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Subject 4. Consumer Equilibrium: Maximizing Utility Subject to the Budget Constraint

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The budget constraint line separates consumption bundles that are attainable from those that are unattainable. A consumer will maximise utility by consuming on the highest possible indifference curve (i.e., we assume all income is spent). This is where an indifference curve is tangent to the highest possible budget line.

A consumer could consume at G, for example, but would be on a higher indifference curve at H. This means that to maximise utility the consumer would consume Q1 of product A and Q2 of product B.

The consumer is maximising utility where the budget line and indifference curve are tangent, i.e., MUB/MUA = PB/PA.

An Increase in Income

An increase in income shifts the budget line out parallel. The new combinations of products that maximise utility can be identified.

If this is a normal good, an increase in income increases the quantity demanded.

Inferior goods have a negative income elasticity of demand. Demand falls as income rises.

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