Question

Explain the reaction of the consumer when Price Ratio (or Market Rate of Exchange) is higher than Marginal Rate of Substitution.

Answer 1

When the Price Ratio (Market Rate of Exchange) is higher than the Marginal Rate of Substitution, the consumer is not in equilibrium.

\[ MRS_{XY}<\frac{P_X}{P_Y} \]

The consumer is willing to sacrifice fewer units of Good Y for one additional unit of Good X than the market requires.

Therefore, the consumer will decrease the consumption of Good X and increase the consumption of Good Y.

This adjustment will continue until the Marginal Rate of Substitution becomes equal to the Price Ratio.