and consumption of Good Y is falling, satisfying the diminishing returns property as increased in consumption of Good X lowers the utility derived from Good X.

• The higher the IC the more it is preferred. This is explained on the based on the principal of more the better. That is IC to the very right is preferred as depicted in the diagram below ICa is preferred to ICb.

• The indifference curve do not interesect each other. This can be explained with the help of diagram shown below-

b) The nominal income the money income which is not adjusted by the price ratio, whereas the real income the nominal income which is adjusted by price ratio.

The budget constraint given below-

XPx + Y Py M

Where Px and Py are the prices and M is the nominal income

Thus, M/Px or M/Py or M/ (Px/Py) is the nominal income adjusted by prices, that is, real income.

It is given that Px = 20 and Py = 30 and M = 1000. The budget the line is -

Px X + Py Y = M

20 X + 30 Y = 1000

If prices are increased then budget line will shift inward but not parallel as increase in prices are different shown below-