Question 1.

Draw and analyze a diagram which shows the solution to the consumer’s optimization
Problem. You should clearly explain what your diagram shows and the nature of the optimal solution.
Use any two goals for your diagram. (In our case we prefer to use Good-X and Good-Y)

The diagram displays an indifference curve map, where each indifference curve represents the
combinations of Goods X and Y that offer the consumer the same level of utility. The budget
constraint line represents the various combinations of Goods X and Y that the consumer can
afford, taking into account their income and the prices of the two goods. The point at which the
highest attainable indifference curve is tangent to the budget constraint line, signifying the
combination of Goods X and Y that maximizes the consumer's utility given their constraints.

At the optimal solution:

1. The customer has reached the highest utility level within their budget; that is, they are on the
highest possible indifference curve.
2. The slope of the budget constraint line (the ratio of the prices of Goods X and Y) and the slope
of the indifference curve (the consumer's marginal rate of substitution) are equal.
3. Because they have reached the point of tangency between the budget limitation and the
indifference curve, the consumer is unable to raise their utility by reallocating their expenditure
on Goods X and Y.

The nature of the optimal solution is that, given their financial constraints, the customer has
maximized their use of Goods X and Y to reach the highest utility level. The consumer's
equilibrium, where they lack motivation to alter their consumption behavior, is represented by
this point of tangency.
We can examine how shifts in income, prices, or preferences might impact customer choices
about what to buy and the equilibrium point that results by comprehending this ideal solution.

1
Question 2. Draw a new diagram illustrating the effects of price change in one of the two goods above
and analyze how it can be broken down into substitution and income effect

The budget line moves to PL2 when the cost of good X decreases. The consumer can so purchase
more of both commodities as his real income increases. The consumer reaches equilibrium at
point R on the higher indifference curve IC2, forming a new budget line PL2. The budget line
now swings to AB, which is parallel drawn to PL2, when income is lowered by the
compensatory variation, forcing consumers to return to IC1 and more goods X because X is now
comparably cheaper than before. Because X is now comparatively less expensive than Y,
consumer income has decreased and they are substituting X for Y by purchasing more X. As a
result, the substitution impact that results from a change in relative prices is represented by the
movement from Q to S on the same indifference curve (IC1). The income effect causes him to
move from S to R on the indifference curve (IC2) and to rise higher as consumer income
increases. As a result, the price effect-driven shift from Q to R splits into two parts: the
substitution effect from Q to S and the income effect from S to R.

2
Question 3. Pick the special offer that you have observed and analyze how it may impact the
consumer behavior. What is the purpose of the deal from the producer’s perspectives? Ensure
that your answer is clear about the ideas from the course you are using.
Special offer: Price Reduction on Good X

Impact on consumer behavior

Substitution Effect: Good X is comparatively less expensive than Good Y when its price drops. Customers
are more likely to use Good X as a result of this pricing change than Good Y. The initial indifference curve
(IC1) shows a shift from point Q to point S as consumers take advantage of the decreased price to
maximize their utility Krainer (2024).

Income Effect: The consumer's real income increases as a result of Good X's price reduction, enabling
them to buy more of both goods. Customers' overall utility increases when they migrate from point S on
the lower indifference curve (IC1) to point R on the higher indifference curve (IC2) due to their increased
purchasing power (2024). Thus, there is a greater consumption of Good X and possibly even more of
Good Y as a result of the interaction between substitution and income effects.

Producer’s Perspective

Increase in Sales Volume: In order to increase sales volume, producers lower the price of Good
X. The substitution impact increases overall sales by encouraging buyers to buy more Good X
than alternatives. By leveraging consumer behavior, this tactic effectively increases sales
volumes.

Market Share and Customer Loyalty: Reducing prices can boost sales by drawing in new clients
and motivating current ones to come back for more. This can increase market share and cultivate
a loyal customer base. Manufacturers can stand out from the competition and develop a devoted
following by providing a more alluring price point.

Inventory and Capacity Utilization: Lower prices facilitate the removal of excess inventory and
maximize the use of available production capacity Mohamed (2024/2024). This tactic guarantees
that manufacturing facilities are used effectively, preventing the accumulation of inventory and
possibly lowering production costs by cutting waste.

In order to affect consumer behavior, increase sales, and achieve market goals, producers
deliberately lower their prices. This strategy improves overall corporate performance by
matching inventory and production management to market demand Patel (2024).

3
 References

Krainer, R. (2024). Asset Pricing and the Structure of Production: Austrian Macroeconomic

Theory and Policy. Social Science Research Network.

https://doi.org/10.2139/ssrn.4781873

Mohamed, A. E. (2024). Inventory Management. In www.intechopen.com. IntechOpen.

https://www.intechopen.com/online-first/88430 (Original work published 2024)

Patel, P. C. (2024). The impact of trademark intensity on firm performance: Unraveling the role

of product market competition, total factor productivity, and SG&A efficiency. MDE.

Managerial and Decision Economics/Managerial and Decision Economics.

https://doi.org/10.1002/mde.4247

(2024, May 21). Githubusercontent.com.

https://raw.githubusercontent.com/hubchev/hubchev.github.io/main/me/_main.pdf