Question 4

The indifference curve below shows Abby's preferences between massage and physiotherapy.

(a)Briefly describe what is meant by the marginal rate of substitution (MRS) between two goods.

(b)If Abby has a budget of $2000 to spend on these two goods and the price of physiotherapy is $80 an hour and the price of massage is $100 per hour, show the budget constraint on the diagram and estimate how much of each service Abby will consume.

(c)Imagine Abby purchases private health insurance and the annual premium costs $200. This implies that she now only has $1800 ($2000-$200) to spend. Her private health insurance fund will subsidise her physiotherapy by $20 per hourly session and her massages by $10 per hourly session.

i.Use the diagram to explain what would happen to Abby's budget constraint

ii.Under the new budget constraint, would Abby be able to obtain a higher level of utility compared to indifference curve 1?