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IAI Actuarial Core Principles · Business Economics · Consumer demand and behaviour

A consumer maximises utility by spending a fixed income on goods X and Y. Price of X is Rs 20 and price of Y is Rs 50. At her current bundle, marginal utility of X is 30 utils and marginal utility of Y is 50 utils. What should she do to raise total utility?

She should buy more X and less Y. Marginal utility per rupee is 1.5 for X (30/20) against 1.0 for Y (50/50). Shifting spending to the good with higher utility per rupee raises total utility until the ratios equalise.

  1. ABuy more Y and less X, because MU per rupee is higher for Y
  2. BBuy more X and less Y, because MU per rupee is higher for XCorrect
  3. CChange nothing, because she is already in equilibrium
  4. DBuy more of both goods, because MU is positive
  5. Buy more Y, because its marginal utility is higher in absolute terms and its price is higher

Explanation

Compare MU per rupee: X gives 30/20=1.5 and Y gives 50/50=1.0. Since X gives more utility per rupee, she should shift spending toward X until the ratios equalise. Comparing raw marginal utilities ignores prices, which is the error in the Y option.

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