A consumer consumes only two goods x and y at a consumption level of these two goods he finds that the marginal rate of substitution is higher than the ratio of the prices explain the reaction of the consumer
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11th
Economics
Consumer Equilibrium and Demand
Consumer Equilibrium
Marginal rate of substituti...
ECONOMICS
Marginal rate of substitution of X for Y is higher than the ratio of prices. Explain the reaction of the consumer in this situation.
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ANSWER
A consumer strikes his equilibrium when MRS
XY
=
P
Y
P
X
.
In a situation when MRS
XY
>
P
Y
P
X
, equilibrium of the consumer is disturbed. On the assumption that
P
Y
P
X
remains constant (and also, income of the consumer is constant) equilibrium can be struck only when MRS
XY
starts falling and becomes equal to
P
Y
P
X
. This happens only when the consumer starts consuming more of X in place of Y. That is, he moves downward to the right along the IC. Convexity of the IC ensures that as the consumer moves downward to the right along his IC, MRS
XY
, tends to fall. Briefly, when MRS
XY
>
P
Y
P
X
the consumer would react to this situation by substituting X for Y so that MRS
XY
, declines and becomes equal to price ratio.