BUDGET SET/ BUDGET LINE INDIFFERENCE CURVE ANALYSIS

Budget Set/ Budget Line Indifference curve Analysis

THERE ARE TWO GOODS    GOOD 1 AND GOOD 2
 PRICES OF TWO GOODS ARE    P1 AND P2
 QUANTITIES OF TWO GOODS CAN BE REPRESENTED BY     X1 AND X2

         INCOME OF THE CONSUMER IS M

 ANY COMBINATION OF GOOD 1 AND GOOD 2 IS KNOWN AS BUNDLE.
  (GOOD 1,GOOD 2)  IN THE SAME WAY (1,2) (3,4) (5,4)  (7,8) (4,3) ARE KNOWN AS BUNDLES.

BUDGET SET
   IT COMPRISES OF SETS OF BUNDLES WHICH A CONSUMER CAN PURCHASE FROM HIS INCOME.
    EQUATION FOR BUDGET SET
       P1 X1 + P2 X2 <= M

BUDGET LINE
   IT COMPRISES OF ALL THOSE BUNDLES WHICH COST THE CONSUMERS EXACTLY EQUAL TO HIS INCOME.
   EQUATION FOR BUDGET LINE           P1 X1 + P2 X2  = M
IT CAN BE DRAWN WITH THE HELP OF HORIZONTAL INTERCEPT AND VERTICAL INTERCEPT.





   HOROZONTAL INTERCEPT -: WHEN A CONSUMER SPENDS HIS ENTIRE INCOME ON THE PURCHASE OF GOOD I.
                                                                 M/ P1
   VERTICAL INTERCEPT -: WHEN THE CONSUMER SPENDS HIS ENTIRE INCOME ON THE PURCHASE OF GOOD 2.
                                           
                                                                   M/P2

•          SLOPE OF BUDGET LINE
   BUDGET LINE IS DOWNWARD SLOPPING MEANS IN ORDER TO HAVE MORE OF ONE GOOD A CONSUMER HAS TO GIVE UP SOME UNITS OF OTHER  GOOD .
    SLOPE OF BUDGET LINE DETERMINES BY HOW MUCH AMOUNT GOOD2 IS GIVEN UP IN ORDER TO HAVE ONE MORE UNIT OF GOOD1.



SUPPOSE WE WANT TO INCREASE THE CONSUMPTION OF GOOD 1 BY ONE UNIT WE HAVE TO SPEND P1  AMOUNT MORE AND SO , WE HAVE TO REDUCE CONSUMPTION ON GOOD 2 BY THIS P1 AMOUNT. 

NOW HOW MANY UNITS OF GOOD 2 WE CAN PURCHASE FROM P1 ?
WE CAN PURCHASE         P1 
UNITS FROM   P1.             P2
NOW SUPPOSE PRICE (P1) OF GOOD 1 =Rs 50
 PRICE (P2) OF GOOD 2 =Rs 20

MONOTONIC PREFERENCES
OUT OF GIVEN TWO BUNDLES A CONSUMER WILL ALWAYS PREFER THE BUNDLE WHICH HAS MORE OF AT LEAST ONE GOOD AND THE OTHER GOOD MUST NOT BE DIMINISHING.

  FOR  EXAMPLE
 (4,5)    &     (5,5)
 (4,5)    &     (5,6)
  But in   this case  -:    (4,5)    &     (5,4)   No ?

MARGINAL RATE OF SUBSTITUTION
 IN ORDER TO INCREASE THE CONSUMPTION OF GOOD1 BY ONE UNIT A CONSUMER HAS TO GIVE UP CERTAIN UNITS OF GOOD2 .
                OR
 THE RATE AT WHICH CONSUMER SUBSTITUTE GOOD1 FOR GOOD2 IS KNOWN AS MARGINAL RATE OF SUBSTITUTION.

DIMINISHING MARGINAL RATE OF SUBSTITUTION
 THR RATE AT WHICH CONSUMER SUBSTITUTE ONE UNIT OF GOOD1 WITH GOOD2 DIMINISHES AS HE INCRESES THE CONSUMPTION OF GOOD1.

u GOOD1        GOOD2          MRS
u     1                 20                 -
u     2                 14                6
u     3                  9                 5
u     4                  5                 4  
u     5                  2                 3

AMONG THESE BUNDLES (1,20) (2,14) (3,9)  (4,5)  AND  (5,2)
THE CONSUMER WILL BE INDIFFERENT AS ONE GOOD IS INCREASING BUT OTHER IS DIMINISHING.ALL {EACH OF} THESE BUNDLES (1,20) (2,14) (3,9)  (4,5)  AND  (5,2) GIVES CONSUMER THE SAME LEVEL OF SATISFACTION.
 INDIFFERENCE CURVE REPRESENTS ALL THOSE BUNDLES AMONG WHICH A CONSUMER REMAINS INDIFFERENT AND GETS THE SAME LEVEL OF SATISFACTION.

CONSUMER'S  EQUILIBRIUM

A CONSUMER IS IN EQUILIBRIUM WHERE THE BUDGET LINE IS TANGENT TO THE INDIFFERENCE  CURVE. IT MEANS THE PREFERENCES OF CONSUMER MATCH WITH HIS PURCHASING POWER. 
WHY SO ?
 WHY NOT AT THE POINTS  WHERE THE INDIFFERENCE CURVE INTERSECTS THE BUDGET LINE.

             POINTS A,B & C LIES ON THE SAME INDIFFERENCE CURVE.THIS MEANS ALL THESE POINTS GIVES SAME SATISFACTION TO CONSUMERS.THE EXPENDITURE ON BUNDLE  A AND B IS EQUAL TO THE INCOME AS THEY LIE ON BUDGET LINE. THE EXPENDITURE ON BUNDLE C COSTS LESS THAN INCOME AS THIS POINT LIES BELOW THE BUDGET LINE.
             NOW OUT OF A ,B &C WHAT THE CONSUMER WILL PREFER TO PURCHASE ?
             OFF COURSE C AS IT COSTS LESS THAN A OR B.
BUT THE CONSUMERS WANTS TO SPEND HIS ENTIRE INCOME. SO THE CONSUMER WILL SHIFT TO HIGHER INDIFFERENCE CURVE.
POINT D LIES ON HIGHER INDIFFERENCE CURVE AND IT ALSO COST EQUAL TO INCOME AS IT LIES ON BUDGET LINE .
            WHEN COMPARED WITH A AND B CONSUMER WILL PREFER D AS IT LIES ON HIGHER INDIFFERENCE CURVE.

Budget line tangent to IC curve
Slope of indifference curve = Slope of budget line
MRSxy = Px/Py

So we can say that the consumer is in equilibrium when marginal rate of substitution between two goods become equal to price ratio of those two goods.

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