Question

Refer to the diagram given below and answer the questions that follow.

1. What does the line AB represent? Why is the line AB negatively sloped? (2)
2. At which one of the given points, D, E and F, will the consumer attain equilibrium? Explain. (2)
3. Briefly explain why the consumer is not in equilibrium at the other two points. (2)

Answer 1

1. The "AB" line depends on the consumer's budget line. The budget line is negatively sloping because it reflects the trade-off between two items; because income is fixed, a customer must buy less of the other goods at fixed prices in order to afford more of one.
2. The consumer will reach equilibrium at point E, where the budget line AB is tangent to the Indifference Curve IC₂. To maximum satisfaction, the consumer purchases OM units of commodity X and OL units of commodity Y. There are two equilibrium conditions:
   1. Slope of IC = Slope of Budget Line
   2. Diminishing MRS
      At point E, we are satisfied. All other points to the left or right of Budget Line are in disequilibrium.
3. The customer is not in equilibrium at point F because, despite having a greater IC, it is outside the consumer's current income level.
   The consumer is not in equilibrium at D because the marginal rate of substitution is less than the slope of the budget line, therefore the consumer is ready to give up very few units of Y to buy an extra unit of X commodity than the market requires. In other words, the customer values X commodity lower than its market worth. It drives consumers to buy less of X and more of Y, causing MRS to rise and the process continues again till MRS = slope of budget line.