Posted by Anjali Kaur on Nov 28, 2021

Practice Test 7-Microeconomics

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1. What is consumer budget?

A budget shows all the combinations of goods and services that a consumer may purchase, given the current prices with his/her income level. So, the consumer budget shows the income level of the consumer with the help of it, a consumer can afford the goods.

2. What are monotonic preferences?

In the case of the indifference curve, consumers will always prefer a bundle offering more of at least one good as compared to another. For example, (5,4) is monotonically preferred to (4,4).

3. Explain the budget constraint with the help of a diagram.

A budget line shows all the possible combinations of consumption bundles that a consumer can afford given the prices of both commodity and income of the consumer.

The budget line shows a set of commodities of two goods that can be purchased if full income is spent on them.

Suppose a consumer has a budget of $20 to be spent on two commodities bread and buns, if the price of bread is $4 and the price of buns is $2 each. Then the consumer can determine various consumption bundles that they can afford. let’s see how?

Price of Bread, X= P1 = $4

Price of Buns, Y = P2 =$2

Income =M= $20

Now, by the hit and trial method and by assuming values for X and Y, we can determine different combinations of a commodity that a consumer can buy. The budget equation after placing the values of price and income becomes:

4X+2Y = 20 equation (1)

Now, assume X is 0 and put this value in the above equation, Y becomes 10. Similarly, we can find all the values for Y, that will fall under the budget of the consumer ($20).

X (Assumed)	Y
0	10
1	8
2	6
3	4
4	2
5	0

Note: All the above values cost exactly $20.

The following is the graphical representation of the above (X, Y) points, after joining these points, we will get the negatively sloped budget line.

Remember, on the X-axis, we represent the number of X commodities, and on the Y-axis, we represent the number of Y commodities.

4. Derive the slope of the budget line.

The slope of the budget line measures the amount of change in good 2 required per unit of change in good 1 along the budget line. Now, let us derive the slope of the budget line as follows:

Take two points on the budget line.

5. What leads to change in budget line?

Three factors cause changes in the budget line; Price of good X, Price of good Y, and income of the consumer.

When only one-factor changes

Income changes

When the income of the consumer rises, the budget line will shift to the right. Similarly, when the income of the consumer falls, the budget line will shift to the left. As shown below;

**When the income of the consumer changes**

When the price of good X changes

Assuming that price of good Y and the income of the consumer remains constant then an increase in the price of good X will make the budget line steeper, that is, the budget line rotates inward on X-axis. Similarly, keeping other factors constant when the price of good X falls, the budget line will become flatter, that is, the budget line rotates outward on X-axis.

When the price of good Y changes

Assuming that price of good X and income of the consumer remains constant then an increase in the price of good Y will make the budget line flatter, that is, the budget line rotates outward on the y-axis. Similarly, keeping other factors constant when the price of good Y falls, the budget line will become steeper, that is, the budget line rotates inward on Y-axis.

When two factors change in the same direction and by the same percentage;

If the price of good X and the price of good Y changes in the same direction and by the same percentage. This will lead to a parallel shift in the budget line. If both the prices fall by the same percentage, then the budget line will shift parallel to the right. Similarly, if both the prices rise, then the budget line will shift parallel to the left. As shown below:

6. Explain Indifference curve analysis with its properties.

An indifference curve is a curve that shows the combinations of two commodities that give the same level of satisfaction to the consumer.

Properties of Indifference curve analysis

Slopes downward to the right.
Convex to the origin.
Higher indifference curves are preferred to the lower indifference curve.
Indifference curves do not cut or intersect each other.
The indifference curve never touches the x-axis or y-axis.

7. Explain consumer equilibrium with the help of an indifference curve analysis.

Consumer equilibrium with the help of indifference curve analysis (Ordinal utility analysis) is at a point where the consumer’s indifference curve touches (Tangent means only touches at one point) the budget line.

Conditions for Consumer Equilibrium by IC Analysis

The budget line should be tangent to the indifference curve.
The indifference curve (IC) should be convex to the origin.
The slope of the Indifference curve (MRS) should be equal to the slope of the budget line (-P1/P2)

Derivation of the Consumer Equilibrium

A consumer is in equilibrium when according to the budget line, he moves to the highest possible indifference curve (IC2).
As shown below, point E is a point of equilibrium that satisfies all conditions.
At point E, the budget line (AB) is tangent to the indifference curve(IC2), (convex shaped).
At point E, the slope of IC2= slope of the budget line. That is the Marginal Rate of substitution = -P1/P2 (Sometimes, minus sign is ignored because MRS is also negative, and slope of the budget line is also negative, which cancels each other).
The consumer will never operate on IC1 because this is under the budget line and by the property of the indifference curve: higher is always preferred to the lower ones.
The consumer will never operate on IC3 because this is beyond the budget line, and he cannot afford it.
Hence, the consumer reaches equilibrium on IC2, which is touching the budget line at point E, indicating consumer equilibrium under IC analysis.

**Consumer Equilibrium using Indifference Curve Analysis**

8. You are living in a country whose economy is underdeveloped. In this context, why is there a need of efficient use of resources?

Answer. If the economy is underdeveloped, it means the economy is operating at a point inside PPC, which shows underdevelopment and inefficient use of resources.

In order to operate on the production possibility curve, the economy has to make sure optimum use of resources.

9. 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.

a. Write down the equation of the budget line.

b. How much of good 1 can the consumer consume if she spends her entire income on that good?

c. How much of good 2 can she consume if she spends her entire income on that good?

d. What is the slope of the budget line?

a. p1x+p2y=m

4X + 5Y = 20

b. X = M/P1

X = 20/ 4 = 5 units

c. Y = M/P2

Y = 20/5 = 4 units

d. Slope of the budget line = -p1/p2 = -4/5

10. 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?

Answer. X = 6

Y = 8

P1 = 6

P2 = 8

6X6 + 8X8 = Income

Income = 100

11. Explain as to why does the budget line downward sloping.

It is negative in the slope and downward curve because an increase in the consumption of one commodity causes a decrease in the consumption of another commodity.