Department of Economics

Bangladesh University of Professionals

CTIII: Assignment

Course Name: Principles of Microeconomics

Course Code: ECON 1101

Submitted to:
Professor Asrarul Islam Chowdhury
Adjunct Faculty
Dept. of Economics
Faculty of Arts and Social Sciences (FASS)
Bangladesh University of Professionals (BUP)

Submitted by:
NAME: Mohammad Sazid Hossain
Roll no: 2014881025
ID no: 20010917
BSS (1st Semester), Session: 19-20
Department of Economics
Bangladesh University of Professionals

Last Date of Submission: Monday, June 15, 2020: By email: asrarul@juniv.edu

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CT III. Que 1:
A household consumes two goods X and Y whose prices are PX and PY respectively. The
income of the household for a single period is M. Interpret the following:
a. How much does the household spend on X and how much on Y?
b. What is the total expenditure of the household?
c. What do the following imply: PXX+PYY<M; PXX+PYY>M; and
PXX+PYY=M? Show each of the constraints in separate graphs.
d. Why does the consumer model assume no savings and no dis-savings?

ANSWER:

a. X and Y goods have prices Px and Py respectively. M is the income. The

household’s expenditure on X = (Price of X) * (Quantity of X)
The household’s expenditure on Y = (Price of Y) * (Quantity of Y)
So, the expenditure of X = PxX and the expenditure of Y = PyY

b. From a. we get, expenditure on X and Y are respectively, PxX and

PyY. So, Total expenditure = PxX + PyY
Budget constraint, PxX + PyY ≤ M

c.

Fig. 1

Here in fig.1, point D within the budget constraint is affordable, not all is spent.
When total expenditure is greater than the total budget; PXX+PYY<M

Fig. 2

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Here in fig. 2, point E is outside the budget constraint which means consumption is
bigger than the budget. When total expenditure is greater than the total budget;
PXX+PYY>M, the household is surpassing income limit.

Fig. 3
Here in fig. 3, point C is on the budget line, any bundle on this line is affordable and
assures all the budget is spent. When total expenditure is equal to budget,
PXX+PYY=M; this means there were neither surplus nor shortage of the budget.

d. The budget line is PXX+PYY=M. This means there is neither any saving nor dis-
savings.
Consumers always tend to spend their income on the optimum bundle which
gets them maximum utility. If the consumers spends all of his allocated budget
or income on buying goods, it means no savings are made. This also means there
are no dis-savings since no extra money is used for consumption.
The choices of expenditure depend on preferences and costs. For example, some
consumers have low food costs and therefore, they’ll be more likely to take
advantages of the saved portion of the budget, while other consumers may have
lower shortage and food costs and thus will take greater advantage opportunities
through discount offers or temporary price reduction.

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CTIII. Que 2:
A household consumes two goods X and Y whose prices are PX and PY respectively. The
income of the household for a single period is M. The budget constraint is: PXX+PYY=M.
a. Determine the slope of the budget constraint. Interpret in a graph.
b. Why does the slope of the budget constraint (PX/PY) show relative prices?
c. What happens to the choice set when M increases and when M decreases,
ceteris paribus? What happens to relative prices? Interpret in a graph.
d. What happens to the choice set when PX increases and when PX decreases,
ceteris paribus? What happens to relative prices? Interpret in a graph.
e. Do 12(d) for an increase in PY and a decrease in PY. Interpret in a graph.
f. PXX+PYY=M determines the household will locate on the budget line.
What determines which point on the budget line the household will
locate? If one of the two goods (X or Y) is religiously forbidden food, how
will you interpret a household’s allocation of its budget in a graph?

ANSWER:
A. Slope of a budget constraint represents how much of the goods(X) the consumer
must be give up in order to be able to afford more of the other good (Y)
Given budget constraint → PXX+PYY=M.
Exponent budget constraint X, Y = 1. Thus, PXX+PYY=M is a straight line.
Re-Arranging the equation, we get,
→ PYY = - PXX + M
→Y = -X (Px/Py) + M
Comparing the equation with Y = mx+c, we get, Slope ∆Y/∆X = - (Px/Py)

Fig. 1
The Slope determines how much Y consumer substitutes for an extra X

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B. A relative price of the commodity such as good or service in terms of another; i.e.
the ratio of two prices. Slop of a budget constraint is nothing but the price ratio of two
goods that we show on X and Y axis. Here, the slope represents how many of the goods
on Y axis the consumer must give up in order to be able to one more of the goods on X
axis, which is similar to the concept of relative price.
C. When M changes, parallel shift of budget line occurs.
 When M increases, it causes the constraint to shift outwards in a parallel manner,
thereby enlarging the budget set, and improving choice. Higher income gives
more consumption choices.

Fig. 2
 When M decreases, it causes the constraint to shift inwards in a parallel way,
thereby shrinking the budget set and reducing choice. Lower income makes the
new budget set smaller.

