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

A consumer maximises utility from two goods with a standard convex indifference map and a linear budget line, and chooses an interior point. Which condition holds at the optimum?

At an interior optimum the indifference curve is tangent to the budget line, so the marginal rate of substitution equals the price ratio. The consumer cannot reach a higher curve, and marginal utility per rupee is equal across the two goods.

  1. AThe marginal rate of substitution equals the ratio of the goods' pricesCorrect
  2. BTotal expenditure on each good is equal
  3. CThe marginal utilities of the two goods are equal
  4. DThe indifference curve cuts the budget line at that point
  5. The marginal rate of substitution equals the ratio of the quantities consumed

Explanation

At an interior optimum the indifference curve is tangent to the budget line, so the slope of the indifference curve (MRS) equals the price ratio. This means MU of X over price of X equals MU of Y over price of Y. Option 3 describes a non-optimal crossing point, since the consumer could reach a higher curve.

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