Fig. 3
Here, the relative price respond both positively and negative depending on the
change in income. If income rises, and the consumer is prone towards buying the
more expensive good, it is a normal good, again, as demand declines for the
other good, it becomes inferior good. A small fall in income results in consumer
buying the affordable good.
D. As real income increases, consumer can buy more, X and Y due to Px ↓.
Since X is cheaper, X is new more attractive than Y. Thus more X more than Y, but more
of both X and Y.

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 Fig. 4
Here, at Y intercept, Py remains unchanged. Due to decrease in Px, Slope (Px/Py) also
decreases, i.e. budget line flattens out.
E.
I. Py increases, consumers have less money to spend, cannot afford much of X and
Y. Good X is cheaper compared to good Y, pushes the pivot inward.

Fig. 5
II. Py decreases, consumers get more choices and can buy more of both X and Y
goods, causing the pivot to move outward.

Fig. 6.

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F.

Here AB represents the budget line, PxX+ PyY = M

∆OAB represent the opportunity set, PxX+PyY <M.
Given, (Px, Py), M,
C → on the budget line; budget spent (no savings nor dis-savings)
D → within budget line; budget spent (savings earned)
E → away from budget line; not possible (exceeds allocated budget)
Again, in case of one of the goods being forbidden, we allocate our whole budget on
one good only.
Suppose, X axis shows approved food and Y axis shows forbidden food in a particular
country. In terms of this case, we’ll spend all our income on X only no matter what the
price is as Y is forbidden.
In Economics, this is known as corner solution. Because we’re maximizing our utility
along one-axis and making zero consumption along the other axis.

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CTIII. Que 3:
3A: As a household consumes more and more of a good X why does total utility
increase but marginal utility gradually decrease? Interpret with a graph.
3B: A household consumes two goods X and Y whose prices are PX and PY respectively.
Why does (MUX/PX) = (MUY/PY) indicate consumer equilibrium? Interpret with logic
and intuition.
3C: Why does a demand curve slope downwards?
ANSWER: 3A. Total Utility is a combined measure of satisfaction gained from
consumption whereas Marginal Utility is a measure of the change in satisfaction gained
from consumption as a result of a change in consumption. Marginal utility always
decreases for each successive quantity of consumption of a good. And total utility
increases with the increasing quantity of a particular item until the marginal utility
becomes zero. The total utility declines when marginal utility becomes negative.
Let’s look at the following example.

Quantity Total Marginal

Consumed(X Utility Utility
) (Tux) (Mux)
1st Candy 10 10

2nd Candy 16 6

3rd Candy 18 2

As X↑, Tux ↑, But Mux ↓

Here, we can see for the first candy the marginal utility is 10, but as the individual
consumes more, his/her utility decreases. It’s because the more an individual
consumes, the less his/her satisfaction is.

Fig. Total Utility Curve

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 Fig. Marginal Utility Curve

3B. The utility maximization rule states the principle of equating the marginal utility
(MU) of X (or Y) to its price Px (or Py) for all goods.
With two goods X and Y and its prices Px and Py, the rule becomes Mux/Px = MUy/Py
Mux/Px = Marginal utility from X in terms of its price. I.e. Mux is benefit, Px is cost.
So, Mux/Px is a benefit cost ratio of X.
Similarly, MUy/Py is the benefit cost ratio of Y.
At equilibrium, Mux/Px = MUy/Py
If the equilibrium condition doesn’t hold, we see two seconds,

 Mux/Px>MUy/Py
Px and Py are constant, Mux > MUy
High marginal utility, MUy indicates consumption of Y in low quantity.
Low marginal utility, MUy indicates consumption of Y in high quantity.
In this case, if we reallocate X and Y, i.e. if we increase consumption of X, Mux become
high. The re-allocations keep going until it reaches equilibrium.

 Mux/Px < MUy/Py

Px and Py are constant, Mux < MUy
MUx is low: Consumption of X is high.
MUy is high: Consumption of Y is low.
X and Y needs reallocation till Mux/Px = MUy/Py
In equilibrium, Mux/Px = MUy/Py

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i.e. benefit ratio of X is equal to the benefit-cost ratio of Y. There is no need for re-
allocation.

3C. From, law of demand we know that, when price fall the quantity demanded of a
commodity rises and vice versa, ceteris paribus. Hence, demand curve slopes
downward to the right.
In economics, a demand curve is a graph which depicts the relationship between the
price of a certain commodity (y axis) and quantity (x axis) of that commodity.
The demand slope of a demand curve is downwards because of the law of diminishing
marginal utility. The more we consume any good, the less utility we get for additional
unit.

From the Fig. Marginal Utility Curve above, we see the marginal utility is higher for
initial unit. But as the consumption increases, the demand falls. We pay higher price for
the first unit of a commodity. But for each additional units of consumption, we pay less,
thus our marginal utility decreases. Since, we already fulfilled some of our need from
first unit of consumption.
This means the demand curve slope downwards.

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